New York Times on Merrill's Risk Management

The New York Times has an odd piece today, "Where Did the Buck Stop at Merrill?" which seeks to determine whether the unexpectedly $8.4 billion third-quarter writeoff was not just former CEO Stanley O"Neal's failing, but also one of Merrill's board. Another shoe may be about to drop, since the Wall Street Journal claimed that Merrill may have engaged in transactions with hedge funds designed to hide losses (note that the Financial Times says that the transactions could be kosher).

The piece doesn't give a clear picture of what the board's role should be (in fairness, there are differences of opinion here), and therefore can't answer the question posed in its headline.

Now, generally speaking, the board's responsibilities include hiring the CEO, reviewing his performance, and making sure there is a succession plan and overall organizational planning; helping set broad policies; providing for fiscal accountability and assuring that there are adequate resources and funding.

Although the article is loath to reach a conclusion, it appears the board wasn't on top of things. My sources tell me O'Neal was nearly forced out in 2004 over the turnover in the top ranks and the lack of any internal replacement. The New York Times also indicates that continuity within the board was an issue:

Nell Minow, editor of the Corporate Library, an independent research firm that rates company boards, said her company had expressed strong concern about the Merrill board for several years, citing, among other things, high turnover and the possibility that newcomers were not asking tough questions. In addition, she said that there was very low share ownership among directors, and “that’s a big red flag about motivation.”

But the far bigger failing was in the risk management area. Unlike most other Wall Street firms, until September, Merrill did not have a head of risk management. And the New York Times has some crucial info but failed to connect the dots:

The particular responsibility for risk oversight and control at Merrill lay with its finance committee — a four-member group headed by Charles O. Rossotti, former chairman and chief executive of American Management Systems, and a senior adviser to the Carlyle Group, the private investment firm. Other members of the committee include Ann N. Reese, a former chief financial officer at the ITT Corporation; John D. Finnegan, chief executive of the Chubb Corporation; and Alberto Cribiore, an executive at a private equity firm....

Merrill’s proxy statement says that its finance committee among other things, “reviews, recommends, and approves policies and procedures regarding financial commitments and investments.” It also “reviews our policies and procedures for managing exposure to market and credit risk, and when appropriate, reviews significant risk exposure.”

But while the finance committee has the main responsibility for risk oversight, another group, Merrill’s four-member audit committee, also shares some responsibility for overseeing risk policies.

Ms. Reese and Mr. Rossotti serve on the audit committee, along with Joseph W. Prueher, a former United States ambassador to China, and Judith Mayhew Jonas, a New Zealand academic who has experience running London’s financial district.

None of these board members had any experience in trading businesses. The closest was John Finnegan of Chubb, since insurers have sizable investment operations, but their time horizons, frequency of trading, and risk appetite are very different from that of a securities firm.

If I were in the board's shoes, I would have engaged a risk management guru, or maybe even two, to bring them to a common understanding of modern practice and key issues. And it's also an accepted practice among boards to do "probes," that is, interview people in the organization up and down the line, on key issues (and note that savvy boards get an org chart and pick their own interviewees, rather than have the executives make the choice).

Hindsight is always 20/20, but it still appears Merrill's board ought to have been more proactive, particularly as the credit contraction progressed.

Maybe Your Humble Blogger Needs a Break (Updates du Jour)

Maybe I am getting a bit burned out. I almost took a night off because I couldn't get worked up as I normally do about the stories du jour.

Yes, Chuck Prince is expected to resign on Sunday. I'm surprised he lasted this long. He was over when he made his now-infamous remark:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Mind you, this wasn't pre-March 2007, when everything looked rosy. This was in July, when the cracks had started to appear and after the Bear hedge fund crisis. That sort of comment is a hubristic death wish, a willful defiance of the warnings. And the odds most assuredly caught up with Prince.

But for my money, the juicier bit in the Wall Street Journal story on Prince's imminent departure is that Citi may take further writedowns:

People familiar with the matter said the Securities and Exchange Commission is looking into the bank's accounting for its off-balance sheet investment funds that have recently attracted scrutiny.....

The board is expected to discuss whether Citigroup should update the amount of write-downs that it has taken on certain securities to reflect their deteriorating value, according to people familiar with the matter.

The issue has generated intense discussion in the bank's senior ranks in recent days and could potentially result in a significant addition to the $3.55 billion capital-markets hit to third-quarter earnings that Citigroup announced just three weeks ago. The company is expected to file a quarterly report with the SEC next week.

Citigroup is the largest player in the $350 billion SIV market, managing seven of these off-balance sheet vehicles that hold a combined $80 billion in assets. SIVs have issued short-term debt to investors such as money-market funds while buying mortgage-backed securities and other assets that carry a higher yield.

"Citi is confident that its SIV accounting is proper and in thorough accordance with all applicable rules and regulations," said Christina Pretto, a bank spokeswoman.

The SEC's review of Citigroup is in the early stages, people familiar with it said. The result could range from no action to a referral to the agency's enforcement division. The SEC is also taking a broad look at how brokerage firms valued assets tied to high-risk mortgages and whether they were timely in their disclosure of losses to investors, people familiar with the matter say.

There has also been surprisingly little discussion of the lack of bench depth at Citi and Merrill. Prince was a weak choice for CEO. For example, Sallie Krawcheck, the former CFO, now head of wealth management, has been given what amount to battlefield promotions. She may be talented enough to pull it off, but she does not have a depth of managerial experience (her stint at as the head of the newly constituted Smith Barney cum research and brokerage operation was relatively brief). Similarly, Vikram Pandit, the new head of investment banking, is undeniably able, but is now supervising some important businesses that lie outside his trading-area expertise.

To Merrill. Bloomberg claims that Stan O'Neal's exit package is one of the five largest and is stoking Congressional ire. However, the proposed measures, to give shareholders more say on pay, is certain to have no impact. Diffuse and largely disenfranchised owners are no match (save when enough team up to wage an effective proxy battle) for comp consultants and craven boards who are nominated by management and therefore beholden.

As for the bombshell that Merrill may have parked securities with hedge funds to delay the reporting of losses, the Financial Times reports that there may be nothing untoward about Merrill's actions:

Experts said that, without further details, it was hard to determine how such a transaction would have differed from a standard commercial paper funding arrangement, other than that it involved a hedge fund. Hedge funds are not typically buyers of commercial paper.

Many banks which underwrite collateralised debt obligations use off-balance sheet vehicles in which to hold the underlying mortgage-backed securities.

The vehicles are funded by issuing commercial paper for which the banks often provide so-called liquidity back-ups. This means the banks commit to buy the paper if other purchasers cannot be found when it comes due.

“It looks just like selling commercial paper with a liquidity facility,” said an analyst at a rating agency.

Whether the Journal's charges are borne out, we still have the other Merrill eruption, namely, the Deutshce Bank estimate that it still have losses to take of $10 billion:

Merrill Lynch & Co. fell the most in six years, leading financial stocks lower for a second day, after Deutsche Bank AG said the world's biggest brokerage may write down an additional $10 billion for losses on subprime assets.

``We have increasingly lost confidence in the financials of Merrill,'' Deutsche Bank analyst Michael Mayo said in a report today. ``Merrill may have additional credit rating downgrades'' should the New York-based firm be forced to write down the value of its debt holdings, Mayo said.

I assume that Bloomberg misquoted Mayo. Merrill can't possibly have $10 billion in losses on subprimes. since it has only $5.7 billion remaining. However, it has $15.2 billion in CDOs, and having almost assuredly sold the better ones (that's how it generally goes in a deteriorating market), the rest looks plenty vulnerable, particularly with CDO downgrades being announced by the rating agencies. We had guesstimated that next quarter losses could exceed $7 billion, and Mayo's figures are plausible.

Other observers suggested the alleged transaction might have involved the hedge fund buying the underlying assets with a guarantee from Merrill that they would be bought back in a year’s time at a set price. One expert said that on the surface this resembled a standard “repo” funding arrangement.

Similarly, we could have written about one of our favorite topics, phony government stats, but that has been ably covered elsewhere. The 3.9% GDP release was a complete crock, and Barry Ritholtz jumped on it right away:

At the risk of sounding shrill, I am compelled to point out the quantum bogosity of this 3.9% GDP number: It is highly dependent upon a rather suspect reading of Price Increases/Indexes for Gross Domestic Product: The Price Deflator rose a much less than expected .8% vs expectations of 2%.

The increase in real GDP in the third quarter reflected positive contributions from personal consumption expenditures (PCE), exports, federal government spending, equipment and software, nonresidential structures, private inventory investment, and state and local government spending that were partly offset by a negative contribution from residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.

The slight acceleration in real GDP growth in the third quarter primarily reflected accelerations in PCE and in exports that were partly offset by an upturn in imports, a larger decrease in residential fixed investment, and a deceleration in nonresidential structures.

Price Indexes for Gross Domestic Product was an astounding low 0.8% (Table 4). In other words, this report benefited as much from higher inflation as it did from true growth.

I obviously take issue with that (as Crude Oil crosses $94 for the first time).

To highlight the impact that this 0.8% price gain had on the reported REAL GDP: that 0.8% gain matches a level last seen in 1998; prior to that, the previous deflator gain of .8% was n 1963.

Similarly, the non-farm payrolls report Friday, which showed an increase of 186,000, was also rubbish. As Michael Shedlock tells us:

The overall numbers look OK on the surface but once again the devil is in the details.

Manufacturing shed another 21,000 jobs this month and continues to lose jobs every month.
Government added 36,000 useless workers.
Leisure and hospitality (typically very low paying jobs) added 56,000 jobs.

But we get back to our usual culprit, the birth-death model, which is a statistical plug to allow for job gains or losses at businesses either so newly created or folded as to not show up in the stats. It has been a source of dubious adjustments for months running. Back to Shedlock:

The BLS has shown a net gain of jobs added to new businesses in both construction and financial activities nine consecutive months from February through October.

The BLS is assuming not only that jobs were added, but that new unaccounted construction businesses were created in this environment where business capex spending has been weak, housing has been horrid, and over 170 lenders have gone out of business or stopped writing loans since last December as per the Mortgage Lender Implode-O-Meter.

Clearly this is reporting from an alternate universe.

A note of caution: One cannot take the birth death adjustments and subtract them from the reported numbers because one set of numbers is seasonally adjusted and the other is not.

Finally, we have been following what so far appears to be an underrreported story, namely, the tsuris of the mortgage guarantors, which include AAA so-called monoline insurers like Ambac and MGIC (see here and here). Elaine Meinel Supkis, who is eccentric, conspiracy minded (which appeals to me even when she is wrong, although she is most often right), and obsessive in her trolling for information, has a very lengthy and very good post, "Bond Insurers Are Going Bankrupt Now." This is going to be important, and her entire post is worth reading. Some excerpts:

From Reuters:

Credit derivative traders are valuing bond insurers Ambac Financial Group (ABK.N: Quote, Profile , Research) and MBIA Inc (MBI.N: Quote, Profile , Research) as deep junk credits, while their stock prices have also plunged on concerns the companies may need more capital to shore up their high ratings.
Credit default swaps on Ambac have surged to around 620 basis points, or $620,000 per year for five years to insure $10 million in debt, from 185 basis points a month ago, according to data provided by CMA DataVision.

Its shares have tumbled nearly 60 percent since the beginning of October, 41 percent this week alone.

Ambac and MBIA both reported third-quarter losses last week caused by their writing down the market value of their respective credit derivative portfolios, which are used to insure assets including residential mortgages against default.

This is a major failure. This is deep beneath the surface of the waters, like the Titanic ripping its hull underwater, these organizations we will visit tonight are similar: they are the hull of the banking system. They are the ones who are supposed to protect the banking system from failure and they are now failing, themselves. This is serious.....

Knowing this background, it is time to look at the effects of this major banking collapse which is bigger, I think, than the previous 3 banking collapses I have seen in the past.
href="http://news.yahoo.com/s/ft/20071102/bs_ft/fto110120072249061435;_ylt=Ajn8QQhKv6OkXw4APDGfuFb2ULEF">CDS traders warn of 'blood on streets'

Bond insurers, or monolines, were also hit hard.
"[These triple-A rated companies are] exposed to the crumbling housing market," said Gavan Nolan, an analyst at derivatives data provider Markit. "Investors in monolines will be waiting for the coming months of housing data with trepidation," Mr Nolan said. CDS on MBIA Insurance rocketed to a four-year high, of 345bp, CMA Datavision said.

Last week the insurer posted $36.6m net loss and halted its share buy-back programme. Contracts on the bond insurance unit of Ambac Financial climbed to a five-year high of 310bp. Gimme Credit, an independent research term, downgraded both MBIA and Ambac this week.

When the AAA rating is dropped, this means one has to pay a higher interest rate because one looks more and more like the bastard sons of Miz Risky, that wench, that wild female who sleeps around and parties all the time and who goes to Vegas at the drop of her panties, no one trusts Risky or her children! But all speculators love her to death. Insurance groups that are supposed to be hedging banks and lenders can't afford to look like Risky's kiddies, they have to appear sober and clean, not drunk and staggering about the place. But who is going to replace these organizations that messed up?

First, I would suggest they never had insured these CDOs and tranches in the first place. Like Moody's and others who also decided they wanted to play footsie with Risky, these guys threw caution to the winds and embraced an obvious old whore and kissed her and got the cooties. Yuck. Well, serves them right!

You have to love someone who has the nerve to write like that.

The Role of Emotion in Risk Assessment

PhysOrg.com reports on the results of a study funded by the National Science Foundation which looked into why people decide to live in homes in risky places, like coastal Florida and areas where wildfires are common. Answer: "the emotional benefits interfere with their ability to assess the risks."

What is surprising it that this finding is considered to be news. This phenomenon is well known in the psychological literature. Indeed, our colleague has a paper which will run in early 2008 in the Conference Board Review on the roots of excessive optimism in corporate settings. It turns out the human brain is not very well integrated. Our cerebral cortex (reasoning mind) sits on top of a limbic system (mamillian/emotional brain, social impulses) and an even older reptilian brain (basic drives: hunger, fight/flight, sex). For the vast majority of people, when the brain is in conflict, the older area wins. So we discount physical risk if it allows us to live in a gorgeous place we might otherwise not be able to afford. Similarly, the reptile brain will trump the mamillian/relationship brain. It's not hard to think of cases where sex gets in the way of prudence.

From PhysOrg.com:

Why do people live in places like southern California where homes intermingle with wooded areas and the risk of wildfire is so great? ....

"It's likely that people who live near heavily wooded areas in California focus on things they love about their location, like environmental beauty or proximity to the ocean, and simultaneously discount the risk of wildfire," said Jacqueline Meszaros, program director for decision, risk and management sciences at NSF.

Researchers found people link perceived risk and perceived benefit to emotional evaluations of a potential hazard. If people like an activity, they judge the risks as low. If people dislike an activity, they judge the risks as high. For example, people buy houses or cars they like and find emotionally attractive, then downplay risks associated with the purchase.

This may explain why people sometimes make seemingly irrational, high-risk decisions, such as settling along the coastline where there is greater vulnerability to earthquakes and hurricanes.

"One of the exciting things in the current generation of research is that emotional components of risk decisions are beginning to be understood in addition to other more established components," said Meszaros. "Turns out that emotions explain a fair amount of what surprises us about people and risks."

People also make decisions about risk based on how they feel about available information concerning a hazard. Interestingly, there was a great deal of information available about California wildfires before the events of October. A July 2007 study on California housing and wildland fires by researchers at the U.S. Forest Service, the U.S. Geological Survey and two U.S. Universities warned of possible problems.

The study found California has a large number of homes in or near highly wooded areas, has a high number of human-caused fires and has some of the most severe fire weather in the country. It also found most Californians live at lower elevations dominated by chaparral surveillances susceptible to frequent, high-intensity, crown fires.

"It's hard to say whether people knew of these findings, and if the findings figured into decisions about living in the area," said Meszaros. "But even if they had read the facts, we have a number of findings that suggest facts alone often are not enough to change peoples' perceptions of risks. People need to relate to those facts at an emotional level for risk judgments to be affected."

Providing "vivid information" about fire risks that engages emotional functions, not just rational ones, people theoretically would judge the risk of living near thickly wooded areas as higher. This could reduce serious public policy problems that result from emotional biases in risk perception and decision making.

Using the theory for certain types of risk communication might be important for city planners, who are considering allowing people to build in an area where there is a known risk. But not much is known yet about the dangers of presenting people with highly vivid information.

More is known about the conditions that lead people to discount vivid information and distrust the sender. For example, studies of fear appeals--such as certain anti-smoking advertising--suggests that some vivid messages can lead to undesirable responses. Certain fear messages may actually have led to more kids smoking.

Meszaros said scientists cannot forecast how many Californians are likely to rebuild in the same locations. She said scientists need better social and economic asset databases to test theories about things like disaster resilience, vulnerability and resettlement.

2005 Bankruptcy Reform: The Banks Got What They Wanted In More Ways Than One

The National Bureau of Economic Research has just published a new paper, "Bankruptcy Reform and Credit Cards" by Michelle J. White, which has a pretty distressing set of findings.

Readers may recall that that the bankruptcy law changes put into effect in October 2005 had been sought by the banking industry for years. They increased the cost of filing for bankruptcy, and considerably restricted access to Chapter 7 bankruptcies, in which debts in excess of non-retirement assets are wiped out and forced most borrowers into Chapter 13 (in which the borrower has to enter into a plan of repayment. Note that the law also made the assumptions for budgeting under Chapter 13 much tougher. This isn't a trivial issue. A cousin who is a bankruptcy lawyer describes the standard of living that the new law allows for to punitive and unrealistic (for example, most people could not eat on the amount allowed for food).

Not surprisingly, bankruptcy filings dropped sharply, from around 2 million in 2005 (a peak as many filed to get in under the old law) to 600,000 in 2006.

However, White found that the banks benefitted in another way:

....by making it harder for consumers to escape their debts, the new law dramatically reduced lenders' losses from default and bankruptcy. As a result, they started lending more, even to consumers with bad credit. Credit card debt increased more quickly during the past two years than at any time during the previous five years.

Consumers should have responded to the new harsher bankruptcy law by borrowing less, which would have lowered their risk of getting into financial distress. But not all consumers behaved in this rational way. Instead, many behaved shortsightedly and took advantage of the greater availability of credit to borrow more than they could easily handle --- ignoring the risk of financial distress. (Economists refer to this shortsighted behavior as "hyperbolic discounting" - consumers who are hyperbolic discounters intend to start paying off their debts immediately, but each month they consume too much and end up postponing repayment until the following month. So their debts steadily increase.)

The new bankruptcy law exacerbated the problem of shortsighted consumers borrowing too much, because it prevented many of them from using bankruptcy to limit their financial distress. Many consumers in financial distress are unable to file for bankruptcy under the new law, because they cannot afford the costs of filing, cannot meet the new paperwork requirements, or are ineligible. This means that their debts will not be discharged and they will remain vulnerable to creditors' collection calls and to wage garnishment that may take funds they need for basic necessities. Because of the new bankruptcy law, consumers can end up in deeper financial distress than would have been possible before 2005.

Survey evidence presented by White supports the idea that most debtors get into financial distress because of shortsighted behavior, rather than because they behave rationally but experience adverse events. In one survey of bankruptcy filers, 43 percent pointed to "high debt/misuse of credit cards" as their primary or secondary reason for filing. Another survey in 2006 found that two-thirds of those who sought credit counseling before filing for bankruptcy cited "poor money management/excessive spending" as the reason for their predicament, compared to only 31 percent who pointed to loss of income or medical bills.

White argues that lowering the costs of filing for bankruptcy would help debtors who are in the worst financial distress by making it easier for them to file. But changes in bankruptcy law cannot solve the basic problem of shortsighted consumers borrowing too much, since these consumers generally ignore the provisions of bankruptcy law until after they are in financial distress. Instead, White argues that changes in credit market and truth-in-lending regulation are more likely to work because they motivate lenders to lend less to the most vulnerable consumers.

Countries as Clubs

Today's dose of dealism comes from Willem Buiter, professor of European Political Economy at the London School of Economics, in his post, "Immigration as a Human Right."

As an aspiring and ultimately unsuccessful immigrant, having gotten prized and rare four-year Australian visa, but unable to pass the hurdles needed to obtain permanent residence, I am very much in agreement with Buiter's views. It is particularly peculiar that in America, a nation of immigrants, many are keen to close the gate behind them. I am bothered by the way illegal immigrants are demonized. They tend to be stereotyped as net drains on government resources, when the reverse is usually true. The ones I know first and second hand pay taxes and are afraid to use public services precisely because they risk being deported.

I don't recall where I read the tidbit, most likely in one of Niall Ferguson's works, but the beginning of the 20th century was the time of the greatest labor mobility in the history of the world. Countries may erect fences to restrict immigration, but with modern telecommunications and capital mobility, the jobs get offshored instead, so the benefits of immigration restrictions appear to accrue more to the politicians who promote them than to the citizens they represent.

From the Buiter via the Financial Times:

I have to declare an interest in the subject of immigration. I am an immigrant (born in the Netherlands), and so are my wife (USA), my son (Peru) and my daughter (Bolivia). We have currently 8 operational passports between the four of us (two British, two Dutch and four American). Even our two cats are foreign breeds – Maine Coon and Norwegian forest cat. Only the newts in our garden pond are truly British (I think).

I feel about nationalities/citizenship and passports the way I feel about underwear: always carry plenty of it, and change it regularly. I have been fortunate indeed in that nationality or citizenship have never been a constraint on what I have been able to do. I served as an external member of the Monetary Policy Committee of the Bank of England before I became a British citizen. I became Chair of the Netherlands Council of Economics Advisers when I no longer held Dutch citizenship.
From a normative point of view, I am with Philippe Legrain who believes that freedom of movement is a human right. For me, when it comes to the rights of nations and countries, libertarian political instincts combine with religious convictions: “The earth is the LORD's, and the fullness thereof; the world, and they that dwell therein”. Not: Britain for the British or Scotland for the Scots, or even British jobs for British workers. I do not recognise national property rights.

Indeed, I would go further than that, and admit to a visceral dislike of and contempt for all forms of nationalism and patriotism. I consider them regrettable historical accidents - manifestations of communal mental corruption that has too often exploded into collective madness, including violent confrontations and war. I recognise the historical reality and continuing significance of the nation state and the notion of 'country', just as I recognise the reality and continuing significance of the HIV virus and of AIDS. I allow for their existence, while hoping for and striving for their elimination.
I disagree with Martin when he says that a country is not just a set of institutions, but also a home, and that people have a right to decide who enters their (collective) home. I view a country as a club with a set of institutions and membership rules. The rules cannot be different for those born in the country (or related through kinship to people born in or resident in the country) than for those contemplating emigrating to that country. Anyone who is willing to abide by the membership rules has the right to join. Anyone also has the right to leave and to join any other club.

Under certain circumstances, exit taxes may be appropriate. These are, however, easily abused for opportunistic political ends, or to abrogate the right to leave. It is clear that, despite remittances and the prospect of eventual return to the country of origin, certain forms of emigration (a brain drain, the departure of qualified doctors and nurses, the exit of the most dynamic and youthful age cohorts) can do serious damage to the rights of those left behind. Whether compensation is due from the emigrant or from the government of the destination country is an interesting question.

Citizenship is, in my view, purely residence-based, and residence is a personal choice. It clearly makes sense, to avoid certain obvious free-rider or collective action problems, to link entitlement to some of the benefits of citizenship in a country to the duration of one’s residence there and/or to the magnitude of the contributions in cash (taxes) or in kind (compulsory military service, jury duty) one has made to the country.

I disagree with Mr. Legrain as regards some of his positive or factual statements about the consequences of immigration on the native population. There are certainly plenty of instances where these effects can be negative. Unskilled immigration into the UK may well bring in labour that is complementary to the labour of native skilled workers; it is likely to lower the wages of native unskilled workers, or to displace them altogether if wages are rigid downwards.

When immigrants are different from natives in appearance or speech, the diversity they bring can as easily become a problem as a benefit. On the Isle of Dogs in the London Borough of Tower Hamlets, where I lived for many years, the old native population, working class white Englanders left behind and marginalised when the docks left, co-existed badly with the large Bangladeshi immigrant community. The resulting resentment let to the first election of a BNP Councillor in a local election (in the ward where I lived, Millwall, in 1993). The two communities are brought together only by their shared dislike of the affluent yuppies that are the most recent immigrants into the area.

This is a huge topic and there are many loose ends. A key question for the ‘countries as open clubs’ view concerns the kind of membership rules that are legitimate. Clearly a rule for citizenship in a country that reproduced the BNP’s party membership requirement – restricting it to "indigenous British ethnic groups deriving from the class of ‘Indigenous Caucasian’" - would not be my cup of tea. I would begin by accepting only those clubs as legitimate whose membership rules (in theory and practice) respect the 1948 Universal Declaration of Human Rights. Beyond that, as long as immigrants impose no adverse rights externalities on natives (that is, as long as they do not infringe these same human rights), they should have the right to settle in the country. Absence of negative rights externalities is compatible with negative conventional externalities (adverse effects on the standard of living of natives, for instance). So it would not be an argument against immigration that it makes (some or even all) natives worse off. I recognise that, given the political governance realities of nation states, this moral argument will carry little practical weight.

If this policy of free migration were adopted by the EU, this could mean that, say, 150 million people might be queuing up to escape the low-lying areas of the Indian subcontinent and move to western Europe in less than a decade or so. In addition to great cultural gains and economic benefits for some of the natives (European landlords and those native European workers with skills complementary to those of the newcomers), this would no doubt also create massive disruption, congestion, overcrowding, urban decay and growth of shanty towns in parts of Western Europe, and to drastic declines in the standards of living of native European workers whose skills are rival with those of the immigrants. The immigrants themselves would on average be significantly better off, or they would not choose to come.

My position that the wellbeing and rights of actual and potential immigrants count neither more nor less than those of the native-born is of course not exactly the brick with which the house of modern nationhood is built. In the UK, as in the Netherlands and the US, vile and virulent anti-foreigner and anti-immigrant sentiment is never far from the surface. The pages of most of the UK tabloids drip with poison when they address immigration-related matters. The flames of xenophobia, racism, anti-foreigner hysteria and anti-immigrant psychosis are also regularly fanned by opportunistic and spineless politicians from both government and opposition parties, oblivious of the damage they do to the social fabric. Large-scale immigration has often provoked communal violence, and at times enduring civil conflict (as in Northern Ireland, Palestine/Israel, Sri Lanka, Tibet, and Assam).

Peaceful coexistence and mutual tolerance among diverse communities, and a significant degree of integration and assimilation are necessary for a ‘country as an open club’ to thrive. The British and Dutch models of multiculturalism, which have encouraged ethnic and religious apartheid, have failed. Something closer to the original American melting pot model is more likely to be successful.

Despite the shock and horror about the recent UK immigration numbers (and yes, it is a scandal that the data are so poor), the scale of recent immigration into the UK (4.8 million gross and 1.6 million net over the last 10 years according to the (unreliable) official figures) has certainly been manageable from the point of view of the natives. The net immigration of about 2.1 million expected between 2006 and 2016 also looks manageable, although it will exacerbate pressure on certain key scarce resources (housing, transportation infrastructure, health and education). We will have to pay somewhat higher taxes to provide the necessary infrastructure and public goods and services.

Immigration has made London the most interesting, diverse, exciting and creative city in the world. It is no longer be an English city, a British city, or even a European city in anything except a geographical sense, but it is the first true ‘worldcity’ or global city – an open city which belongs to all the people of the world. This is no doubt why the enemies of the open society, including the suicide bombers that have targeted it and may to so again, hate it so much. Those who don’t like what immigration has done and will continue to do to London or who feel threatened by it can, of course, under the 'countries as open clubs model', always move somewhere else in the European Union.

The late Harry Johnson, professor of economics at the LSE and the University of Chicago, used to say that the whole 'aid vs. trade' debate about how to promote development and eliminate poverty was just shadow boxing. If the rich, economically developed countries were serious about development and the elimination of global poverty, they would simply open their borders to all comers. He was right.

Day After the Rate Cut, Lobbying Begins for the Next One

I will confess to being cynical about the reporting in the Wall Street Journal. As we have noted repeatedly in the past, it generally goes overboard to stress the positive its market-related reporting. That says the reporters too often lack the time or savvy to go beyond their sources' spin.

Now Thursday was undeniably a bad day in the equity markets, and credit markets also exhibited "flight to quality" behavior. But while the New York Times attributed the reversal in part to fears about financial institutions triggered negative views about Citigroup and worries about other institutions, plus profit taking and "buy on rumor, sell on fact," the Wall Street Journal embarked on a wide-ranging review of credit market woes. This normally would be useful, except the Journal's first two sections are largely equity focused, despite the fact that the credit markets are worth more in aggregate. So the neglectful credit market coverage, with occasional bursts of catch-up like today, is probably confusing and may be alarming to mainstream readers.

And add to that the all too apparent subtext: the credit markets are fragile! The Fed funds rate is already calling for another rate cut in December!

Bernanke and the FOMC have no one but themselves to blame. Barry Ritholtz of The Big Picture called it:

This is brilliant:

"It's like monetary policy is being affected by the tantrums of Wall Street As every parent knows, the worst thing you can do is give in to a tantrum, because then you get five more of them."

-James Paulsen, chief investment officer at Wells Capital Management.

Looks like we are having a bit of a tantrum today . . .

In fairness, the Financial Times did tell us that things were pretty rocky:

Markets were so rattled that the New York Stock Exchange instituted trading curbs to prevent a wholesale sell-off. The Federal Reserve, which on Wednesday had hoped its 25 basis-point rate cut would ease financial conditions, injected $41bn in temporary reserves into the banking system – its biggest such move since September 2001. Meanwhile, the Vix index, a measure of equity market volatility known as Wall Street’s “fear guage”, rose 15 per cent.

But nevertheless, the Journal piece is disingenuous starting with its headline, "New Worries Grip Credit Markets."

Huh? These are not new worries. They are more acute versions of existing worries. But per above, they may seem new to readers by virtue of the Journal's intermittent coverage. And the Journal quickly, by the third paragraph, tells us that the markets don't buy what the Fed is selling:

The angst in the financial markets stood in contrast to the views Federal Reserve officials expressed Wednesday. They said their latest rate cut, combined with a more aggressive one in September, should help forestall negative fallout from credit market turmoil on the broader economy.

Shortly thereafter, there is a section on how the housing market is getting worse. This is not news to anyone who has been following housing closely. The fundamentals are lousy and there is no reason to expect a bottom before 2008, and that could be optimistic:

The worry is that the huge financial edifice that is built on top of the now-shaky mortgage market could weaken, potentially causing lenders to tighten up on loans and slowing the economy. Besides the problems with banks and brokers, there was evidence of more problems in the mortgage market. Mortgage-servicing companies, which collect payments from borrowers, said delinquency and prepayment data were worse than expected.

"Mortgages are still deteriorating at an accelerating pace, and that's scary," said Karen Weaver, global head of securitization research at Deutsche Bank AG. "We haven't come near a stabilization, and we expect things to get worse as the bulk of resets" of interest rates on adjustable-rate mortgages "have yet to come."

The percentage of subprime mortgages -- those to home buyers with weak credit -- that were more than 60 days behind in their mortgage payments topped 20% in August, up from 18.7% in July and 17.1% in June, according to latest data from FirstAmerican Loan Performance.

Meantime, home prices in many markets have slipped. They were down more than 4% in the month of August from a year ago, as measured by the S&P/Case-Shiller index. The weaker prices have prevented some borrowers from refinancing into new loans loans, and have reduced the value of the collateral backing mortgage loans and securities.

However, some of the estimates from experts and the markets on current conditions and updated estimates of losses are solid reporting. But the discussion of collateralized debt obliagations is confused, as the writers try to apply data from subprimes (the unmentioned-by-name ABX indexes) to CDOs, which are completely different instruments. The Markit TABX index is what passes as a proxy for heterogeneous CDOs:

Mark Zandi, an economist at Moody's Economy.com, estimates that of the $2.45 trillion in especially risky mortgages currently outstanding -- including subprime mortgages, interest-only mortgages, mortgages that exceed Fannie Mae lending limits and others -- as much as a quarter could suffer defaults in the months ahead. Total losses on these mortgages, he estimates, could reach $225 billion. That would hit bondholders hard, since the value of mortgage securities is driven by the performance of underlying mortgages. And it could make such bonds harder to sell in the future.

Many expect the value of homes to continue to slip as well. Mr. Zandi puts the drop at 10%, from the market's peak in the fourth quarter of 2005 to its projected bottom in the fourth quarter of 2008. That would be a decline that would wipe out more than $2 trillion in home values. That's less than the $7 trillion in stock wealth wiped out by the tech bust, but still would represent a significant hit to the economy.

Because mortgages are bundled into securities sold to investors all over the world, the deterioration in mortgages' value is having a widespread effect. Many of the more complex securities, known as collateralized debt obligations, or CDOs, are held by banks and brokerage firms. They've been the cause of much of the big losses at those institutions.

In CDOs, risk is portioned out to different groups of investors. Those willing to take the biggest risks buy securities with the highest potential returns, while investors who want more safety give up some return to get it. Already, the riskier "tranches" of CDOs have sunk dramatically in value. An index that tracks risky subprime bonds has fallen to a record low of 17.4 cents on the dollar, down 50% from August, according to Markit Group.

That decline, while worrisome, hit investors willing to take risk. But the recent turmoil stems from declines in the market for the safest securities. Rated triple-A, they should be affected by mortgage defaults only in extreme circumstances. An index that tracks triple-A securities is trading at 79 cents on the dollar, down from roughly 95 cents just a month ago.

At the top are "super senior tranches." It is a decline in value of these supposedly safe securities that is hurting many banks and brokerage firms.

In October alone, ratings firms Moody's InvestorsService, Fitch Ratings and Standard & Poor's have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. In a glimpse of how much banks have at stake, Swiss-based UBS holds more than $20 billion of super-senior tranches of CDOs. They're among the reasons UBS, which reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter....

Thursday, odds of another rate cut shot up again in the wake of the stock market's fall. Futures markets now perceive a December rate cut as slightly more likely than no change.

Paul De Grauwe: "Central banks should prick asset bubbles"

Paul De Grauwe, professor of economics at the University of Leuven, makes a persuasive and succinct case as to why central banks need to combat asset bubbles. Reading his argument, one might even wonder why the topic is controversial.

Yet it is. Beyond insuring the safety of the banking system, central bankers' mandates extend only to the real economy: promoting growth and containing inflation. For example, a January post quotes Fed governor Frederick Mishkin arguing that "this concern about burst bubbles may be overstated" and that central bankers cannot identify bubbles in the making.

One might argue, as De Grauwe does, that protecting the financial system requires the regulatory authorities to worry about asset price inflation. That viewpoint, however, has never been widely accepted, in aprt because moderate asset inflation makes everyone feel richer.

A former central banker, Australia's Ian Macfarlane, explains the conumdrum that heretofore constrained even those central bankers who recognized the dangers of runaway asset prices:

The biggest single challenge starts with the recognition that as an economy becomes more developed, its financial side grows a lot faster than its real side. As a result, economic outcomes will depend more on what happens in asset markets and less on what happens in the real side of the economy, such as in the goods and labour markets....If a major financial shock were to occur, such as a large fall in share or property prices, the effect on the economy would be greater than before.

So the central question is whether booms and busts in asset markets are more likely to occur in the future. No one knows, but there is no reason to believe that they will become less frequent or smaller....

If it is likely that asset price booms and busts will be at least as common as over the past two decades and that their effect on the economy will be larger, what can monetary policy do about it? There was a time when we felt that monetary policy, by returning the economy to low inflation, would have a stabilising effect on asset markets.... But the broader evidence does not support the view that low inflation will prevent booms and busts developing in asset markets....Some have even gone as far as to suggest that low inflation may encourage the build-up in asset prices.

So, if low inflation does not provide any insurance, what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?...

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community's wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not...In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed....

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy....

No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

Observe what a difference a few months of deleveraging-induced pain makes. The conseqences of ignoring asseet bubbles now seems so self-evident as to demand action.

From the Financial Times:

The credit crisis that hit the world economy in August teaches us many lessons about the workings of integrated financial markets. It also teaches us something about the responsibilities of central banks.

Until the crisis, the consensus view was that central banks should target inflation and that is pretty much all they should do. In this view, central banks should not target (or try to influence) asset prices either, as was stressed by the former Federal Reserve chairman Alan Greenspan, because central banks cannot recognise bubbles ex ante. Or, if they can, the macro economic consequences of bubbles and crashes are limited as long as central banks keep inflation on track. Inflation targeting, we were told, is the new best practice for central bankers that makes it unnecessary for them to try to influence asset prices.

The credit crisis has unveiled the fallacy of this hands-off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector and a central bank is not in the business of insuring private portfolios.

The problem that we have seen in the recent crisis is that the banking sectors were not insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. Since the banking system was implicated, the central banks were also heavily involved owing to the fact that they provide insurance to the banks as lender of last resort. Some may wish that central banks would abstain from supplying this insurance. However, central banks are forced to provide liquidity during a crisis because they are the only institutions capable of doing so. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected.

There is a second reason that the hands-off approach has been shown to be wanting. During the past few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long and, as a result, have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no super vision, just as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.

So, what should central banks do besides target inflation? First, central banks should recognise that asset bubbles are a source of concern and that they should act on the emergence of such a bubble. The argument that a bubble can never be recognised ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble. This is the case for most asset bubbles in history.

It has been argued that even if central banks can detect bubbles, they are pretty much powerless to stop them. This argument is unconvincing. It is not inherently more difficult to stop asset bubbles than it is to stop in flation. Central banks have been highly successful at stopping inflation.

Second, central banks should be involved in the supervision and regulation of all institutions that create credit and liquidity. The UK approach of dissociating monetary policy from banking supervision has not worked. Central banks are the only insurers against liquidity risks. Therefore they are the ones who should control those who create credit and liquidity. Failure to do so will continue to induce agents to create excessive amounts of liquidity, endangering the financial system.

The fashionable inflation-targeting view is a minimalist view of the responsibilities of a central bank. The central bank cannot avoid taking more responsibilities beyond inflation targeting. These include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.

New Credit Crunch Tactic: Barter in Lieu of Price Discovery

If this factoid about barter being used to effect distressed subprime trades (and she admits it is, at least so far, an isolated example) had come from anyone other than Gillian Tett, the captial markets editor for the Financial Times, I'd be inclined to discount it. But the fact that it is happening at all really is a stunner. In the modern world, you normally see barter for large transactions only when that parties have to operate outside the banking system, either for less than upstanding reasons or due to capital controls.

Tett uses this to segue into a discussion of how banks and investment banks have been very chary of marking down their holdings of illiquid assets, but auditors, unwilling to repeat the mistakes they made in the Enron era of being too accommodating, are taking a tough line on valuation. In particular, she focuses on the fall in the ABX indexes and what that means for pricing of subprime holdings.

From the Financial Times:

This week, a banking friend made a startling confession. In recent weeks he has been furtively unwinding some large investment portfolios linked to subprime securities.

But as he has embarked on this sordid task, he has discovered that the only effective way to get rid of these distressed assets is to avoid putting any tangible price on the trade.

Instead, he has resorted to using a tactic more normally associated with third world markets than the supposedly sophisticated arena of high finance: barter.

“Barter is the only thing that works right,” he chuckles grimly. “It is like the Dark Ages.”

I daresay this is an extreme example. But it nevertheless reveals a crucial point: namely that while this summer’s credit turmoil is already several months past, parts of the credit world remain plagued by strikingly high levels of fear and mistrust.

Indeed, in some arenas, such as mortgage-linked securities, sentiment now seems to be getting worse, not better. And that raises the prospect that we are now moving into an entire new phase of this year’s credit squeeze.

Take the ABX index, the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded.

But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire.

Never mind the fact that the risky tranches of subprime-linked debt (the so-called BBB ABX series) have fallen 80 per cent since the start of the year; in a sense, such declines are only natural for risky assets in a credit storm.

Instead, what is really alarming is that the assets which were supposed to be ultra-safe – namely AAA and AA rated tranches of debt – have collapsed in value by 20 per cent and 50 per cent odd respectively.

This is dangerous, given that financial institutions of all stripes have been merrily leveraging up AAA and AA paper in recent years, precisely because it was supposed to be ultra-safe and thus, er, never lose value.

But the trend also has crucial significance for investment banks. Until quite recently, many Wall Street banks tended to value their subprime linked holdings using models, because they (and their auditors) knew it was hard to get prices for these opaque instruments through real market trades. But I am told that this autumn some banks’ auditors have started to crack down on this approach, particularly in the US, owing to the so-called “Enron factor”.

More specifically, the experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool – namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.

However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.

No wonder that my banking friend is now furtively resorting to barter, to unwind his clients’ investment portfolio. And no wonder that investors are currently so suspicious about the health of financial entities – and so nervous about the potential for secondary shocks. This new wave of fear is unlikely to vanish quickly. Call it, if you like, The 2007 Credit Crunch Story, Part II.

The Continuing Deterioration of the Collateralized Debt Obligation Market

If you really want to worry about the credit markets, it might behoove you to turn your attention from subprimes to the vastly more arcane, opaque, and larger problem of collateralized debt obligations. A structured credit product, they are so heterogeneous in terms of structure and composition that it is difficult to make meaningful generalization about them.

However, quite often they took the difficult-to-sell weaker tranches of seucritizations and resecuritized them, and through the magic of credit enhancement, assignment of priorities in payment, default histories of little relevance, and complicit rating agencies, a good bit of the value of these CDOs were rated AAA. $2.5 trillion of CDOs was issued in 2006 alone.

Easier-to-grasp stories have captured the headlines, but the bad news about CDOs continues. The latest sighting is in the Financial Times' Lex column:

It is August all over again. Or maybe worse. An index used as an imperfect proxy for collateralized debt obligations is pricing supposedly safe AAA securities dramatically below par. Having knocked the banks on the head, the CDO crisis is reaching into sleepier corners of finance: the bond insurers. MBIA and Ambac, the two largest, saw their shares slump on Thursday. This is scary because, bluntly, what hurts Ambac and MBIA hurts the rest of the credit market. So many transactions, and not just linked to CDOs, depend on the guarantee these two provide. Complex structured finance deals have been made possible, or priced attractively, because the insurers have shouldered some part of the credit risk that others could not. If that guarantee were not worth what it was, say because MBIA or Ambac were downgraded, all those transactions that included the guarantee would get knocked. This panic has “contagion” written all over it.

Why are CDOs, specifically, so troubling? After all, many investors – and the insurers – concentrate their exposure at the tippity-top of the capital structure. In MBIA’s case, the losses on certain pools of securities would have to range between 15 and 60 per cent before affecting MBIA’s insurance. Under a stress scenario run a couple of months ago, Standard & Poor’s projected a deterioration in the collateral of mortgage-backed securities that underlies CDOs. It still felt the insurers’ capital cushion was safe. For instance, it assumed that half of all BBB tranches examined were wiped out – not just in default but valueless.

This would be statistically extraordinary. First, it would imply historically huge losses on the underlying mortgages. Second, it would imply extreme correlations of default between different geographic regions of the US. If you can imagine there are CDOs out there whose collateral is made up entirely of tranches of BBB mortgage securities – so called mezzanine CDOs – and these tranches are precisely the ones that become hypothetically worthless, all at the same time, then one-off hits could be scary.

Asset Backed Commercial Paper Outstandings Still Falling

The market for asset backed commercial paper continues to shrink, which does not bode well for the proposed SIV rescue plan. Commercial paper is short-term funding, less than 270 days, used by corporations and even more so by financial firms.

Note that this story on MarketWatch focuses on ABCP outstadings. The dramatic Fed rate cut of September has not led to improvement, merely ameliorated the deterioration. The article notes that unsecured CP outstandings continue to grow, but that market has not been in crisis.

From MarketWatch:

The outstanding level of asset-backed commercial paper fell for the 12th straight week, the Federal Reserve reported Thursday. Asset-backed paper dropped by $9 billion, or 1%, to $875 billion. Asset-backed paper, which are short-term IOUs backed by assets such as mortgages, credit cards or other receivables, has plunged by $308 billion, or 26%, since the crisis of confidence in credit began in early August. The collapse of the market has prompted large banks to seek alternative funding for their special investment vehicles. Citigroup's shares were lower on Thursday on reports it needed to raise $30 billion in capital. The larger market for commercial paper continued to recover, rising $9.9 billion, or 0.5%, to 1.88 trillion

Chemistry Sets a Casualty of War on Terror

The article below, from the 12 Angry Men Blog, mourns the dumbing down of home chemistry kits.

One has to wonder at these heavy-handed efforts to contain threats, particularly in a society that lacks gun controls. Are we next going to make styrofoam a controlled substance, since mixed with gas, it produces a decent napalm substitute?

From 12 Angry Men:

What do Islamofacism, methamphetamine production, tort lawyers, and homemade fireworks have in common? The answer is that they are all part of the seemingly inevitable process of destroying the childhood Chemistry Set. A.C. Gilbert, in 1918 was titled the “Man who Saved Christmas” with his innovative ideas of packaging a few glass tubes and some common chemicals into starter kits that enabled a generation to learn the joy of experimentation, and the basis for the scientific method of thought.

Some of Gilbert’s original sets included such items as sodium cyanide, radioactive samples (complete with a Geiger counter), and glass blowing kits. I will freely admit that one of the first things I did with my chemistry set was to attempt to make an explosive. I remember mixing up chemicals that evolved free chlorine gas and having to evacuate the house. I remember mixing potassium nitrate and sugar to make rocket engines and quickly evolving to higher specific impulse fuels. I remember the joy of finally obtaining some nitric acid which allowed me to nitrate basically everything in the house (cotton for gun cotton, glycerine and alcohol for nitroglycerine). So yes, I have to admit that there is a risk involved. But this is how people learn. Sometimes knowledge comes with pain — one-shot induction.

Today however, the Chemistry Set is toast. Current instantiations are embarrassing. There are no chemicals except those which react at low energy to produce color changes. No glass tubes or beakers, certainly no Bunsen burners or alcohol burners (remember the clear blue flames when the alcohol spilled out over the table). Today’s sets cover perfume mixing and creation of luminol (the ‘CSI effect’ I suppose).

In some States, you need a FBI criminal background check to purchase chemicals. Some metals, like lithium, red phosphorus, sodium and potassium, are almost impossible to purchase in elemental form. This is thanks to their use in manufacturing methamphetamine. Sulphur and potassium nitrate, both useful chemicals, are being classified as class C fireworks (here is a good precursor link). Mail order suppliers of science products are raided. Many over-the-counter compounds now require what is essentially a (poor) background check. Even fertilizer (ammonium nitrate) is under intense scrutiny. Where does this trend end? Ten years from now, will the list include table salt, seawater and natural gas — precursors to many industrical chemicals?

Then there is the liability issue. Of course some people buy into the lets be safe at any cost and assert that much chemistry can be done without explosions and stinky fumes. If a ladder manufacturer is under a constant barrage of liability suits, imagine the torrent of litigation directed to those giving a child a set of potentially dangerous chemicals. Its a CHILD, for God’s sake. [Oh, I’m sorry, for a minute there I was waxing Democrat.]

Yet there is still a little hope. Although Thames and Kosmos can’t ship their sets with the full range of chemicals needed to perform their listed experiments, at least they provide a list of sources from which to acquire them (assuming the appropriate permits, licenses, fees, FEES, background checks, and did I mention fees.) What is at stake here is no less than the future of America’s competitiveness and the innovation the make the United States the magnet for international entrepreneurs and scientists. Without the chemistry set, will we have scientists and innovators, or just a country of rock stars, political commentators and movie idols.

Maybe the Real Reason for the SIV Rescue Plan?

The negative reactions on the proposed SIV rescue plan (officially known as the Master Liquidity Enhancement Conduit) have become so widespread that I haven't been reporting as closely on this topic as I did earlier. However, some of the recent coverage has finally surfaced at least one reason for the plan that at least makes sense (whether readers regard it as legitimate is another matter entirely).

Recall that one of the ongoing mysteries about this program is that it involves a great deal of fuss and expense for what appears to be little or no gain.

The new MLEC will buy high-quality assets from exiting SIVs (which begs the question of what happens to the crappy assets left behind). The old SIVs get cash and some securities from the MLEC. The MLEC has some credit enhancement and issues commercial paper and medium term notes.

The problem is that the MLEC is not going to be fully guaranteed by the banks providing credit enhancement, so the investors will want the assets in the MLEC to be price within hailing distance of current values. That, of course, is what the SIV sponsors want to avoid, or at least minimize, since selling assets into the MLEC at realistic prices will require them to take losses.

In addition, there has been no discussion as to the end game for the MLEC. There have been some comments that indicate that it will sell the assets it holds, but over a long-ish period of time, thus reducing market impact.

But if any bank sponsor is not stressed financially, it too could simply fund its SIV and simply liquidate more gradually. So then the question becomes whether the benefit exceeds the fees the MLEC will charge. For banks that aren't in duress, the answer would appear to be no.

But a new piece of the puzzle emerged yesterday in the Wall Street Journal:

Supporting these off-balance-sheet funds, known as structured investment vehicles or SIVs, is the heart of the rescue effort led by Citigroup, J.P. Morgan Chase & Co. and Bank of America Corp. Accounting groups have raised the question of whether Citigroup and other managers of the SIVs should account for the funds, many of which face potential losses, on their own balance sheets.

A spokeswoman for Citigroup said, "Citi is confident that it has accounted for the SIVs it sponsors on behalf of investor-clients properly and in thorough accordance with all applicable rules and regulations."...

If it doesn't work, Citigroup and other SIV managers could find themselves in a bind that could force them to take financial hits.

If the rescue plan failed and buyers continued to stay away from the commercial-paper market, the bank might feel pressure to pony up cash to backstop the SIVs to preserve its reputation with the vehicles' investors, who would otherwise incur the bulk of the losses. But that prospect has raised the issue among accounting professionals about whether the bank shares in potential losses to such an extent that it should consolidate the SIVs onto its own books..

So the MLEC keeps the losses from being consolidated. That now appears to be a clear benefit, and perhaps the only benefit, of this scheme.

The New York Times today, in two different stories, indicated that the pressure, generally and on Citi, the biggest SIV sponsor, is increasing. From "$75 Billion Fund Is Seen as Stopgap":

Nearly three weeks after the country’s biggest banks announced a $75 billion fund to help stabilize the credit markets, the reality is sinking in that the plan will provide hospice care to troubled investment funds, not resuscitate them....

The proposed bank fund “is more a towline to get them to the scrapyard,” Lou Crandall, chief economist at Wrightson ICAP, a financial research firm, said....

Citigroup’s seven SIVs are under pressure to repay investors. Several less robust funds could face downgrading. Over all, the 30 or so SIVs have been forced to sell assets at an alarming pace — shedding roughly $75 billion since July and shrinking the industry by a fifth. Market participants expect SIVs to unload even more, as much as $15 billion a week....

“People get the idea that this is a total solution or a complete rescue,” a person involved in the plan said. “But the goal is actually much less ambitious: it is really to provide an orderly unwind or promote a restructuring.”

According to people briefed on the fund, the plan will encourage SIV investors to extend their short-term notes by at least six months...

Analysts say the fund will not benefit all SIVs equally, with those sponsored by big banks gaining the most. All this has turned the spotlight on Citigroup — which, skeptics suggest, shaped the plan specifically to ease its troubles....

At least 10 other foreign banks — including Dresdner Kleinwort of Germany, HSBC and Standard Chartered of Britain, the Bank of Montreal and Rabobank of the Netherlands — manage SIVs.

Market players say they are under just as much, if not more, strain than Citigroup. To delay the day of reckoning, they have been buying commercial paper and riskier notes from the SIVs they sponsor. Some are also looking to restructure, too.

A second New York Times article, "Analyst Raises Doubts About Citigroup Dividend,," focuses on the fact that even before the SIV crisis, Citigroup was more thinly capitalized than other large banks. The "$30 billion capital shortfall" is thus the analyst's estimate of what it will take, between increasing reserves and equity, to bring the bank in line with industry norms:

A long-time banking analyst said late last night that Citigroup may be forced to cut its dividend or sell assets to stave off what she said was a $30 billion capital shortfall, moves that could pull down its shareholder returns for several years.

The analyst, Meredith A. Whitney of CIBC World Markets, downgraded Citigroup’s stock to sector underperform, from sector perform, and called for the bank to bring precariously low capital levels more in line with its peers.

“We believe the stock will be under significant pressure and could trade in the low $30s,” she wrote. That would be as much as a 28 percent decline from yesterday’s $41.90 closing price for Citigroup shares.

If correct, the findings could be yet another blow to Citigroup’s chairman and chief executive, Charles O. Prince III, who has endured a barrage of criticism in the last few years for his failure to control costs and improve results. A 57 percent earnings drop in the third quarter, when both its big investment banking and consumer operations suffered heavy losses, raised doubts about his attention to risk management and his ability to lead the company....

In the third quarter, Citigroup said it lost $1.3 billion from mortgage-related securities amid the credit market downturn. Executives conceded they did not pay enough attention to credit risk or adequately hedge their positions.

But Ms. Whitney’s report turned the spotlight on other potential miscues, including Mr. Prince’s growth strategy. The report points out that Citigroup’s capital levels have declined to their lowest levels in decades after a recent spate of acquisitions. Citigroup’s tangible capital ratio stands at 2.8 percent, nearly half of the level of its peers.

While Mr. Prince has long promoted internal and international growth, Ms. Whitney’s report points out that Citigroup has spent more than $26 billion on acquisitions since spring 2006. That, on top of the $5.9 billion in losses and a 10 percent dividend increase in January, has strained its capital position.

Citigroup’s management has said that it expects capital to return to its target levels in early 2008. It plans to use stock in its Nikko Cordial purchase, improving its balance sheet management, and not repurchasing stock until it bolsters its capital cushion.

Other banking and risk experts agree with Ms. Whitney’s analysis, however, and some suggest that it may even be conservative. Citigroup’s capital position “is too low based on the risks on the trading side but the kicker is that Citigroup is going to have a lot more losses” on the consumer side, said Christopher Whalen, the managing director of Institutional Risk Analytics. “It is going to be a one-two punch.”

The more news that comes out, the more it looks like the MLEC is all about Citi.

Update: 11/1, 12:00 PM: More coverage from Bloomberg on the analyst earnings downgrades for Citi:

Citigroup Inc., the largest U.S. bank, fell to the lowest in four years in New York trading after three analysts cut their ratings and CIBC World Markets said the company may have to reduce its dividend to shore up capital.

CIBC and Morgan Stanley recommended investors sell the shares, while Credit Suisse analyst Susan Roth Katzke reduced her rating to the equivalent of hold from buy. Citigroup may have to sell assets, shrinking opportunities for growth, CIBC said.

Analysts are souring on Citigroup after the company reported $6.5 billion in writedowns and losses from credit markets, jeopardizing Chief Executive Officer Charles Prince's promise to increase earnings faster than costs. The combination of $25 billion of acquisitions in the past 19 months and the lowest cushion for losses ``in decades'' increases the risk of owning the stock, CIBC's Meredith Whitney said.

``The Citigroup news is a wake-up call for those who think these issues will go away with the Fed cutting rates,'' said Michael Metz, the New York-based chief investment strategist at Oppenheimer Holdings Inc., which manages $60 billion. ``We're not going to get resolution on these credit issues for months.''....

Citigroup fell $2.19, or 5.3 percent, to $39.17 in composite trading on the New York Stock Exchange at 10:55 a.m., after falling as low as $38.13.....

Prince began making acquisitions after the Fed lifted a ban on deals by the company in March 2006. The ``buying binge'' increased assets while earnings stagnated, Whitney said.

Profit fell to the lowest in three years as the company reported writedowns from credit and trading losses. The ratio of Citigroup's tangible equity to tangible assets fell to 2.8 percent, half the average of its peer group, Whitney said. She cut her estimate of Citigroup's earnings per share for this year to $3.68 from $3.75, and reduced her outlook for next year to $4.20 from $4.55.

Citigroup's tier 1 capital ratio, a measure used by regulators to make sure banks have enough cash to cover losses, fell to 7.4 percent at the end of the third quarter from 8.64 percent at the same time last year..

IRS Investigating Hedge Funds and Private Equity Firms

The IRS is turning up the spotlight on hedge funds and private equity firms. It appears that some may have been taken what might politely be called overly aggressive tax positions.

It's going to be pretty hard for these captains of capitalism to convince the public that they need to keep their favorable tax treatment of carried interest if they are determined to be tax cheats. Some of the allegations, like not filing tax returns, are things that even people with no financial sophistication will understand full well.

From Bloomberg:

The Internal Revenue Service has begun an inquiry into suspected tax abuses at hedge funds and private-equity firms after determining many firm partners don't file returns and may have improperly characterized transactions.

The tax-collection agency is studying whether funds improperly structured stock swaps to avoid withholding taxes, whether they dictated loan terms to banks before agreeing to buy loan portfolios, and whether they improperly classified income as capital gains to take advantage of the lower rate....

Donald Rocen, a former deputy chief counsel at IRS who became a partner at the Washington law firm Miller & Chevalier in September, said it makes sense that the IRS would begin an inquiry because of the charges by lawmakers that fund managers aren't paying a fair tax rate on their earnings, which can top $1 billion a year.

``The IRS reads the papers, too,'' Rocen said. ``They know they're going to be held accountable for what's going on with hedge funds.''

The compliance initiative is patterned after a similar one in 2004 and 2005 that targeted executive pay at corporations. That probe found cases where corporate officials used tax dodges or failed to file tax returns, a crime. That initiative led to audits of an undisclosed number of corporate executives.

Unlike corporations, which are likely to have in-house tax attorneys, hedge funds and buyout firms are often smaller partnerships less likely to have staff lawyers to prepare filings for the IRS and the Securities and Exchange Commission.

Donald Alexander, a former IRS commissioner, said the new inquiry may reveal even more abuses than the executive-pay probe, which focused on the use of family limited partnerships, deferred-compensation arrangements, abusive ``split-dollar'' life insurance arrangements, golden parachutes, and stock options involving phantom companies.

``My guess is that hedge-fund types are less likely to comply than corporate CEOs,'' said Alexander, who is now at the Washington law firm Akin Gump Strauss Hauer & Feld LLP. ``Taking risks is their stock in trade.''

According to the IRS, the inquiry is focused on seven areas of potential abuse. They include:

-- suspicions that hedge funds and private equity funds are failing to file or improperly filing tax and information returns;

-- cases where funds are structuring cross-border loans to get around requirements that taxes be withheld on the proceeds;

-- evidence that managers aren't paying tax on all of their income;

-- improperly classifying ordinary income that should be taxed at the 35 percent rate as capital, where gains are taxable at 15 percent and losses can be claimed more liberally;

-- the flow of funds between onshore and offshore entities;

-- how inventive payments and other income is timed and allocated;

-- improper accounting methods that minimize income.

IRS officials said the agency was focusing on stock swaps derivatives that offshore hedge funds use to avoid paying a 30 percent withholding tax on corporate dividends, according to the two people who attended. The derivatives, known as total return swaps, allow an investment bank to pay an offshore hedge fund an amount equal to the dividend and appreciation on a corporate stock.

This structure changes the definition of the income, allowing the offshore fund to claim it didn't earn dividends and therefore doesn't owe the 30 percent withholding tax.

``The Treasury and IRS are well aware of the anomaly created by the disparate treatment of total return swaps,'' said Matthew Stevens, a tax attorney at Alston & Bird LLC in Washington, in an advisory to clients. ``Interested investors should closely monitor this area of the law.''

The agency also is questioning how much involvement hedge funds have in dictating the terms of loans that they agree to buy from banks.

If the agency determines that the funds are ``engaged in a trade or business'' rather than simply trading in securities, it would change the nature of the income they earn from such transaction to ordinary from capital gains, subjecting that income to higher tax.

The Hatchet Job on Bear CEO James Cayne

There is a very critical page one story in the Wall Street Journal, "Bear CEO's Handling of Crisis Raises Issues,"wrapped in the veneer of balanced reporting, on Bear Stern's chief James Cayne.

Let me be clear about one thing: I am in no position to judge whether the charges made against Cayne are accurate. But the timing of the article stinks to high heaven. There is no crisis looming at Bear right now; in fact, it pulled off what many, yours truly included, thought would not be possible: it not only secured an investor, the Chinese state sponsored bank, Citic, but the terms also appear very favorable to Bear.

I have a strong suspicion that any future investments in securities firms will be on terms advantageous to the investor, which would mean Bear got a deal done at the last time when a decent deal was to be had. Admittedly, that is a function of Bear having had the first serious blow-up, but they nevertheless raised capital against the odds.

The criticism of Cayne made in the piece, in essence, is he spent too much time on the golf course and playing bridge while crises were in motion at Bear. There is also a nasty bit in the middle alleging how he smokes marijuana occasionally in his office and on the golf course. If the office bit can be corroborated, that was world class stupid, and may be what gets him in the most trouble. Regardless, its inclusion in a piece like this suggests that someone, or several someones, were out to dispense every bit of dirt on him.

And while the article, apparently deliberately, does not make the charge explicitly, it is clearly indicting Cayne of the charge that led to the exit of co-president Warren Spector of, that is, of spending too much time away from the office (in his case, at a bridge tournament) during Bear's hedge fund crisis this June. In other words, the pot was calling the kettle black.

Thus this smells of being instigated, if not by Spector himself, then by aggrieved friends and allies. And the peculiar timing was likely a function of how long it took to do the spadework.

But is Cayne guilty of dereliction of duty? The test is whether his absences were detrimental, and it is hard, and also too early, to tell. Cayne was critical to cinching the Citic deal. So far, despite the hedge fund disaster, Bear took writedowns for its third quarter that were lower than expected, and something of a relief to analysts. They now look trivial compare to the writeoffs taken by Merrill, UBS, and Deutsche Bank. We will need to wait till the fourth quarter to see whether Bear was unduly optimistic, and does some heavy bloodletting then, or whether its risk management lapses turn out to have occurred mainly at its hedge funds after all.

Martin Wolf is Down on Biofuels

Martin Wolf, the Financial Times' highly regarded economics editor, has an usually blunt article today, "Biofuels: a tale of special interests and subsidies." While the main target is the way special interests are turning biofuels into yet another agricultural pork barrel, he makes a number of important observations: biofuels are only marginally cleaner than conventional energy sources; many of the incentives are counterproductive (witness the discussion of "flexible fuel" vehicles); the policy "rationalisations" are bogus: and of course, biofuels make food more costly.

Wolf also has an important observation buried in the piece, perhaps because it was the subject of a Financial Times editorial, namely, that what is needed is a clear and predictable price for carbon. That would give manufacturers, users, and investors long enough planning horizons to decide themselves among the various options. And perhaps most important, it would put greater focus on energy conservation, which is far and away the most productive near-term step, and less on various schemes that enrich promoters on a current basis and give the public at large the false hope that they can simply switch to a clean energy source and life will continue as before.

From the Financial Times:

Energy security and climate change are two of the most significant challenges confronting humanity. What we see, in response, is the familiar capture of policymaking by well-organised special interests. A superb example is the flood of subsidies for biofuels. These are farm programmes masquerading as answers to energy insecurity and climate change. Not surprisingly, they have the depressing characteristics of such programmes: high protection, open-ended support to producers, and indifference to economic rationality.

Already the support in members of the Organisation for Economic Co-operation and Development costs about $13bn to $15bn a year. But this sum generates much less than 3 per cent of the overall supply of liquid transport fuel. To bring the biofuel share to 30 per cent, as some propose, would cost at least $150bn a year and probably more, as marginal costs rose.

Someone needed to take a close look at the rationality of all these supports. An excellent report from the Global Subsidies Initiative of the International Institute for Sustainable Development does just that*. It does not tell a pretty story.


Policy is extraordinarily complex. It can also be highly irrational. Brazil is, for example, the most efficient supplier of bioethanol, but confronts tariffs of at least 25 per cent in the US and 50 per cent in the European Union. A smaller example is the advantage given to production of “flexible-fuel vehicles” in US corporate average fuel-efficiency standards. Because the fuel-economy credit is biggest for the least energy-efficient models, manufacturers concentrate on sport utility vehicles and light trucks. Yet almost all the drivers of these vehicles use ordinary petrol. The result is greater consumption of petrol, not less.

The cost of support per litre of ethanol varies between $0.29 and $0.36 per litre in the US and $1 in the EU (see chart). Support for biodiesel varies between $0.2 per litre in Canada and $1 in Switzerland. But the cost of petrol, in terms of equivalent energy units, is $0.34 and of diesel is $0.41. Thus, the subsidy to biofuels is often greater than the cost of the fossil fuel equivalent. Not surprisingly, the production costs of subsidised biofuels are also generally much higher (see charts).

Does this costly shift to biofuels at least deliver reductions in net emissions of greenhouse gases? Not by as much as one might suppose, is the answer. The net greenhouse gas emissions of expensive European rapeseed oil-based diesel are a mere 13 per cent less than those of conventional diesel. Similarly, net emissions from US corn-based ethanol are only 18 per cent less than conventional petrol.


This highly subsidised source of demand is also having a big impact on demand for foodstuffs. In 2007, for example, the increase in US demand for corn-based ethanol will account for more than half of the global increase in demand. Much the same is true for US and EU use of soyabeans and rapeseed in biodiesel. The rising price of food is good for producers. It is dreadful, however, for consumers, particularly for those in poor food-importing countries. Increased production of biofuels also adds stress on existing land and water supplies.

Is it possible to justify this cornucopia of complex and expensive subsidies, mandates and protectionist measures? No. But that does not stop people from trying. Indeed, they point to a host of different (and often changing) justifications, as is too familiar from the history of farm policies. Here are just five of them.

Rationalisation one: biofuel subsidies reduce farm support payments. But, in fact, US evidence strongly suggests that these subsidies are being piled on top of existing farm subsidies, not replacing them.

Rationalisation two: mandating biofuels will lower petrol prices. But it is obviously mad to try to lower the price of a commodity by subsidising the production of more expensive alternatives.

Rationalisation three: subsidising biofuel is an efficient way to reduce reliance on risky fossil fuels. But biofuels are, under current technologies, complements to, rather than substitutes for, fossil fuels and are also vulnerable to their own risks of weather and disease.

Rationalisation four: subsidising biofuel is an efficient way to reduce greenhouse gas emissions. According to the report, the cost of eliminating a tonne of carbon dioxide equivalent through biofuels varies from a low of about $150 to as much as $10,000. Even the lower of these figures exceeds almost all estimates of the marginal benefit of reducing a tonne of emissions. It certainly much exceeds the cost of many alternative ways of doing so.

Rationalisation five: subsidies are only needed to establish the infrastructure. But if biofuels are to be competitive, it will be unnecessary to subsidise the infrastructure. Investors can do that for themselves.

This then is a classic farm programme: a costly system of transfers looking for a rationale. Or, as the report puts it: “The bewildering array of incentives that have been created for biofuels in response to multiple (and sometimes contradictory) policy objectives bear all the hallmarks of a popular bandwagon aided and abetted by sectional vested interests.”

So what should be done? Here are some simple negative suggestions: eliminate increasingly popular (because apparently costless) mandates to use specific quantities
of biofuels, since these shift all the risk of fluctuations in demand and supply of foodstuffs on to their use as food; discipline the stacking of subsidies on one another; and eliminate all open-ended supports for production before these become impossible to reverse.

Here, also, are some positive ideas: define the objectives and instruments of policy precisely, in terms of the overall goals of energy security and reductions in emissions of greenhouse gases; create a single global price of carbon that governs all activities; make producers compete for any support that is offered; let the markets decide on sale of flexible-fuel vehicles (and indeed the energy efficiency of vehicles); and, above all, move to free trade in biofuels.

We should at least try to learn from painful experience with a century of farm policies. I know that is naive. But is it impossible to respond to the big challenges of energy policy and climate change by applying a little intelligence, for a change?

*Biofuels – At What Cost? Global Subsidies Initiative, www.globalsubsidies.or

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Jim Rogers Increases His Bets Against Investment Banks

Famed investor Jim Rogers has been down on the investment banking industry for some time, and thinks there is even more reason to be negative, as a Bloomberg story reports. However, I think George Soros would take exception to the characterization of Rogers as "co-founder" of Quantum. Rogers most assuredly worked for Soros.

Note that we have argued that investment banks are at risk of becoming sufficiently impaired to have larger consequences for the financial system. It takes a lesser degree of conviction to merely dislike their stocks.

From Bloomberg:

Jim Rogers, co-founder of the Quantum Hedge Fund with billionaire George Soros, boosted his bets against U.S. securities firms because of their salary ``excesses'' and money-losing investments.

Rogers said he increased his year-old short positions in the past six weeks in U.S. investment banks, using exchange-traded funds and bets against individual companies he declined to name. Stocks in the industry, which pays too much in bonuses, may fall as much as 70 percent in a bear market, he said.

``You see 29-year-olds on Wall Street making $10 million to $20 million a year, and they think it's normal,'' Rogers, 65, said in an interview in London today. ``There have been lots of excesses,'' said Rogers, chairman of Beeland Interests Inc.

The top five U.S. securities firms will probably earn a combined $29.3 billion this year, according to analysts surveyed by Bloomberg, breaking a three-year record streak after Merrill Lynch & Co. reported a $2.2 billion third-quarter loss. Goldman Sachs Group Inc., Morgan Stanley, Merrill, Lehman Brothers Holdings Inc. and Bear Stearns Cos. earned $30.7 billion last year, three times more than their profit in 2002.

Goldman Sachs, Wall Street's most-profitable securities firm, said Sept. 20 that it set aside $16.9 billion to pay salaries, benefits and bonuses in the first nine months of the year, topping the record amount for all of last year.

A month later, Merrill Lynch reported its biggest quarterly loss amid $8.4 billion of writedowns for subprime mortgages, asset-backed bonds and bad loans. The 12-member AMEX Securities Broker/Dealer Index has fallen 13 percent since the start of June, while the Standard & Poor's 500 Index was little changed.

``Who knows how bad the balance sheets are,'' Rogers said. ``They took on gigantic amounts of bad paper.''....

Rogers said he made the investments using his own money. He declined to say how much he oversees.

The slump in the U.S. housing market ``still has a long way to go'' before recovering, he said. ``Market excesses don't clear themselves out in just four or five months; they take years.''

In keeping, Jeff Matthews gives us Stan O'Neal's recent golf record.

A Revealing Subprime Chart

If you want a vivid illustration of why subprimes have turned out to be the mess they are, the graphic below, courtesy Russ Winter who also supplied this explanation:

The term used here, “DTI proforma” , measures what debt payments to income on 2005 and 2006 vintage subprime teaser loans would have required if the loan were fully indexed, fully amortized, and included insurance and property tax. The results are shocking.

This chart paints a very sorry picture as to how many borrowers can be rescued.

Do the math. Even using the teaser rates, and the phony affordability mortgage servicing burden figures, 65% were devoting over 40% of their income to their mortgage and related costs. 40% is usually considered the max for prudent lenders. That number rises to over 80% with the correct computation. Oh, and that assumes the "income" part of the equation is accurate. Remember that a high proportion of subprime mortgages were stated income loans, and for those, income was typically exaggerated by a considerable degree.

Bottom line: very few subprime teaser borrowers can be saved, even with the heroics of keeping them at their starter rates. No wonder the servicers aren't trying to do mods. In most cases, there isn't any point.

Beware Dubious (as in Most) Surveys

One of my pet peeves is lousy research, and even worse is lousy-with-intent pseudo-research. The airwaves are filled with fake factoids crowding out real information.

I was once tempted to write a post on what it takes to do good survey research, simply because surveys are widely cited and most people probably mistakenly think they deliver reliable findings. In fact, it takes quite a lot of work and testing to devise a good survey instrument, and most people sponsoring studies don't want to spend the time and money.

John Kay of the Financial Times has taken aim at the same topic, for different reasons: too many surveys these days are done for public relations purposes, to stir up some noise, and were never even undertaken as serious research.

The more the public starts to be skeptical of pronouncements based on surveys, the happier I will be. From the Financial Times:

This is the age of the bogus survey. I woke up recently to the news that 95 per cent of children in Britain had been victims of crime. Of course they had. From a legal perspective, pushing a classmate or taking a pencil without the intention of returning it is a crime. School playgrounds are hotbeds of crime and always have been.

The difference between the bogus survey and real research is that real research has the objective of yielding new information, while bogus surveys are designed to generate publicity. The organisation that had undertaken this bogus survey – I forbear from mentioning its name – did not disguise that it had done so in order to draw attention to the problem of abuse of children.

Statistics about the incidence of real criminal activity against and among children are hard to come by and hard to interpret. We do not really know whether things are getting better or worse, or by how much – at least not without careful research and analysis, which would be hard to explain on television. Programme producers will not ask you to appear to spell out these complexities, but will allow you to horrify viewers and listeners with alarming news.

Public relations professionals understand these triggers, to such an extent that commissioning a bogus survey is now a standard element in the pitch they present to potential clients and conducting these surveys is an increasingly large part of the activity of market research organisations.

The agencies appreciate, although they are normally too polite to spell it out to their clients, that Universal Widgets is not a very interesting company, widgets are not a very interesting product, and Nigel Snooks, the chief executive, is not a very interesting man. But a survey that shows that two-thirds of men have contemplated hitting their wives with a widget will produce many media slots in which Mr Snooks of Universal Widgets can recount the findings.

There is even a term for this kind of activity. It is called “thought leadership”. That term illustrates the problem. It probably does not matter much that the bogus survey is used to generate spurious news. The danger is that opinion polls designed to produce eye-catching answers displace serious thought and analysis. The organisation that announced that 95 cent of children had been victims of crime judged, correctly, that its survey better served its needs than serious research into the problems with which it was concerned, that had not been done.

The study of business is afflicted by confusion between the results of a survey of what people think about the world and a survey of what the world is really like. At another recent meeting I heard a platform speaker announce that 40 per cent of books would be electronically published by 2020. A pesky academic asked exactly what this number meant and what evidence it was based on. The speaker assured the audience that the number had been obtained in a survey by eminent consultants of the opinions of the industry’s thought leaders.

I imagine most of the thought leaders had no more idea than anyone else what the question implied, or what the answer was, and did not devote more than the briefest consideration to their response, so I am not surprised that the median answer was close to a half. If you want to know the future of publishing, you will learn more by peering into a crystal ball. It will at least give you time to think.

Newspapers, broadcasters and consultants will start to distinguish bogus surveys from substantive knowledge only when their audience demonstrates that it knows the difference. Academics and think-tanks need to be reminded that generating publicity is not a legitimate research objective. The column in The Week magazine called “what the scientists are saying”, a compendium of silly claims from scientists trying to attract attention, is as embarrassing to the cause of real science as Private Eye’s Pseuds’ Corner is to real literature.

When you are asked for your opinion in your role as thought leader, put the phone down. You will be serving the public interest as well as saving your time.

Rubin Criticizes Weak Dollar Policy

Robert Rubin spoke out against policies that weaken dollar, from the commonsense perspective that a cheap dollar lowers the US standard of living. That's a bit simplistic, since the impact of a weak currency on citizens depends on how dependent a country is on imports, and critically, to what degree domestic goods could substitute for imports. However, he is right to point out that trashing the dollar isn't the best fix for our economic woes.

A Bloomberg story yesterday provides another indicator of the dollar's diminished status:

Bargaining while buying some trinkets in the Maldivian capital, Male, recently, I heard most unexpected words: ``You can keep your dollars.''

This tiny nation of 1,200 islands has long accepted U.S. currency out of convenience for visitors and financial sobriety. The dollar tended to do better in global markets than the local monetary unit, the rufiyaa. That may be changing and it's a bad omen for the world's reserve currency.

``My dollars aren't as popular here as they've been in the past,'' says Moyez Mahfouz, 51, who has visited the Maldives from Bahrain with his family once or twice a year for a decade. ``More and more on this trip, I'm being asked for rufiyaa.''

From Bloomberg:

Former Treasury Secretary Robert Rubin said relying on a falling currency to stoke exports isn't a ``sound approach'' and urged economic policy changes that would strengthen the dollar.

``The lower the exchange rate, the less that we receive in exchange for what we produce, and that lowers our standard of living,'' Rubin said in an interview after attending a conference in Washington. ``Our objective ought to be to have a strong currency based on sound policy.''

Policy makers aren't pursuing solutions to the country's economic deficiencies and looming budget deficits, said Rubin, who served under Bill Clinton, a Democrat. By contrast, Treasury Secretary Henry Paulson and other Republicans have lauded the U.S. economy as ``healthy'' and hailed demand for American exports as a boon for growth.

Policies should be focused on curbing government spending, raising revenue and addressing the soaring cost of government programs such as Social Security and Medicare, said Rubin, now chairman of Citigroup Inc.'s executive committee. Improving education, research and infrastructure are critical to increase productivity, he said.

``You put it all together and I think we can do very well economically and then we can have a strong currency,'' said Rubin, who served as the chief economic adviser to President Bill Clinton. ``We're certainly not on those policy tracks right now.''

The dollar traded at $1.4438 per euro at 3:24 p.m. in New York, after dropping as low as $1.4438 yesterday, the weakest since the European currency's debut in January 1999.

The slide ``seems to have helped with respect to exports,'' Rubin said. At the same time, ``a much weaker dollar'' could have ``inflationary effects,'' he said, while declining to predict the U.S. currency's direction.

The dollar has declined in four of the past five years, and is down 7.5 percent so far in 2007 against a broad index of world currencies. During Rubin's tenure at the Treasury from 1995 to 1999, the same index increased 24 percent.

Record exports helped trade contribute 1.3 percentage points to economic growth in the second quarter, outweighing the impact of the decline in home construction.

Treasury Secretary Henry Paulson earlier today reiterated his support for a ``strong'' U.S. currency during a trip in India. ``I am strongly committed to a strong dollar,'' he said.

Federal Home Loan Banks Standing in for Commercial Paper Buyers

I had wondered why, given the swift and brutal contraction of the commercial paper market in August and September, that there weren't more apparent signs of distress. Outstandings fell an eyepopping $368 billion.

Commercial paper is short-term borrowings, maximum 270 days, but typically much shorter. If a borrower can't roll his commercial paper but still needs the dough, he has to either find other sources of funding pronto or sell other assets. And given that the contraction was almost entirely in the asset backed commercial paper market, meaning CP supported by mortgages, car loans, credit card receivables, one would have expected to see a change in borrowing terms in those markets.

Now the mystery has been unraveled. It turns out many mortgage-related ABCP issuers have gone to a lender of last resort, namely the Federal Home Loan Banks, which have extended $163 billion of loans to them. Like Freddie Mac and Fannie Mae, they are considered to be government sponsored enterprises. Even though the Federal Home Loan Banks are technically a cooperative of private banks, the Federal government is sufficiently involved in their oversight (for example, their board is appointed by the President and approved by the Senate) that they are regarded as enjoying government support and fund at favorable rates. Worryingly, and again like Fannie Mae and Freddie Mac, they have had accounting issues, but legislation mandating tougher oversight stalled in the Senate.

So risk has been passed from institutions that could have been permitted to fail (or at least suffer) to one too big too fail. We'll learn all too soon whether this was a move that we will regret.

From Bloomberg:

Banks shut out of the market for short-term loans are finding salvation in a government lending program set up to revive housing during the Great Depression.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs' Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is ``taking a lot of risks through the Federal Home Loan Banks that are unnecessary,'' according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

The home loan banks, known as FHLBs, are increasing risks to taxpayers by assuming the role as a lender of last resort, said Wallison. That's the job of the Federal Reserve, he said.

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said.

U.S. lawmakers need to ensure ``the institutions don't blow up in the taxpayer's face,'' Representative Christopher Shays of Connecticut, a Republican on the House Financial Services Committee that is responsible for oversight of the system, said in an interview.

The FHLBs are cooperatives created by President Herbert Hoover in 1932 to spur mortgage lending. The system's 8,100 owners and customers range from New York-based Citigroup Inc., the largest U.S. bank, to the single-branch Custer Federal Savings & Loan in Broken Bow, Nebraska. Their government ties support top AAA ratings from Standard & Poor's and Moody's Investors Service.

They borrow in the bond market and lend the money to their members. Federal Home Loan Bank obligations, when combined with the $1.5 trillion debt and $4.7 trillion in bond guarantees of Washington-based Fannie Mae and Freddie Mac in McLean, Virginia, are 46 percent more than the $5.04 trillion of Treasury debt held by the public.

Lenders turned to the FHLB as two main sources of funding, short-term IOUs backed by mortgages and mortgage-bond sales, began to dry up in August. That's when losses on securities tied to subprime home loans began to spread throughout the credit markets and investors retreated to the relative safety of Treasuries and their equivalents.

Asset-backed commercial paper outstanding fell 25 percent to $883.7 billion as of last week from $1.18 trillion on Aug. 8, data compiled by the Fed show.

Sales of mortgage bonds, excluding those issued by Fannie Mae and Freddie Mac have tumbled by 66 percent to a monthly average of $39 billion from $115 billion in 2006, according to Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

The home loan banks ``were the only game in town for a lot of borrowers,'' said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are ``like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it's the only timepiece you have.''

In July, lenders could raise funds by issuing one-month asset-backed commercial paper that yielded 1.8 basis points less on average than the one-month London interbank offered rate. A basis point is 0.01 percentage point.

In September, the asset-backed commercial paper, when it was available, cost as much as 51 basis points more than Libor. At the same time, the Federal Home Loan Bank of New York offered one-month funds at an average of 48 basis points below Libor, making their loans more attractive.

The FHLB's outstanding discount notes rose to a record $311 billion in the first three quarters, the most since 2001, according to data compiled by Zurich-based Credit Suisse Group.

FHLB loans probably will continue to grow in the next few months, though at a slower rate than during August and September, said Margaret Kerins, an agency debt strategist at RBS Greenwich Capital in Greenwich, Connecticut.

``Each day we seem to have new financial institutions announcing losses and so this probably isn't over,'' she said.

The home loan banks can lend at below-market rates because their government charter enables them to borrow more cheaply than other financial institutions. The ties to the government suggest the U.S. will bail them out in times of trouble.

The system sold $3 billion of two-year notes on Oct. 26 at a yield of 4.26 percent, or 46 basis points more than Treasuries of similar maturity. Stamford, Connecticut-based General Electric Co., also rated AAA, has $1 billion of notes due a month later that yield 4.6 percent.

Some lawmakers said they are concerned the FHLBs are taking on too much debt after they were unable to account properly for their own risks.

Five of the banks, including the Atlanta and Pittsburgh branches, restated earnings from 2001 through 2004, while the Chicago and Topeka branches corrected mistakes from 2001 through 2003. All of them fixed accounting errors for financial contracts used to protect against swings in interest rates.

The mistakes at the home loan banks, as well as those at Fannie Mae and Freddie Mac, prompted Republican lawmakers to spend the past four years pushing for legislation to create a tougher regulator for the government-chartered enterprises. While the House passed legislation in May, the Senate Banking Committee has yet to do so.

The failure to create new laws ``is predicting disaster,'' Baker, a Republican on the financial services panel, said in an interview. The FHLBs ``have the potential for adverse economic impact if not properly administered,'' he said.

The banks require borrowers to put up mortgages, mortgage bonds and other assets as collateral. None has experienced ``a credit loss on an advance to a member, ever,'' Ronald Rosenfeld, chairman of the Federal Housing Finance Board, the Washington- based regulator of the FHLBs, said in an e-mail.

The New York bank looks at detailed data on each asset when deciding how much to extend against it and doesn't accept delinquent loans or non-AAA rated bonds as collateral, Paul Heroux, its head of member services said in an interview.

``The home loan banks are extremely low-risk institutions,'' Allan Mendelowitz, one of five directors of the Federal Housing Finance Board, said in an interview. ``There is probably no contingent risk to the taxpayer.''

Investors said the same about mortgage securities, which had home loans as collateral and were given top AAA ratings by S&P and Moody's. Then defaults soared for loans to people with poor credit and some securities fell as much as 80 cents on the dollar.

A collapse would create ``tremendous pressure to have the taxpayer bear the cost of a bailout,'' said Representative Ed Royce, a Republican from California on the House Financial Services Committee.

The FHLBs have $276 billion of bonds maturing in 2008 and $174 billion in 2009, according to data compiled by Bloomberg. The system last week began to refinance about $144 billion of its so-called discount notes sold in August and September with maturities ranging from eight to 12 weeks, FTN's Vogel said.

Borrowing from the system during that period was probably a record for a two-month span, Vogel said. The FHLBs disclose their borrowing at the end of each quarter.

Calabasas, California-based Countrywide, the largest U.S. mortgage lender, almost doubled borrowings from the Federal Home Loan Bank of Atlanta to $51 billion during the quarter, the company said in a statement last week.

Countrywide began to use the FHLBs in August as analysts at New York-based Merrill Lynch & Co. raised the possibility that the company could go bankrupt after it had trouble raising funds in the commercial paper market. Countrywide later sold a $2 billion stake to Charlotte, North Carolina-based Bank of America Corp., the second-biggest in the U.S. after Citigroup.

``You don't want to use the phrase `going out of business' in the press, but they would be in a much, much worse liquidity position if they didn't have the Federal Home Loan Bank system sitting out there,'' said Paul Miller, an analyst at Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

Washington Mutual, the largest U.S. savings and loan, boosted its borrowing from the FHLBs by $31 billion, the company said this month.

The Seattle-based lender's ``funding flexibility'' put it in ``a much stronger position to withstand the market disruptions of the third quarter,'' Chief Financial Officer Thomas Casey said on a Oct. 17 conference call with investors. Washington Mutual spokeswoman Libby Hutchinson declined to comment further.

Paramus, New Jersey-based Hudson City Bancorp, the third- largest thrift in the U.S., borrowed $800 million from the FHLBs in the third quarter, 25 percent more than a year earlier, said Chief Executive Officer Ronald Hermance.

``Even AAA rated credits were having a tough time issuing paper,'' Hermance said. ``It took everybody back to the Federal Home Loan Banks.''

A Wee Bit of Good Environmental News

This blog generally features less than cheery news on the environment/species loss/global warming front, mainly because there isn't a hell of a lot positive to report.

So we wanted to pass along a wee positive development about wee creatures, namely frogs. As readers may know, frog populations have been falling, and one of the culprits appeared to be a nasty fungus.

It turns out a surprisingly inexpensive and effective treatment has been found. From the BBC:

New Zealand scientists have found what appears to be a cure for the disease that is responsible for wiping out many of the world's frog populations.

Chloramphenicol, currently used as an eye ointment for humans, may be a lifesaver for the amphibians, they say.

The researchers found frogs bathed in the solution became resistant to the killer disease, chytridiomycosis.

The fungal disease has been blamed for the extinction of one-third of the 120 species lost since 1980.

Fearful that chytridiomycosis might wipe out New Zealand's critically endangered Archey's frog (Leiopelma archeyi), the researchers have been hunting for a compound that would kill off the disease's trigger, the fungus Batrachochytrium dendrobatidis.

They tested the chloramphenicol candidate on two species introduced to New Zealand from Australia: the brown tree frog (Litoria ewingii) and the southern bell frog (L. raniformis).

"We found that we could cure them completely of chytrids," said Phil Bishop from the University of Otago.

"And even when they were really sick in the control group, we managed to bring them back almost from the dead."

"You could put them on their back and they just wouldn't right themselves, they would just lie there. You could then treat them with chloramphenicol and they would come right," Dr Bishop explained.

The researchers tried using chloramphenicol as both an ointment, applied to the frogs' backs, and as a solution.

They found that placing the animals in the solution delivered the best results. The team has admitted it was surprised by the outcome.

"You don't usually expect antibiotics to do anything to fungi at all. And it does. We don't understand why it does, but it does," said Russell Poulter.

Professor Poulter, the molecular biologist who hunted down chloramphenicol, added: "It's also got the great advantage that it's incredibly cheap."

The scientists are now making their research widely known ahead of formal publication in a science journal because of the pressing need for a safe and effective treatment for the chytrid disease.

The blow that chytrid has dealt to the frog population is already immense.

The disease has probably accounted for one-third of all the losses in amphibian species to date, says Professor Rick Speare, an expert in amphibian diseases who works with the University of Otago's frog research group.

These losses are huge - and this is in addition to other threats such as habitat destruction, climate change, pollution and hunting.

Since 1980, more than 120 amphibian species have disappeared; and according to the World Association of Zoos and Aquariums, in the near future many more species are in danger of vanishing.

"We are losing an awful lot of these creatures now and if we don't do something intelligent, then we're going to lose an awful lot more," said Professor Poulter.

But a hopeful finding is that the introduced frogs that have been infected with chytrids are now more resistant to further infections.

"We haven't quite understood how that could happen," said Dr Bishop. "It might be a natural thing; if a frog survives a chytrid infection then it is resistant when it gets attacked again."

The researchers believe that zoos now will have more options, either to be able to control an outbreak or to rescue infected frogs from the wild, knowing that they can be cured.

The next challenge the research team has set itself is to find a treatment that will work in the wild.

"I would really feel quite satisfied if we could say, 10 years from now, that you have to be careful walking around [Australia's] Kosiuszko National Park or you might tread on a corroboree frog because they're all over the place," said Professor Poulter. "I would take real satisfaction from that."

I have a picture of science classes rounding up wild frogs, dipping them and releasing them......

Arguing Against a Rate Cut

Despite the widely-held view that the Fed will lower the Federal funds rate another 25 basis points this Halloween, some continue to argue against further reductions.

We've taken that position here before, and will recap some of the reasons. The 50 basis point cut in September was a pre-emptive strike, based not on evidence of slowing growth but out of concern for the deteriorating housing market and fragile conditions in the money market.

While the Fed's action gave a nice boost to the stock market, and reduced Libor spreads and credit default swap prices somewhat, it also led to a rise in long-term rates based on increased inflation expectations, and higher long rates are a negative for house prices. And it appeared to do almost nothing for the continuing crisis in the money markets. Commercial paper outstandings continued to fall after the cut, and the SIV market is still in trouble, as witnessed by the announcement of the Citigroup-JP Morgan-Bank of America-sponsored rescue plan, and the restructuring of some failed SIVs (Cheyne and Cairn).

In addition, the dollar has continued to fall against most currencies, and further interest rate cuts could lead to a rapid decline, which would also be destabilizing.

The Fed has only a hammer, in this case monetary actions (interest rate moves and liquidity increases or reductions) and therefore the current economic woes look like a nail. But the ailing housing and money markets will not be cured by looser monetary policy. Their problems are lack of transparency and insolvency. A 25 basis point cut, or even a 200 bp cut, isn't going to put more cash in the pocket of someone who can't make his mortgages payments, or make money market investors suddenly trust SIVs that hold mortgage-related paper.

The experts argue that the Fed has to cut rates this week because the markets expect it. Since when is making the markets happy the Fed's job? (Whoops, I know the answer to that question: since Greenspan).

The role of the Federal Reserve, as William McChesney Martin put it, is to take the punchbowl away when the party starts getting good. In other words, one of its responsibilities is to deny the industry what it wants, because what it wants isn't necessarily in its best interest.

Further consider that the Fed feels pressured to act because Fed fund futures have a rate cut priced in. Maybe the Fed needs to look at other markets to gauge the likely efficacy of its actions.

The markets have already discounted a rate cut, meaning they are well nigh certain it will happen. Yet the ABX indices, which are a increasingly reflect sentiment about the housing market have been deteriorating rapidly at the very time when confidence in a Fed cut this month has been rising (see yesterday's update). If this free fall doesn't prove the irrelevance of a Fed funds cut to the housing market, what does?

Both the Financial Times and Mark Thom's Economist's View provide insightful views. The Financial Times comment, by Manuel Hinds and Benn Steil is as close to snarky as the FT gets and ominously (and quite seriously) draws parallels between the US and developing countries that suffered financial crises (shades of our Banana Republic Watch), specifically, the combination of modest inflation in consumer goods and bubbles in investable assets.

Thoma features fellow University of Oregon prof and Fed watcher Tim Duy. Interestingly, at the beginning of October, Duy was predicting further rate cuts, even though he was opposed to the idea. He thinks they are unlikely for now based on GDP growth. He also shows that the Fed has communicated its views pretty clearly, but the financial media has turned a deaf ear.

First, from the Financial Times:

The Federal Reserve’s dramatic 0.5 per cent interest rate cut on September 18 was greeted with euphoria in the stock market, which soared 5 per cent in the two weeks that followed. This fact itself was hailed as vindication for a Fed that felt Jim Cramer’s pain, and gave the world the cheaper dollars the market guru shrieked for in CNBC’s (and YouTube’s) most memorable “Mad Money” segment ever.

To those who worry about inflation, the Fed could point to crunching credit as a danger to growth, and ipso facto a force for disinflation. Waiting for the numbers to prove it would just be reckless dithering.

We have sympathy for Ben Bernanke, Fed chairman, and company. The job of a price fixer is never easy. What should money cost? For most of human history this was easy: once you fixed a conversion factor with gold, you just sat back and let the forces of supply and demand do their stuff. But since the collapse of the Bretton Woods currency regime (the last vestige of thousands of years of commodity money), discretion has been the watchword. Nine smart folks at the Fed board have taken over the job of deciding what the price of money should be. If the hagiography and hatred showered on Mr Bernanke’s predecessor, Alan Greenspan, is any indication, that price should be wisely wiggled down to make jobs, up to prick bubbles and now, apparently, back down to offset losses on millions of bad credit decisions.

So, are our cheaper dollars now at the right price? In the coming months, all eyes will be on the consumer price index for the answer.

Unfortunately, there are circumstances in which excessive monetary creation can destabilise the economy while the rate of CPI inflation remains low. These tend to be present when the danger of monetary destabilisation is at its highest because people have lost faith in the ability of money to keep its value through time.

As one of the great monetary economists of the last century, Jacques Rueff, pointed out in the late 1960s, people react to the “growing insolvency” of a reserve currency, such as the dollar, by acquiring “gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity”. Sounds familiar? Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.

This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35 per cent to 7 per cent. Inflation then soared as the Tequila crisis exploded.

Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5 per cent in Indonesia and 3.8 per cent in South Korea.

The same symptoms have been visible in many other monetary crises in developing countries. They seem to be visible today in the US. Following the 2001 dotcom crash, resources flowed into real estate, foreign exchange and commodities, while CPI inflation remained modest. In 2007 the housing bubble finally burst, causing credit to crunch as the market struggled to out the owners of dud mortgages and mortgage-linked contracts. The Fed reacted with cheaper dollars, which did precisely nothing in that regard. Credit risk fears remain unabated. But the market duly dumped dollars for harder assets, pushing the euro, shares, oil and gold to record dollar prices.

Gold, having been global money for the better part of 2,500 years, and therefore the commodity most sensitive to expectations of macroeconomic in stability, provides the best measure of the extent of the rush towards inflation-proof hard assets.

Between August 2001 and August 2007, the dollar price of gold soared 144 per cent, while the CPI rose only 17 per cent. The last time such a substantial and sustained appreciation of gold was observed was in the 1970s, on the heels of America’s loose money policy and balance of payments deterioration in the 1960s and Rueff’s warnings regarding “the precarious dominance of the dollar”. There were two episodes, from 1971 to 1975 and from 1977 to 1980. In both, the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.

The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative.

It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar’s decline and offer the world a viable private alternative that has permanent intrinsic value.

As the Fed debates whether the world is truly crying out for even cheaper dollars, it would be wise to heed the lessons of monetary history.

Below, Tim Duy focuses on the fundamentals, as he argues the Fed will, and finds they do not justify a rate reduction:

The Fed begins a two-day meeting today, with market participants widely expecting a rate cut. I am mentally prepared to be on the wrong side of this call, joining the lonely few, but I just can’t tease another rate cut out of the incoming data.

In my mind, the argument for a rate cut hinges on one crucial assumption – that the market is expecting a rate cut, and the Fed will not want to disappoint.....

The problem with this view is that Fed Chairman Ben Bernanke does not believe it is his job to lead markets around by the nose like his predecessor. I think under the new regime, the Fed expects their comments to be taken at face value. And I think they are pretty effectively communicating their view on the economy: Outside of housing, there is minimal spillover, and whatever spillover exists is completely expected. From Bernanke on October 15 (italics mine):

Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners' equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

A week later, Chicago Fed President Charles Evans reiterated the outlook:

Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

Such comments – that the economy is roughly in-line with the Fed’s forecast – are essentially ignored by commentators. Has anyone noticed that the data flow has steadily caused 3Q07 estimates of growth to be raised above 3%? Think about it – the Fed cut rates 50bp during a quarter in which growth topped 3%, just after a quarter with almost 4% growth.

The Fed is never that proactive. Never.

Yes, I know, forecasts for 4Q07 are low on the potential impact of the August market turmoil. But note that we have almost no data on the 4th quarter to assess the quality of those forecasts; largely some volatile data on consumer confidence and jobless claims. Moreover, the Fed expects weakness, and is trying to look through it to mid-2008. And the Fed already cut 50bp because they knew that they would not have any good data on which to assess the 4th quarter at their October meeting. Nor would they normally commit to policy with only a single month’s data. The month is not even over! That was the “risk management” portion of their decision to cut 50bp in September. How many rate cuts do you take as insurance?

And, on risk management, Fed Governor Frederick Mishkin, one of the architects of 50bp move, sees financial conditions improving:
'

'Market functioning has certainly not yet returned to normal,'' Mishkin said in a speech at a seminar commemorating the 1907 U.S. financial panic, which led to the Fed's creation. Still, Fed actions ''have helped improve conditions in several short-term funding markets and instill confidence in investors that liquidity would be available if needed,'' he said.

They did not expect conditions to return to normal overnight; they are simply looking for things to be moving in the right direction. And they are – notice that the ABX market is coming unglued again, as documented by Calculated Risk, but the impact on financial markets is considerably more muted than this summer.

I also believe that this latest jump in oil prices will cause Fed policymakers to question their confidence in the inflation outlook more so than the growth outlook (if economic activity was really coming unglued, oil consumption should be slowing). And notice that despite a softer near term outlook for the economy, FedEx is still prepared to boost its air rates 6.9% next year, following this year’s 5.5%. They must be pretty confident of their pricing power. In my mind, the entire commodity complex is a worrying signal about the path of inflation, but I doubt the Fed is as concerned. Likewise the Dollar; I still have trouble believing the Fed has completely written off the Dollar, but continued rate cuts would signal that the Greenback remains a one-way bet.....

If the Fed decides they are unwilling to defy the market, or that “risk management” requires additional rate cuts, I would have to conclude that regardless of what the statement says, that one must expect a series of multiple rate cuts. They will be responding to the deteriorating housing market, and I simply expect no stabilization in that market in the near future....

Bottom Line: I believe the Fed intended to take a pass in October with the 50bp rate cut. I believe market participants were correctly reading the data until they got caught up in the risk management story. I think the Fed has been explaining past actions, not future policy. For that, you need to look at their forecast. On the basis on the data alone, the Fed is already so far in front of the curve it is hard to justify another cut at this point. I absolutely do not expect the Fed to cut 50bp.

This is the most contrarian call I have made; I simply believe that the case for a rate cut is much weaker than market participants appear to believe.

Countrywide Skeptics

As most readers probably know, subprime mortgage broker/lender Countrywide Financial's CEO Angelo Mozilo, which posted a massive loss for its third quarter, predicted a return to profit this quarter. Not only did the stock rise 32% that day, but CFC's announcement was perceived to be such good news that it gave the stock market a boost.

I will confess to not having given the Countrywide forecast much thought beyond considering it to be not credible. Now CFC could have deliberately over-reserved, and it therefore relying on being able to reverse those reserves if results don't meet its cheery prediction. However, the ABX indexes are continuing on as close as you can get to a vertical trajectory downward, so it looks pretty likely that any cushion will be consumed by increases in delinquencies and foreclosures (remember, a foreclosure puts an end to servicing revenues). CFC has announced a borrower salvage program that is unlikely to help its profits. I don't see much factual underpinning for the idea that CFC has turned the corner.

Now my view is based simply on the continuing-to-deteriorate fundamentals for housing and my belief that anything that comes out of Mozilo's mouth has to be taken with a handful of salt. But Michael Shedlock and Accrued Interest, who have thought about CFC more deeply, are also dubious.

Shedlock points out that the spike-up in the stock price was due to a short squeeze and then turns to substantive matters. First he gives us some juicy bits from Mozilo's pronouncement that I somehow missed:

Countrywide said borrowers were behind in payments on 29.08 percent of subprime loans it services as of September 30, up from 23.71 percent in June. The delinquency rate rose to 5.76 percent from 4.56 percent on prime home equity loans, and to 4.41 percent from 3.35 percent on conventional first mortgages.

That trajectory does not speak well for capital returning to the market. When losses start piling up, lenders tend to over-learn their lessons and become stringent often at precisely the time when reducing credit availability can have knock-on effects.

Shedlock's comments:

It appears that Countrywide attempted to throw in everything but the kitchen sink into those "one time losses". But even with that strategy it is premature for Countrywide to be acting as if the "perfect storm" is over. Those increases in delinquencies are going to translate into increased foreclosures and increased REOs (Real Estate Owned) sometime down the line.

One has to laugh at the statement that the third quarter represented an "earnings trough." After all, a $2.85 per share loss is quite a "trough". The estimate was a loss of $1.65 per share. It's quite amazing to see a $1.20 per share earnings miss be treated as such magnificent news.

In addition, Countrywide appears to be bragging about securing another $18 billion in "highly reliable" credit lines. Instead investors ought to be worried about the possibility that Countrywide will again need those credit lines.

Accrued Interest, by contrast, was willing to consider the possibility that Countrywide was correct and might show profits soon, and the tone of the post was neutral. However, the arguments do not bode well for CFC.

AI posits that mortgage lending could become more profitable by virtue of a shift in the supply/demand balance. Continuing demand for mortgages versus a withdrawal of lenders and investors suddenly means more pricing latitude on the part of lenders, and almost certainly margin improvement. He also points out that most salvageable of the current subprime borrowers facing resets will be refinanced, either by CFC itself, or Wamu, the FHA, or various state-sponsored programs. His conclusion:

So back to Countrywide. I don't think they are in a good position to take advantage of higher loan margins. I think actual banks with actual balance sheets and better access to emergency liquidity are in stronger position to realize new opportunities in mortgage lending. On the other hand, if we assume that Countrywide underwrites nothing other than easily securitized stuff, and has indeed written down all its assets (including both loans and servicing rights) to their true value, then there is no reason why they shouldn't be profitable to some degree in the near future.

The big IF in the previous paragraph is the true value of their assets. By that I mean not the market value, but what those assets really turn out to be worth. We are living in a world where determining the value of mortgage assets is extremely difficult. We know that there are assets currently priced at 50 cents on the dollar which will eventually pay off in full. And we know there are assets similarly priced which will turn out to be worthless. If Countrywide has written down all their risky assets to x cents on the dollar, and on average, that's what those assets eventually pay out, then everything will be fine. If they realize x-y, then it may be several quarters before they're back in the black.

Finally, the thing that I don't like about Countrywide is their access to non-market capital. A bank can go to the Fed or to the Home Loan Banks and get emergency capital. So if WaMu or Fifth Third or US Bank or some other large retail bank were to have sudden trouble with securitization, they'd have options. Countrywide Bank is too small to consider it a realistic option to fund Countrywide's overall operation, and as we saw in August, Countrywide is subject to liquidity problems.

In terms of the market overall, both in credit and stocks, you'd hope that Countrywide delivers on their promise. If not, I think there will be a very negative reaction in both markets.

Worries About Monoline Insurers Grow

Monoline insurers, such as MBIA, Ambac, and FGIC, are in the business of providing financial guarantees. And one of the products they got involved in guaranteeing was mortgage-related structured credits, much to their peril, as we noted back in August.

As subprime losses have mounted, so too have worries about the ability of these guarantors to maintain their AAA ratings. The Wall Street Journal on Friday pointed out that their funding costs were rising, a sign of concern about credit strength:

Financial institutions and bond insurers were targeted by cautious investors. The cost of credit protection on insurer American International Group Inc. and bond insurers such as Ambac Financial Group Inc., rose while their stock prices tumbled as worries about their exposure to the subprime mortgage market mounted.

Today, the Financial Times went so far as to suggest that the monolines might suffer serious mortgage-meltdown damage. This would bode ill for the local governments, since these firms are the main source of credit enhancement for municipal bonds.

From the Financial Times:

Investor worries are mounting that the next big casualties from the credit squeeze might be the specialist companies that act as guarantors for bond issuers.

These companies, which write insurance to boost the credit ratings of various kinds of bonds, have seen their share prices pummelled and the cost of protecting their debt against default soar. Over the past week, sector leaders such as MBIA, Ambac, XL Capital Assurance, Radian and MGIC have all been hit hard.

In recent years, these companies, known as monolines, have moved away from their role of guaranteeing, or wrapping, bonds issued by US municipalities towards writing business related to structured asset-backed finance deals, such as mortgage-backed bonds and collateralised debt obligations.

Following the turmoil in structured credit markets, this business has turned sour, which could affect the cost of borrowing for the local US authorities who rely on their guarantees.

“Our conclusion is that MBIA and the rest of the financial guarantors are facing a prolonged period of stress,” said Rob Haines, an analyst at CreditSights, a research house.

Standard & Poor’s said it was reviewing new data on bond insurers to determine the companies’ ability to weather any further subprime-related storms.

The sector suffered last week, particularly after it produced a string of disappointing third-quarter results, which included hefty writedowns on the value of the insurance contracts written on structured bonds.

MBIA reported earnings on Thursday and saw its shares finish the day 14.9 per cent lower at $46.99. They had recovered to $47.47 on Monday, well off their 12-month high of $76.02.

The cost of protecting $10m of MBIA’s debt against default in the credit default swap market has soared from about $22,000 annually for a five-year contract back in February to more than $231,000 last week, said data provider CMA Datavision.

MBIA and its peers believe the market has overreacted and expect to see the writedowns recovered as the bonds they have insured regain their market values and mature. Michael Grasher, an analyst at Piper Jaffray in New York, concurred that the recent weakness in the financial guarantors was an overreaction: “The market is betting that management has fallen asleep at the wheel. We don’t agree.”

Fed Reluctant to Cut Rates This Week

Bernanke is hoist on his own petard. He and the members of the FOMC had hoped that their dramatic cut in the Fed funds rate in September would be enough of a balm to the markets to give them more policy latitude in later months. Instead, the markets took it as a signal that Uncle Ben is their best friend, and they are lobbying for more, via the expectations signaled in futures prices. Now the FOMC is hostage. If they do what they think is right for the economy, they might roil the markets.

I wish we had Volcker back. He was more willing to inflict short-term pain for long-term benefit. A further rate cut will do nothing to shore up the areas of the market where the troubles lie, such as SIVs and CDOs. Certain types of mortgage-related assets are either not trading at all, or would trade only at distressed prices, due to problems of credit quality and transparency. A rate cut will not fix either problem.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and his colleagues sound as if they'd prefer to just say no to an interest-rate cut this week. The financial markets may not let them.

Policy makers from Bernanke on down have avoided signaling they want to reduce benchmark lending rates at their Oct. 30-31 meeting, ever since lowering them by a larger-than-anticipated half percentage point in September. Instead, Fed officials have stressed how uncertain the outlook is and, in words Bernanke used twice in a single week, how ``challenging'' it is to make policy.

Traders don't agree. They consider the chances of a rate cut this week as a cinch, judging from federal funds futures prices at the end of last week. If the Fed disappoints them, it risks upsetting still-fragile markets and hurting the economy.

``The Fed is reluctant to ease,'' says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions. ``But it also doesn't want to unsettle the financial markets unnecessarily.''

The likely rationale if the Fed cuts: a desire to prevent the worst case, in which renewed market tumult, rising oil prices and falling home values drive the U.S. economy into recession.

The Fed, though, may combine such a move with an open-ended statement that doesn't promise further cuts. Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns....

``The markets are yo-yoing all over the place,'' says former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Group Co. in Washington. ``The Fed ought to have a cooler head.''....

Anecdotal information the Fed has gathered from business contacts, which has more weight in uncertain times, shows the economy expanding, albeit at a slower pace than when the central bank's Federal Open Market Committee met last month....

Policy makers, including San Francisco Fed President Janet Yellen, have also highlighted the economy's ability to weather financial turmoil in the past as reason to avoid overreacting to the latest market squall.

They cite 1998, when stocks slumped and credit costs rose after the collapse of hedge fund Long Term Capital Management in September. Helped by three rapid-fire rate cuts by the Fed, the economy barreled ahead, growing by 6.2 percent in the fourth quarter....

The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice chairman of Macroeconomic Advisers LLC of St. Louis. Instead, it once again faces calls for another cut. And traders are betting it will comply once more, if only to short-circuit a renewed increase in borrowing costs in credit markets.

Update, 10/29, 4:45 PM: Further observations from the Nattering Naybob:

No cut on Oct 31st means BIG disappointment. Cut?? Initial glee, but then we could see a redux of Jan 31, 2001 rather than the 1998 scenario.

Between June 99 and May 00, the Fed raised to 6.5%, then held for 7 months. During which the Dot.com implosion began the stock market slide in Mar 2000.

In a surprise meeting 01/03/01 the Fed cut 50 bps, the markets rocketed to the upside for 4 weeks.

At the regularly schedule meeting on 01/31/01; The Fed cut another 50 bps. The market initially jumped up then closed down that day.

Looking at a chart it appears after raising, then holding, the 2nd cut reinforced lower economic expectations and a weaker dollar, which sent the market into a 3 year tail spin.

An economic-risk index compiled by Citigroup suggests that credit costs are rising after dropping in the aftermath of the initial 50 bps September rate cut.

Shang-Jin Wei: Yuan Float Will Yield Only Modest Benefits

At Vox EU, Shang-Jin Wei argues in "Don’t over-sell the benefits of a change in the Chinese exchange rate policy," that the upside of an end to the dirty float of the yuan (or as he prefers, the renminbi), has been overstated. His analysis is elegant and persuasive, and the piece is colorfully written as well.

He argues for the savings deficit hypothesis, that as long as Americans have a lousy-to-non-existent savings rate, our balance of payments won't get better. And he finds, empirically, that there is no evidence that a floating exchange rate speeds up a current account adjustment.

Wei also believes that while a more freely floating currency will be a net plus for China, he doesn't perceive the benefits to be large. I am a bit surprised that he does not address the argument commonly made, that the massive dollar purchases are playing a major role in domestic inflation (it has gotten so severe that China has imposed price controls). One would think that that would be a selling point.

From Vox EU:

Those urging China to adopt a more flexible exchange-rate regime sell the policy advice on the ground that it will substantially speed up the adjustment of global current accounts and that it will also substantially enhance the effectiveness of China’s domestic macroeconomic policies. Both supposed benefits may be exaggerated.

The Chinese renminbi (RMB) has come under intense scrutiny in the last five years, and calls for its revaluation have found receptive audiences amongst economists, politicians and the popular press. Many have advocated that China move to a more flexible exchange rate in order to alleviate global imbalances and improve its own macroeconomic management. But the benefits of an exchange-rate regime change for China and for the world may have been over-sold in policy circles. I say so on two grounds. First, the role of a flexible exchange-rate regime in facilitating current account adjustment may be vastly exaggerated. Second, the virtue of a flexible RMB exchange-rate regime in enhancing the effectiveness of China’s macroeconomic stability may also be over-rated.

Would a flexible exchange rate really speed up current account adjustment?

I ask this question not just due to the fact that a country’s current account imbalance is the difference between its national savings and national investment, that the large US current account deficit is a reflection of its large saving deficit, and that the US bilateral deficit with China is only part of its overall deficit with the rest of the world. All these are true.

Beyond these, many economists and policy wonks take it as self-evident that a flexible exchange-rate regime must deliver a faster current account adjustment. Many IMF statements also reflect this supposition. There is in fact no systematic evidence supporting it. I call this a faith-based initiative, something widely assumed to be true and actively peddled to countries as policy advice, but with little solid supportive evidence.

In a systematic analysis of this issue, Menzie Chinn and I find absolutely no support in the data for the notion that countries on a de facto flexible exchange-rate regime exhibit faster convergence of their current account to the long run equilibrium.1 This is true when we control for trade and financial openness; and this is true when we separate large and small countries.
To be sure, the current account does have a tendency to revert to its long-run steady state. This is clearly reflected in our empirical work. However, the speed of adjustment is not systematically related to the degree of flexibility of a country’s nominal exchange-rate regime.

Should we be surprised by this finding? Perhaps not. The current account responds to the real exchange rate, not the nominal exchange rate. If the real exchange rate adjustment does not depend very much on the nominal exchange-rate regime, then the current account adjustment would not depend very much on the nominal exchange-rate regime either. Menzie Chinn and I therefore go on to check whether the nature of a country’s nominal exchange-rate regime significantly affects the adjustment process of its real exchange rate. After looking at enough regressions, we conclude that the answer is no: the real exchange-rate adjustment is not systematically related to how flexible a country’s nominal exchange-rate regime is. If anything, there is slight, but not very robust evidence that less flexible nominal exchange-rate regimes sometimes exhibit faster real exchange-rate adjustment.

Just to be clear, if one could engineer a real appreciation of the renminbi, it could have some effect on China’s trade or current account balance. Indeed, in a separate research project that I am doing with Caroline Freund and Chang Hong, using China’s bilateral trade data and separating processing from non-processing trade, we find evidence that bilateral trade volume clearly responds to changes in bilateral real exchange rate, especially for non-processing trade.2 But a more flexible exchange rate does not promise a faster current account adjustment or resolution of global current account imbalances.

If China does opt for a more flexible exchange-rate regime today, its real exchange rate will most likely appreciate on impact. However, given China’s still-shaky financial sector and the credit crunch in advanced economies, it is certainly possible for the real exchange rate to go the other direction the day after tomorrow. After all, today’s expectation of an RMB undervaluation is a relatively recent phenomenon, emerging in late 2003. As clearly shown in Figure 1, taken from a paper with Jeffrey Frankel, until October 2003, the market actually expected a RMB depreciation, as measured by the non-deliverable forward rate.3 But the expectation shifted in late 2003 when US officialdom and scholars at prominent think tanks started to up the volume in the call for an RMB revaluation.


The very high speed of China’s foreign reserve accumulation really took off within the last four years, as seen in Figure 2. It may very well be responding to a shift in market expectation on the RMB movement, or at least the reserve accumulation and the exchange rate speculation feed on each other. However, if it took only four years for China’s FX reserve to triple in value, it may take only another four years for it to lose 60% of the value once the exchange rate expectation starts to reverse itself. Economic history books are full of examples of seemingly sudden shifts in market sentiment. A tight credit market in developed countries, such as the one we are seeing today, has in the past engendered a reversal of global capital flows, and a concomitant shift in the valuation of emerging market currencies.


Would a flexible regime vastly improve the effectiveness of China’s macro policies?

To appeal to China’s self-interest, advocates of a more flexible exchange-rate regime say it will greatly enhance the effectiveness of China’s domestic macroeconomic policy. A more flexible regime, as the logic goes, would free the domestic interest rate to serve as an instrument for domestic macroeconomic stability, and may benefit other policy objectives as well, such as financial reform and addressing future shocks. While I agree that a shift to a more flexible exchange-rate regime is a net positive for China, I would caution that the benefits of doing so for China should not be overrated.

First, China’s current monetary policy still has room for maneuver. Fundamentally, China’s capital controls, while leaky, are binding at the margin. The gap between lending and deposit rates can be widened further. The required reserve ratio might also be raised if desired.

Second, China’s fiscal policy still has room for maneuver. True, there are a lot of contingent liabilities that should and may show up on the country’s balance sheet. On the other hand, state-owned firms collectively are making a profit that is not currently counted in the government budget. The state may require these firms to pay up more dividends to augment existing fiscal management tools.

Third, to the extent that the de facto dollar peg constrains the conduct of China’s monetary policy, it may not be a bad thing. The most important goal of a good monetary policy is to maintain price stability. The de facto peg to the US dollar has served China well – beyond its role in promoting exports – as it has provided an anchor for its monetary policy. Once the country switches to a substantially more flexible exchange-rate regime, it will by definition lose this nominal anchor. One might prescribe an inflation targeting framework. But one could question how faithfully China will follow such a framework.

China’s recent monetary history has clear bouts of double-digit inflation, as shown in Figure 3. So resisting political pressure to deviate from maintaining price stability isn’t necessarily a strong suit for the central bank. The current leadership at the Central Bank, Governor Zhou Xiaochuan and his deputies, happens to be superb. But leadership at the central bank could change, and a look at the recent history doesn’t inspire absolute confidence that an inflation-targeting framework will be faithfully followed. So a less stable domestic price is a risk that cannot be easily ruled out if and when the country shifts to a more flexible exchange-rate regime.


Conclusion

I have stressed two points. First, the notion that a flexible exchange-rate regime would facilitate a faster current account adjustment is in fact not well supported by empirical evidence. Second, the virtue of a flexible exchange-rate regime in enhancing the effectiveness of China’s macroeconomic policy may also be overrated.

I still think that the benefits of moving to a more flexible exchange-rate regime likely outweigh the costs for China. On the other hand, China faces many challenges in its economy, including environmental degradation, rising income inequality, pervasive corruption, mining production safety, food production safety, and a constant threat of massive unemployment, to name just a few. In the grand scheme of things, when ranking all the reforms to do on the basis of benefit to cost ratio, how much priority this particular reform – the shift of the exchange-rate regime - should be given is a separate question.

Nouriel Roubini's Latest Take on Housing

Nouriel Roubini is a bit self-congratulatory in his latest post, and one can't begrudge him. He took a lot of heat for his early prediction that the housing market would deteriorate badly and pull down the broader economy.

So far, since growth has slowed only somewhat, some economists still hold out hope that the impact of housing on GDP will be limited. Roubini, in "The Recessionary Macro Effect of the Worst U.S. Housing Bust Ever," argues that the data coming in continues to support his earlier, grim forecasts.

He also notes that mortgage rates would have to fall 200bp to make current housing prices viable, and argues that the Fed was hoping that its September rate cut would be a step in that direction. But as most readers are well aware, long bond rates, which are the basis for pricing fixed rate mortgages, rose rather than fell based on higher inflation expectations.

From Roubini:

A friend of mine who is a senior professional in one of the largest financial institutions in the world has sent me privately – and confidentially - the following email messages. Like me, he predicted a year ago that this would be the worst housing recession in US history and described a bust process that would go through 4 phases. Here is the way he is putting it:

It appears that we are now entering phase 2 on the timeline for the housing bust:

Phase 1: rising mortgage defaults, homes prices start falling, sale volumes falls, housing starts and permits decline.

Phase 2: home-builders’ bankruptcies, housing starts and permits crash, substantial layoffs in construction and real estate-related fields (mortgage brokers, mortgage lenders, etc.).

Phase 3: substantial price declines in major metro areas, large rise in defaults of prime but low-equity mortgages.

Phase 4: large-scale government intervention to help households going bankrupt. This is a political phenomenon, so the timing and nature of this cannot be reliably forecast.

Evidence of financial distress and default among homebuilders in phase 2:

Public builders in trouble....

I fully agree with him with one caveat: we are not just at the beginning of phase 2 but most likely already at phase 3 as most of the aspects of phase 2 have already occurred by now and some elements of 3 are already on their way (home prices are falling sharply in some major metro areas, we are seeing the rise in defaults in near prime and prime mortgages and some near prime and prime lenders are in trouble). And we are getting close to phase 4 as over a dozen proposals to rescue 2 million plus households on the way to default and foreclosure are now being debated in Washington.

Next, this senior colleague sent me the following additional message - after my latest blog revisiting my predictions – on the macro impact of the worst housing bust in US history:

Follow-up to your blognote today...

Even more interesting is that the current view has not substantially changed from that of a year ago. The evidence is now overwhelming and consensus admits what they denied last year: that we will experience at least a severe housing downturn -- in price action unlike anything since the 1930's, probably also in rates of foreclosure.

But consensus opinion remains unshaken that there will be only minor macro effects. This seems extraordinary to me. A 70 year record decline in what is perhaps the largest private asset class, the collateral for the majority of household debt, whose leverage is at an all-time record high. A downturn - perhaps crash - in the construction and real estate industries (18% of 2005 total metropolitan area GDP).

Perhaps the most astonishing aspect of this event is the refusal to recognize the possible dimensions, the impact, of what is coming.

Indeed, the soft landing consensus is increasingly delusional in believing that the biggest housing recession in US history will not have severe macro effect. Most of the consensus now recognizes that, after the spurt in growth in Q3 (probably a little above 3%) the economy is now rapidly decelerating and Q4 will be weak: for example one of the most bullish houses – JP Morgan – is now forecasting a Q4 growth of only 1%, fully in the growth recession territory (Bloomberg consensus for Q4 is an optimistic 1.8%). But this consensus next goes to assume and predict that Q4 will be the bottom of the US growth slowdown and that economic growth will recovery in soft landing territory (2.5%).

What is the basis for this alleged 2008 growth recovery? Mostly wishful thinking as the economic and financial shocks leading to falling demand (a worsening housing bust; anemic capex spending; slowdown in commercial real estate demand; sharp private consumption slowdown) and weak supply (weakening ISM; slowing down employment; glut of supply of new and existing homes, auto/motorvehicles, consumer durables; a capacity overhang; an excess inventory buildup) will fully persist into 2008. Indeed, as David Rosenberg, the chief US economist for Merrill Lynch put it in his most recent report:

We think a miracle is needed to avoid recession. With domestic demand growth struggling to stay above a 1% run-rate, if we manage to avoid a recession with another huge down-leg in homebuilding activity and home prices, we think it will be a miracle.

A miracle to avoid a recession! Indeed it seems that many of the soft landing optimists are now in wishful thinking mode, if not hoping for a miracle. As Ed Leamer showed in his Jackson Hole paper, six of the last eight housing recessions have ended up in a economy-wide recession; and this housing recession will end up being more severe than all of the former eight ones. The only two exceptions of a housing recession not leading to economy-wide ones were those during the Korean War and the Vietnam war when a massive fiscal stimulus rescued the economy. What we spent – or waste – on Iraq is not sufficient to get that fiscal stimulus; we would need another equivalent of $200 billion fiscal stimulus to do the job. A war with Iran is such an option: but a war in Iran would lead to an overnight doubling of oil prices to $200 per barrel plus and would lead to a certain U.S. and global recession.

Home prices will have to fall by 20% to bring back home affordability to semi-normal levels; or mortgage rates would have to fall by 200bps to get the same result. Chances of the latter happening are zippo as long rates went up after the Fed eased on September 18th. So the adjustment will occur via a painful and deflationary 20% fall in home prices that will trigger an economy wide recession as any mainstream macro-econometric model shocked with a 20% fall in home prices shows.

No wonder that Mishkin – in his Jackson Hole paper – went through a benchmark scenario where home prices fall by 20%; do you think that Bernanke had not read Mishkin’s paper before the Jackson Hole meeting? And the implication of the Mishkin paper was that the Fed needed to start with a 200bps Fed Funds cut to try to attempt to counter this home price shock alone; even that would not be enough as long rates and mortgage rates are likely to fall less than otherwise hoped by the Fed.

So no surprise that Marty Feldstein urged at Jackson Hole the Fed to cut rates right away – to start with – by 100bps. But, at best, the FOMC will give us another 25bps as a Halloween Treat on Wednesday, not the 200bps implied by the Mishkin analysis. So, what the Fed does is – again – too little too late. The consensus among the independent academic luminaries at Jackson Hole (Feldstein, Leamer, Shiller, and even implicitly, Mishkin) was that this was the worst housing bust ever and that the macro effects would be severe with a high risk of a recession. So why is the Wall Street consensus and the Fed not getting it?

What does the macro econometric model used by the Fed imply if you shock it with the worst US housing recession, 20% fall in home prices, collapsing HEW, a severe liquidity and credit crunch, a rise in investors' risk aversion and uncertainty, and oil at $90? Would someone at the Fed let us know? And - based on that model - which cut in the Fed Funds rate it will take to avoid a recession? Hopefully someone at the Fed may have that answer and provide it to the public.

Is Merrill in Peril?

At this juncture, the question of "Whither Merrill?" is largely rhetorical. We won't know for certain until the fourth quarter results come in, and for all firms, those are likely to be telling. However, consider the following:

Some securities analysts already estimate that based on further deterioration in the mortgage markets since September 30, Merrill is now sitting on an additional $4 billion in losses.

Although these charts are for ABX BBB and AAA indexes, which are proxies for the subprime paper (there are no proxies for CDOs), these charts, courtesy Calculated Risk, give an idea of the recent trajectory:

ABX-HE-BBB- 07-2


ABX-HE-AAA-07-2

As of the end of the second quarter, Merrill owned $32.1 billion of collateralized debt obligations, reportedly AAA, and $8.8 billion of subprimes. A combination of sales and writedowns has whittled those figures to $15.2 billion and $5.7 billion, respectively.

However, CDOs have tremendous embedded leverage. Their prices are far more sensitive to changes in the performance of their underlying assets, than, say, subprime RMBS. That is why we have had the spectacle of rating agencies downgrading them, not by the normal grade or at worst two that you see for corporate bonds, but by huge amounts. Now that the rating agencies have gone through a process of reviewing ratings on various mortgage securities, Moody's is turning to CDOs, and some issues have already gone from AAA to junk. That rapid a downgrade is impossible in the corporate bond world in the absence of fraud.

In addition, while Merrill has sold more than half of its earlier CDO inventory, it's almost a given that what was most saleable was their better paper. What remains is more vulnerable. And with the subprime market taking, CDOs are sure to follow, both due to their direct exposure (a lot of subrprime paper went into CDOs, but many are subprime free) and to the knock-on effects on confidence.

With SIVs restructuring this quarter, which will entail some selling of mortgage related paper, there will be more stress on these markets. Between market deterioration and downgrades, it's not hard to imagine Merrill taking 50% losses on its remaining CDO inventory. That would mean further writedowns in excess of $7 billion.

More Doubts About Hedge Fund Performance

Hedge funds charge vastly higher fees than other money managers because they allegedly deliver better investment returns. Yet when you look at most hedge fund indices, they don't look much better, and are sometimes worse than simple long-only strategies. And remember these indices almost certainly overstate performance, since they exhibit what is called "survivorship bias." Funds that die are not included in the index, and since the mortality rate among hedge funds is higher than among mutual funds, it produces a greater gap between the returns reported in the indices versus those earned by a typical investor.

There are other distortions in results shown by hedge fund indices: the hedge funds report voluntarily, and they tend not to report poor results; the figures they submit are not audited; the results can include the best results from funds being incubated with small amounts of money.

The result of these distortions in aggregate is significant. A 2003 study, "A Critical Look at the Case for Hedge Funds," by Richard M. Ennis and Michael D. Sebastian published in the Journal for Portfolio Management, found that from 1992-2002, the Hedge Fund Research Composite Index's reported an average return of 11.3%. Yet the Hedge Fund Research Fund of Funds Index, which gives the results earned by investors in funds of hedge funds, showed returns over the same period of only 7.1%. And remember funds of hedge funds are supposed to allocate capital to the winners. This return also fell short of the performance of S&P 500 Index and the Lehman Aggregate Bond Index over this time frame.

Yet one rationale for hedge funds still persists: some hedge funds produce superior returns repeatedly. Unlike mutual funds, where mean reversion rules out, various studies have found that some top performers remain top performers.

Even that defense of hedge funds may have bitten the dust. A new study claims that the earlier research was based on faulty methodology.

Remember the logic for the exorbitant hedge fund fees. Investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperform the market are rare indeed.

The new paper, "Hedge Funds: Ability Persistence and Style Bias," by Matteo Belleri and Marco Navone (hat tip All About Alpha) tells us that the past research on this topic is largely bunk:

…the vast majority of the relevant contributions is focused on the persistence of funds total return. Only a small number of articles try to analyze the persistence of fund managers ability measured as the difference between fund return and the performance of an index of hedge funds with the same strategy.

The authors found something sneaky: while a few managers did outperform repeatedly in their reported strategy, when they reran the numbers, defining the strategy based on a three year regression of returns, they found no persistence in superior performance.

What does this result suggest? Style drift. Hedge fund managers are supposed to adhere to a certain program, say global macro, market neutral, distressed investing, emerging markets, commodities. What the authors' findings suggests is that hedge fund managers cheat. If their strategy is going cold, they dabble in something else.

Now if you an old-fashioned hedge fund investor, meaning a wealthy individual, you'd applaud someone who behaved like that. All you care about is absolute, or perhaps inflation-adjusted, return.

But institutional investors have become the dominant force in the industry, and they care not only about the alpha a fund generates, but also its "alternative beta." The fact that a particular hedge fund does global macro means it has a profile of returns that may not be correlated with other investments the fund has, and is attractive for that reason. Thus, if a fund deviates from its style, it won't deliver the type of alternative beta it promised. That is a major no-no for the hedge fund consultants who serve as the gatekeepers for institutional investors.

The study by Belleri and Navone is a major challenge to conventional wisdom about hedge funds. It will be interesting to see what sort of additional research it provokes.

Larry Summers on How to Manage the Dollar's Decline

Whoever wrote the headline to former Treasury Secretary, now Harvard professor Larry Summers' latest comment in the Financial Times did him a disservice. The lead-in, "How American must handle the falling dollar," implies that Summers has a specific, hard-headed program. Instead, the piece offers a succinct and subtle analysis of what is wrong with our current approach but offers little in the way of a prescription.

Summers' main observation is that America is adhering to a posture that worked when the facts on the ground were different, namely, we had solid growth prospects and our trading partners had floating currencies. Now, we have a deteriorating economy and quite a few countries peg their currency to the dollar. The one shift is that we are focusing our energies on getting China to float its currency, which Summers argues isn't the best way to go about things. The problem is clearly greater than China and putting China on the spot has the perverse effect of making it more difficult for them to go along.

Not surprisingly, Summers advocates taking a multilateral approach with a new group larger than the G-7. He also urges shifting the focus of policy away from the impact on workers toward:

..... the desirability of a strong, integrated global economy that benefits the citizens of all countries, not on the idea that economists or politicians can calculate “fair” exchange rates.

That is a nice-sounding ideal, but I wonder if it can be made to work in practice. The sands are shifting on the question of when and to what degree free trade is beneficial. Dani Rodrik has argued that widely touted figures that claim to come up with large per capita benefits are dubious at best, and more rigorous calculations come up with modest gains. A vocal minority, including Paul Samuelson and Alan Blinder, believes that more open trade can be detrimental to workers in high-wage countries. More recently, Thomas Palley has added an interesting wrinkle, arguing that the problem lie in the fact that large companies increasingly make productivity-enhancing investments in low-wage countries.

I'm not sure how you can neatly decouple overall economic impact from the effect on workers if large numbers of workers are affected. I am also not certain that we are not close to an efficient frontier on the trade front. Further integration of markets raises issues of national sovereignty. Further liberalization may also do more to redistribute income and wealth within a country than to create average gains.

Mind you, I am not saying these reservations are correct, but they are becoming more widespread. The advocates of greater liberalization are going to have to do a better job of making their case than in the past, and in particular, marshaling empirical data rather than theory. As the wide-ranging debate with China illustrates, currency and trade policies are interdependent.

From the Financial Times:

The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yolked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

Think of the questions Chinese policymakers must ask themselves. What is the highest US priority – global financial stability or market access for well-connected US firms? Can the US take yes for an answer or is it a certainty that a new president will insist in 18 months on a new set of economic diplomacy accomplishments with China? In which areas, if any, is the US prepared to adjust its policies in response to global interests? Given that the Chinese authorities have presided over nearly double digit annual growth for a generation, do US officials who make assertions about what is in China’s interest have the experience and knowledge of China that should cause their views to be taken seriously? Why is China being singled out? How could China – even if it wished to – act in ways that the US prefers without appearing to yield to international pressure?

Maintaining global financial stability and the role of the dollar requires a more strategic approach – a task that, given the political calendar, is likely to fall to the next US administration.

The G7 process has lost its focus on exchange rate issues over the years as its member governments stopped trying to manage their rates. In any event, the G7 is something of an anachronism in the current international context.

It needs to be radically reinvented, starting with a change in its composition. Yet its history – particularly in its early years, when it focused heavily on macroeconomic and exchange rate policies – is instructive. Two principles stand out.

First, any new approach must be premised on the desirability of a strong, integrated global economy that benefits the citizens of all countries, not on the idea that economists or politicians can calculate “fair” exchange rates.

The right and potentially effective case for adjustments in the current alignment of exchange rates relies on their unsustainability and the distortions they induce in macroeconomic policies, not on ideas of fairness to workers.

Second, multilateralism is better politics and economics than unilateralism but it must not become an excuse for inertia. Any new group should be as large as necessary and no larger, should meet with some frequency and should include central bankers. It should be analytically informed but everyone should know that key decisions will ultimately be taken by senior officials in the national interest, not by international organisations.

The stakes are high. Well-managed finance cannot on its own make a country stable and prosperous, let alone the world. But history tells us that poorly managed finance foments instability and economic insecurity.

Ben Stein and Space Aliens

I do not want to step on the turf of fellow blogger Felix Salmon, who has established a new feature, the Ben Stein Watch, to commemorate the generally deranged and uncomfortably close to stream-of-consciousness output of the Sunday New York Times columnist who styles himself as "lawyer, writer, actor and economist." Well, at least he puts economist last, since his formal economics training appears to have ended as an undergraduate, but he gets bonus points for being the son of former chairman of the Council of Economic Advisers, Herbert Stein.

I'll leave the much deserved evisceration of this week's column, "Pledging Allegiance to the United States of Hedge Funds," to Felix. I assume this piece is meant to be humorous, because it certainly can't be taken seriously. But Stein's not a skilled enough writer to pull it off, so it comes off as being merely unhinged.

I finally put my finger on why Stein bothers me. Most readers probably are too well heeled to actually stand in line in grocery stores, but one of the things that makes it tolerable for me is the occasional sighting of Weekly World News. For those of you who don't know it, it is far and away the cheesiest, lowest production value, most outrageous weekly tabloid, and by a considerable margin. Alien abductions, weird human crossbreedings, sightings of Hitler, bizarre marriages/birth/diseases are among its staples. Where else can you read about Bigfoot kidnapping a lumberjack and keeping him captive as a love slave? I figured the staff had to get high every week to come up with this stuff.

But the thought recently occurred to me that if I actually believed in Area 51, or were a fellow tabloid publisher, the existence of Weekly World News would bother me, because it it degraded things that meant something to me.

Stein is the Weekly World News of economics writers. He natterings are so often contradictory or contrafactual that he might as well be writing about space aliens. But at least the guys at Weekly World News know that they are merely free associating and having good fun with it. I'm not sure Ben Stein recognizes that that is what he is doing.

New York Times, take note. American Media recently shuttered Weekly World News. Maybe Stein's days are numbered as well.

Update 10/28, 6:30 PM: Felix Salmon weighs in here and Dean Baker has done the heavy lifting of taking Stein's latest, such as it is, seriously.

Conventional Wisdom Watch (Financial Innovation Edition)

Even though I have said some unkind things about the Economist, once you get outside the world of politics, it is a very good guide to leading edge conventional wisdom.

What do I mean by "leading edge conventional wisdom?" It is the sort of thinking dispensed by well regarded think tanks and private sector experts who have the ear of powerful people. They seek to traffic in ideas that are on the cusp of being widely held. These gurus don't want to be too far out in front, since being a Cassandra is tantamount to being a crank. And if they turn out to be wrong, their views need to palatable enough so that they won't be look ridiculous in hindsight.

The latest example of "Economist as barometer" comes via the article "Spooking investors" in its current issue. To its credit, the piece gives a very nice overview of the current credit mess and how we got there. But the part that caught my attention is how the article explicitly discusses conventional wisdom about structured products, correctly pointing out that they were once widely considered to reduce risk by dispersing it more widely. But the article repudiates this earlier view.

Now in fairness, if you read past pronouncements about the virtues of financial innovation, they focused on the role of securitization (which goes well beyond structured finance) and risk dispersion (which happens through other mechanisms as well, particularly credit default swaps and other derivatives). See here for excerpts from and a link to a very good speech on this topic by New York Fed President Timothy Geithner. In it, he made an prescient comment:

....these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.

Back to the Economist. What is interesting, particularly if read in contrast to Geithner's speech of a mere seven months ago, is the undertone of skepticism about high-falutin' finance. This is new, and particularly unexpected from an outlet like the Economist. And while the focus of the piece was on the real trouble spots, the new found reservation about financial innovation is likely to continue for some time beyond the acute phase of the credit crunch.

One final observation: the subhead reads: "Financial markets remain on edge because the credit crunch has not been solved." The word choice is intriguing. It doesn't say, "because the credit crunch has not abated" or "the credit crunch has not resolved itself." The use of the word "solved" evokes a problem solver, meaning an person, team, or organization. That suggests a belief that the situation is so out of balance it will not right itself on its own and calls for intervention.

From the Economist:

The big question is whether the current mood is temporary, as investors digest their high-yield excesses, or whether the sickness will prove a more lasting malaise. Much depends on how America's housing bust plays out. Like a toffee apple with a maggot inside, the debt markets have been tainted by their links with America's subprime mortgage crisis. Those loans to dodgy borrowers have been bundled up into fancy financial vehicles known as structured products, and it is proving hard to sort out the mess.

But it is also clear that the financial system is less sound than it seemed. Conventional wisdom held that the process of slicing debts into numerous structured products dispersed risk and thus reduced it, especially for banks. But it turns out that the risk that banks ushered out of their front doors sneaked in again through the back. This is because the new owners of structured assets are either big clients of the banks or have borrowed from them.

Furthermore, structured finance's dependence on leverage and illiquid assets has left it prone to crisis. New institutions, such as hedge funds and conduits—what Paul McCulley, of Pimco, a fund management group, has called “the shadow banking system”—are highly dependent on borrowed money, or leverage. And they are also highly attracted to illiquid assets, which offer outsize returns. But when markets turn, those institutions are caught on a hook: they are forced to cut their borrowings but find it difficult to sell assets. And if they receive only rock-bottom prices, they may be forced out of business. That is why what seemed like a liquidity problem may turn out to be one of solvency.

In many ways, the structured-debt malaise stems from success, particularly that of central banks. Their record of taming inflation, moderating recession and riding to the rescue whenever financial crises threatened has encouraged investors to take risks, in particular to lend to less creditworthy borrowers and to invest in illiquid assets. This trend can be self-reinforcing. When risky borrowers find it easy to get credit, they are less likely to go bust, which makes them appear less risky. And when lots of investors buy illiquid assets, trading volumes increase, making the assets seem more liquid.

Borrowing to invest in higher-yielding or risky assets is one form of the “carry trade”. This was the strategy of obscure bodies known as structured investment vehicles (SIVs) and conduits. They borrowed short-term and invested the proceeds at a higher yield, often in complex products linked to bundles of loans. The margin was their profit. Such assets offered an excess return to compensate investors for their illiquidity.

Both high yields and illiquid assets are also attractive to hedge funds, which have become the rising powers of the fund-management industry. Because of the high fees they charge, hedge funds need to make big gross returns to deliver decent net returns to their clients.

Historians of the financial markets will recognise that what the SIVs and some hedge funds were doing was, at heart, the oldest game in the business: borrowing short and lending long. The strategy depends on the continual ability of investors to renew their funding or to sell their assets (at a decent price). When one part of the equation goes wrong, so does the other: if investors in general are unable to obtain funding, there will be few willing buyers.

Things duly went wrong in August. Both the credit and money markets became frozen, while in the stockmarket, computer-driven trading models that had worked for years suddenly failed (see article). At the same time, it became clear that the modern financial system had dispersed risk much less successfully than people believed.

Many of the most dubious assets were, indeed, held by hedge funds. But most hedge funds obtain their finance from the banks and 60% of hedge-fund assets are handled by three prime brokers (all of which are big investment banks). In addition, hedge funds own the same assets as banks' trading desks. This means that when the hedge funds are forced to sell, the trading desks are likely to lose money.

Similarly, the SIVs and conduits were not wholly independent of the banking system. Conduits were “off balance-sheet vehicles” that allowed banks to be exposed to complex bonds without requiring them to hold reserves against them. Many SIVs were operated by banks, had banks as investors or had arrangements to call on bank financing when their conventional sources of liquidity failed.

Anorexic models
Don't banks and hedge funds employ mathematical geniuses who develop highly sophisticated models to control these risks? They do, but they have a difficult task. The standard statistical approach to risk management is based on a “bell curve” or normal distribution, in which most results are in the middle and extremes are rare. It is the bell curve to which investors are referring when they talk about a “nine standard deviation event”. But financial history is littered with bubbles and crashes, demonstrating that extreme events or so-called “fat tails” occur far more often than the bell curve predicts.

In a fat-tail world it is very hard to monitor how much risk you are taking on. Many banks use a “value at risk” approach, which tells them the maximum daily loss a portfolio might face, based on measures of past volatility. This requires a trader to cut his positions when volatility rises. But if all traders are trying to do the same, volatility will rise even further, well beyond the limits the models suggest.

The same difficulty faces investors who control their positions on the basis of daily market volumes. Ideally they want trading to be heavy so they can sell without shifting prices against them. When times are good, volumes are usually high; but when times are bad, they can be non-existent.

That suggests models should have been built on the assumption that liquidity can disappear overnight. But apart from the mathematical complexities involved, that would have created another difficulty. In the short term those using conventional models would take greater risks and earn higher returns for their clients. The cautious firm would lose business and see its star employees lured away to firms that can pay bigger bonuses. By the time the crisis occurred, and the cautious firm was proved right, it could be too late.

Investors accordingly assume that markets will stay liquid or that they can exit before anyone else. In August they found out how wrong that assumption could be. “It turned out that only two markets were truly liquid: German-bond and US-Treasury futures,” says Manoj Pradhan, a fixed-income analyst at Morgan Stanley.

The world is still sorting out the mess. This week Royal Bank of Scotland entered into exclusive talks with a struggling SIV, a $6.6 billion fund run by Cheyne Capital, which may result in a refinancing.

On a grander scale, there are plans for a $100 billion bail-out fund known as the super-SIV. Backed by four American banks it plans to acquire assets from so-called “orphan SIVs”—those without bank backing. If forced to unload their assets all of a sudden, these “orphan SIVs” could cause a sharp drop in prices. That would force other investors to lower their balance-sheet valuations, making the crisis worse.

What is not clear, in either case, is whether the device will solve the problem. The hope is that the super-SIV, in particular, will improve confidence by setting a market price for the fund's assets. However, the super-SIV intends to buy only the most creditworthy notes from other SIVs, leaving them stuck with the rest, euphemistically known as “toxic waste”.

Furthermore, the super-SIV seems to embody a contradiction. In August the worry was that banks were overexposed to SIVs. The new fund will only extend their exposure. If the mortgage-backed market does go to hell in a handcart, the banks will have an even bumpier ride.

That raises the question of whether SIVs and conduits ought to exist at all. “It's not clear that the business model of SIVs and bank conduits can survive in the current form,” says Mark Benson, of CQS, a hedge-fund manager.

With the picture so blurry, investors will remain nervous. The cost of insuring high-yield debt against default rose by the biggest amount in one day since late July on October 19th. The spread (excess interest rate) paid by high-yield borrowers is only around half a percentage point lower than it was at the height of the crunch.

Thundering to blundering herd
Merrill Lynch's disastrous third quarter indicates more trouble might be in store. Its results encompass a difficult period in September, unlike those of other Wall Street banks, which reported earlier. That suggests their fourth-quarter numbers could be bad, too. Many of the write-downs related to “super senior” AAA-rated securities, indicating even the best structured products are not very good.

Just as the housing market was dependent on subprime borrowers, the structured-debt markets were dependent on subprime investors. Both were too reliant on borrowed money, and suffered when their ability to borrow was taken away.

This crunch in structured debt could still undermine the global economy, by prompting a broader tightening of credit conditions that chill consumer spending. Alternatively, if the economy deteriorates before the credit problem is solved, the damage to the financial sector could be immense. As the Bank of England's latest financial stability report warns, “In the short run, the financial system in the advanced economies remains vulnerable to new shocks.” Never mind the ghosts and goblins; it is the credit crunch that should keep investors awake at night.

Rising Ozone Levels to Reduce Agricultural Productivity by 40%

Ozone is getting increasing attention as a greenhouse gas, and the findings are not pretty. We reported earlier on research that found that ozone interferes with plant photosynthesis, which both reduces its effectiveness as a carbon sink and reduces plant productivity.

A new MIT study (hat tip Mark Thoma) reports that rising ozone levels are particularly damaging to crop output, and it estimates the impact by 2100 will be a 40% fall in productivity. However, the authors forecast that it will be partially offset by allocation more land to farming.

Um, where will this land come from? The human race is already engaging in massive deforestation. And forests, or even shrubland, consume more CO2 than crops. Turning more land over to agriculture is just an acceleration of one of the trends that has produced climate change in the first place.

From MIT News:

A novel MIT study concludes that increasing levels of ozone due to the growing use of fossil fuels will damage global vegetation, resulting in serious costs to the world's economy.

The analysis, reported in the November issue of Energy Policy, focused on how three environmental changes (increases in temperature, carbon dioxide and ozone) associated with human activity will affect crops, pastures and forests.

The research shows that increases in temperature and in carbon dioxide may actually benefit vegetation, especially in northern temperate regions. However, those benefits may be more than offset by the detrimental effects of increases in ozone, notably on crops. Ozone is a form of oxygen that is an atmospheric pollutant at ground level.

The economic cost of the damage will be moderated by changes in land use and by agricultural trade, with some regions more able to adapt than others. But the overall economic consequences will be considerable. According to the analysis, if nothing is done, by 2100 the global value of crop production will fall by 10 to 12 percent.

"Even assuming that best-practice technology for controlling ozone is adopted worldwide, we see rapidly rising ozone concentrations in the coming decades," said John M. Reilly, associate director of the MIT Joint Program on the Science and Policy of Global Change. "That result is both surprising and worrisome."

While others have looked at how changes in climate and in carbon dioxide concentrations may affect vegetation, Reilly and colleagues added to that mix changes in tropospheric ozone. Moreover, they looked at the combined impact of all three environmental "stressors" at once. (Changes in ecosystems and human health and other impacts of potential concern are outside the scope of this study.)

They performed their analysis using the MIT Integrated Global Systems Model, which combines linked state-of-the-art economic, climate and agricultural computer models to project emissions of greenhouse gases and ozone precursors based on human activity and natural systems.

Results for the impacts of climate change and rising carbon dioxide concentrations (assuming business as usual, with no emissions restrictions) brought few surprises. For example, the estimated carbon dioxide and temperature increases would benefit vegetation in much of the world.

The effects of ozone are decidedly different.

Without emissions restrictions, growing fuel combustion worldwide will push global average ozone up 50 percent by 2100. That increase will have a disproportionately large impact on vegetation because ozone concentrations in many locations will rise above the critical level where adverse effects are observed in plants and ecosystems.

Crops are hardest hit. Model predictions show that ozone levels tend to be highest in regions where crops are grown. In addition, crops are particularly sensitive to ozone, in part because they are fertilized. "When crops are fertilized, their stomata open up, and they suck in more air. And the more air they suck in, the more ozone damage occurs," said Reilly. "It's a little like going out and exercising really hard on a high-ozone day."

What is the net effect of the three environmental changes? Without emissions restrictions, yields from forests and pastures decline slightly or even increase because of the climate and carbon dioxide effects. But crop yields fall by nearly 40 percent worldwide.

However, those yield losses do not translate directly into economic losses. According to the economic model, the world adapts by allocating more land to crops. That adaptation, however, comes at a cost. The use of additional resources brings a global economic loss of 10-12 percent of the total value of crop production.

Global estimates do not tell the whole story, however, as regional impacts vary significantly.

For example, northern temperate regions generally benefit from climate change because higher temperatures extend their growing season. However, the crop losses associated with high ozone concentrations will be significant. In contrast, the tropics, already warm, do not benefit from further warming, but they are not as hard hit by ozone damage because ozone-precursor emissions are lower in the tropics.

The net result: regions such as the United States, China and Europe would need to import food, and supplying those imports would be a benefit to tropical countries.

Reilly warns that the study's climate projections may be overly optimistic. The researchers are now incorporating a more realistic climate simulation into their analysis.

Reilly's colleagues are from MIT and the Marine Biological Laboratory. The research was supported by the Department of Energy, the Environmental Protection Agency, the National Science Foundation, NASA, the National Oceanographic and Atmospheric Administration and the MIT Joint Program on the Science and Policy of Global Change.

It is part of the MIT Energy Initiative (MITEI), an Institute-wide initiative designed to help transform the global energy system to meet the challenges of the future. MITEI includes research, education, campus energy management and outreach activities, an interdisciplinary approach that covers all areas of energy supply and demand, security and environmental impact.

Wall Street Journal Gets It Wrong on Bankruptcy

Although riding herd on the Wall Street Journal is one of our favorite forms of recreation, we missed a couple of misstatements that were noticed by more alert eyes.

Katie Porter at Credit Slips, caught two instances in two days in which the Journal mischaracterized bankruptcy practices, first pending legislation, and second, an unproven assertion about bankruptcy filers' behavior. In both cases, the Journal suggested that lenders were getting a raw deal; Porter begs to differ.

From Credit Slips:

In recent days, however, the Wall Street Journal has published pieces about bankruptcy that contain inaccuracies. An editorial on October 24th, The Mortgage Meltdown, grossly mischaracterizes pending bankruptcy legislation. The bill, the Emergency Home Ownership and Mortgage Equity Protection Act of 2007(HR 3609), would reverse the existing preferential treatment in Chapter 13 bankruptcy law for home mortgages and permit debtors to modify their home loans in certain ways. The Wall Street Journal says that the legislation will "allow bankruptcy filers to treat home loans as similar to unsecured credit-card debt." The editorial then sarcastically posits "Guess how eager lenders will be to offer low mortgage rates if they have no better chance of collecting on a mortgage than they do on a credit card?" This characterization isn't mere alarmist hyperbole. It's flatly wrong. Mortgages are liens; they give the lender a security interest in the debtor's real property. Absent unusual circumstances, secured creditors retain their property interestsin the collateral. If they aren't paid--inside or outside of bankruptcy--they can foreclose on the property. In contrast, credit cards are normally unsecured debt. The lenders have no collateral. Unsecured debt and secured debt are treated differently in bankruptcy law, just as they are in state law. The apt comparison for HR 3609's proposal is that home mortgage lenders would be treated just like lenders whose collateral are vacation homes, or commercial property, or rental houses, or whose collateral are cars, motorcycles, or appliances. The Wall Street Journal should print a correction, making clear that the bill would not put mortgage lenders on par with credit card companies, and retracting its suggestion that the legislation would thereby cause mortgages to have the same interest rates as credit cards. Perhaps some would excuse the Journal because these statements were in an editorial. But a recent news article on bankruptcy as a home-saving device was also misleading.

The article appeared on October 23 as a front page story. The problems began right away--the article's very title, More Debtors Use Bankruptcy to Keep Their Homes, does not appear to be squarely supported by any evidence in the story. The truth is that the government does not track how many people who file bankruptcy are homeowners. These data simply don't exist. In an apparent remedy to this problem, the article offers the rise in Chapter 13 bankruptcy cases as evidence that bankruptcy is increasingly the refuge of choice for families facing foreclosure. While studies do show that the proportion of homeowners in Chapter 13 is higher than in Chapter 7, the article's statement that "an increasing number of homeowners have filed for bankruptcy in Chapter 13" doesn't actually show that foreclosures are driving bankruptcies. As absolute numbers, both Chapter 7 and Chapter 13 bankruptcies are higher last quarter than in the same quarter in 2006. So while there are an increasing number of Chapter 13 cases, that same statement is true for Chapter 7 bankruptcy. Indeed, the percentage growth in Chapter 7 cases is actually higher than Chapter 13. Using the very figures in the Journal's graphic in the article, one can see that the share of cases that are Chapter 13 filings has actually fallen from 39% in 2006 to 37% in 2007. How is this credible evidence that "Chapter 13 Filings Gain in Popularity?" As most law students will tell you, bankruptcy isn't an easy subject. The law is hard to understand, and the policy tensions in the statute are complex. I'm glad to see journalism on bankruptcy and foreclosure, but inaccuracies or unsupported assertions create obstacles to informed policymaking.