naked capitalism

Jim Hamilton, in his latest post at Econbrowser, uses as a point of departure the oft-invoked image that Bernanke is walking a tightrope between inflation and recession.

Because Hamilton is a Serious Economist, he has to be measured and fact based, which sometimes means he can’t be as pointed as I suspect he might like to be.

Hamilton is effectively saying that the notion that there is a path that keeps the economy from suffering either a recession or inflation is garbage.

Bernanke (at least publicly) is failing to admit that our damaged credit system is central to our woes. Cutting rate is not going to make insolvent borrowers suddenly credit worthy (except in a small proportion of marginal cases), nor is it improving liquidity in the sectors where it is needed, such as the securitization market or auction rate securities. Those sectors are suffering from serious doubt about the product, not merely due to the decline in the perceived quality of the collateral/creditworthiness, but the basic design of the product (dubious role of the rating agencies, uncertainty about the effectiveness of credit enhancement, and in the case of CDOs, the discovery that downgrades can be dramatic). Hamilton even suggests that the recent monetary moves played a direct role in the vertical ascent of commodities prices in the last two months.

Hamilton has neither the occasionally combative temperament nor the bully pulpit of a Paul Krugman, but the information he presents, even in his understated manner, is an indictment of the Fed. There are point where he treats Bernanke with more deference that he deserves, for example, when he makes the mind-boggling claim that commodity futures prices indicate that food and energy prices will flatten out this year.

The only defense Hamitlon can find for the central bank’s actions is that it may be deliberately stoking inflation to erode the value of America’s debt overhang.

Hamilton gave an excellent presentation at the Jackson Hole conference that (among other things) argued that interest rate policy would be ineffective in dealing with the credit crisis and that more emphasis needed to be placed on institutional reform. Despite the fact that the reasoning is unassailable (and confirmed by the failure of repeated rate cuts to stop the seize-ups afflicting important sectors of the market), Hamilton’s prescription (and others like it) have been ignored.

Oddly, this conundrum reminds me of the situation that led Daniel Ellsberg to release the Pentagon Papers. Ellsberg was perhaps the best informed person in the US about Vietnam; he had been there for both the Department of Defense and the State Department, and unlike most US operatives, had spent considerable time on the ground, including under fire.

Like many people in the intelligence community (he worked for Rand), he believed if he could only get the ear of the President and get them to understand what a hopeless exercise Vietman was, they would withdraw. But reading the Pentagon Papers, which gave the history of the US involvement from the inside, showed Ellsberg that every Administration involved in Vietnam knew full well that the US would not succeed. The Presidents had not gotten optimistic briefings; quite the reverse. Yet even though they knew this was a costly and doomed enterprise, they refused to withdraw, deeming the prestige of the US to be at stake.

I wonder if a similar dynamic is at work here, that the Fed in fact appreciates full well the nature and depth of this crisis, yet is following a conventional and futile pattern of action because to do otherwise would be to admit the Emperor has no clothes.

From Econbrowser:

Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope– if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we’ll see a resurgence of inflation. I am increasingly persuaded that’s not an accurate description of the situation.

We’ve seen some quite remarkable movements in commodity markets the last two months. The graph below plots the price of 14 that I could get my hands on quickly through Webstract, with each price normalized at 100 for January 1. Every single one of these prices has risen dramatically since then. The most tame among the group has been zinc, which is up a mere 6.5% over the last two months, or 39% at an annual rate. Topping the group is wheat, up 46% over two months; I won’t try to translate that one into an annual inflation rate because I don’t want to scare you.

When Bernanke opined yesterday,

diminishing pressure on resources is also consistent with the projected slowing in inflation,

he evidently wasn’t referring to aluminum or barley or coffee or cocoa or copper or corn or cotton or gold or lead or oats or silver or tin or wheat or zinc.

If it were just a few commodities moving, I wouldn’t be concerned, as any of these prices can be quite sensitive to small disruptions in supply. But we are clearly looking at an aggregate phenomenon here, and it seems unreasonable to suppose that the phenomenon has nothing to do with choices by the Fed. Although I have been skeptical of Jeff Frankel’s story that low interest rates were the primary cause of the broad movements in commodity prices over the last several years, it is very plausible to me as one explanation of what we’ve seen happen over the last two months.

Bernanke’s latest statement also included the following:

The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections). A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets.

Now it is true that if you look at the time profile of futures contracts on these commodities, you don’t see an upward slope, a fact in which Bernanke has taken solace on a number of previous occasions as well. But even if there is no further increase in the price of wheat, surely it’s reasonable to anticipate increases yet to come in the price of bread and Wheaties and pasta.

I think part of the basis for Bernanke’s optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke’s textbook suggests that, for given inflation expectations, if output falls below the “full-employment” level, inflation should go down, not up.

But what exactly does the theoretical full-employment level of output correspond to in the present situation? There are fundamental problems with credit markets at the moment, and these arise not from a nominal interest rate or wage rate that are too high (the usual textbook suspects), but instead from a real disruption in the basic process of financial intermediation, as if somebody had dropped a bomb on our financial system, preventing it from efficiently allocating credit. To the extent that’s the case, it may be that “full-employment GDP” would actually decline this year, and an effort to use a monetary expansion to prevent that would indeed be inflationary.

Of course, a serious problem in the market for credit is another area with which Bernanke the academic is quite familiar. But as I explained when I had an opportunity to address the Fed governors and presidents last fall, fiddling with the level of the fed funds rate is not a particularly efficacious tool for dealing with this problem. I’m not saying it’s of no help. But I think the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The monetary cure for our ails of course also has a downside, in that we’ll later need an artificial recession to bring the inflation back down. Greg Mankiw notes Allan Meltzer’s displeasure at this prospect:

A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public’s complaints about inflation.

I agree with Meltzer that the recent Fed rate cuts are buying us higher output at the moment at the cost of lower output in the future, for just the reason Meltzer gives. But I disagree that the recession Bernanke is trying to avoid would be a “small” one. The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter.

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

No, I don’t believe that Bernanke is walking a tightrope at all. But I do hope he’s checked out the net that’s supposed to catch him if he falls.

Paul Davies, in “True impact of mark-to-market accounting in the credit crisis,” discusses a paper by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton University that claim that mark-to-market accounting play a direct, perhaps central role in the credit bubble, and that it works just as dramatically in reverse.

Once they explain the thesis, it’s so blinding obvious that one wonders why that sort of thinking hasn’t gotten top billing sooner. When asset prices rise (say because interest rates fall), the balance sheet gains lead directly to increases in a firm’s equity. Financial institutions tend to maintain the same level of gearing, so when equity goes up, they want to increase their balance sheet size. Similarly, when asset prices fall, the losses are hits to equity, and balance sheets contract.

These expansions and contractions happen system-wide, and lead to what is perceived as increases and falls in liquidity. The authors argue that liquidity tantamount to the rate of growth in aggregate balance sheets.

I’ve only skimmed the paper, but it looks suitably rigorous and has lots of analyses and charts. It’s puzzling that it hasn’t gotten more attention.

The writeup by Davies presents the findings faithfully and makes some observation of his own.

From the Financial Times:

Back in April 1993 the eyes of the world were on the beseiged Balkan town of Srebrenica, which the UN declared a safe haven for Bosnian muslims, and on Northern Ireland, where secret talks between leaders from rival factions kick-started a tentative peace process.

In the same month, a less-noticed development saw US accountancy regulators approve a rule that paved the way for today’s widespread use of mark-to-market accounting standards. This rule, which forced US banks to carry more securities at market value, emerged from the wreckage of the US savings and loan crisis when losses on loans had been hidden by the use of “historic cost” accounting.

Only now, in the middle of a global credit crisis, is the impact of the broad introduction of mark-to-market accounting becoming clear. The critical concerns are around how much these changes helped to inflate the credit bubble and whether they will increase the speed and destructive power of its collapse.

To be fair, the US banks protested at the outset that the move would change their role in the economy. So did the French banking federation before similar changes came to Europe in 2005. It warned that fair-value accounting “could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis”. Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced a string of work about this kind of “pro-cyclicality” in finance and the economy, culminating in a paper last September entitled Liquidity and Leverage .

This paper examines the links between asset prices and the value of banks’ capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance sheets.

The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire – or created “positive feedback loops”.

The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating “negative feedback loops” with a destructive impact on all kinds of asset values – from structured finance to house prices and equities.

In a way this is nothing new – the old adage about a banker is that he gives you an umbrella when it is sunny and asks for it back when it starts to rain.

But there are two important differences. First, fair-value accounting will speed up the process. One of Adrian and Hyun’s conclusions is that it was the speed of balance sheet expansion that caused the most blatant excesses of US mortgage lending.

Second – this isn’t mentioned in the paper – there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.

This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.

Banks’ use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.

What we will see over the remainder of this year is an ongoing painful reduction of capital values and leverage levels throughout the economy, centred around banking.

Investors need to believe this re-adjustment has at least stabilised before they will return. Each new wave of price falls in leveraged loan markets or asset-backed securities markets — and each post-earnings restatement of losses from the likes of AIG, Credit Suisse or whoever is next – illustrates that the prognosis is not good either for the financial world or the wider economy.

The lesson for regulators is that the solution to one problem almost always contains the seeds of another.

The Financial Times today reports that sales of asset backed securities and related debt could easily reach $100 billion in 2008 between the winding up of SIVs and forced selling by the occasional ABS hedge fund player hitting the wall.

Note that some, perhaps many, of these players do not have much latitude in the timing of their dispositions. The $100 billion figure is the estimate of SIV medium term notes maturing before year end. Given the existing strains on their balance sheets, most banks will presumably fold the SIVs and pay out the MTN holders whatever is their due. The continuing sale of ABS is likely to keep prices low for some time and will also make it hard to sell new asset backed securities.

From the Financial Times:

Troubled leveraged funds are likely to sell almost $100bn worth of asset-backed bonds and financial company debt by the end of the year as they struggle to avoid defaulting on their own debt, according to analysts at Citigroup.

Sales of asset-backed securities, such as mortgage-backed bonds and collateralised debt obligations, have gathered pace in recent weeks, pushing prices down further and keeping the market shut for new issues.

However, selling pressure looks set to increase as structured investment vehicles (SIVs) face a wave of medium-term debt repayments over the next few months, with more than $10bn due in each of the next seven months, up from the $4bn that matured in February, according to Citigroup analysts.

“Just less than $100bn, or 65 per cent, of the existing medium-term note [MTN] debt is due to be repaid in 2008, leaving around $50bn of MTN outstanding at the end of the year,” Birgit Specht at Citigroup said. “This looks like a good proxy for both the magnitude and the pace of a potential wind-down this year.”….

“While the SIV crisis may have few surprises left, we remain firmly of the view that bank bail-outs are unlikely to stem the flow of asset sales,” said Ganesh Rajendra, head of securitisation research at Deutsche Bank. He added that recent weeks had already seen a notable pick-up in selling pressure.

It is not just SIVs that are being forced to sell such bonds. Yesterday, news arrived about the collapse of Peloton, a London-based hedge fund specialising in asset-backed bonds, and there is rising concern about who might be next.

Of the $100bn due in MTN repayments, Citigroup estimates that almost $85bn is due by the end of September. There will also be repayments due on short-term commercial paper and repo facilities with other banks.

In addition, there is about $25bn-$30bn of debt that defaulted SIVs have already failed to repay.

Harvard Professor of Political Economy has penned a prototypic New York Review of Books essay on Alan Greenspan’s The Age of Turbulence. That means no snarkiness.

What would likely disappoint readers of this blog is that Friedman thinks that Greenspan acquitted himself well in managing monetary policy; he argues that growth was weak after 2001 and the Fed’s super-low interest rates did not produce inflation. He amazingly fails to see that negative real interest rates discourage savings (which were already low in the US) and supercharge speculation.

Nevertheless, Friedman makes an observation I haven’t seen elsewhere, that despite Greenspan’s claim to be a loyal defender of free markets, he was intervened frequently, at least as far as monetary and fiscal policy were concerned:

Greenspan continually reiterates his belief in the power of private economic activity organized in free, competitive markets. Government interference, therefore, is for him mostly a bad idea. It was, he writes, “the embrace of free-market capitalism,” not monetary policy, that “helped bring inflation to quiescence.” Further, in his view, free markets are not only efficient but robust. In the face of disturbances—higher oil prices, say, or a decline in either consumer or business confidence—they tend to correct themselves. “If the story of the past quarter of a century has a one-line plot summary,” he writes, “it is the rediscovery of the power of market capitalism.”

This mantra is strikingly at odds with Greenspan’s account of what he and his colleagues did during his years at the Federal Reserve. They took corrective action, gave advice and even instructions, and took the initiative in anticipating the difficulties markets might face. They did so not just in the immediate aftermath of the September 11 atrocities, which anyone would recognize as out of the ordinary, but in one episode after another throughout his years at the Federal Reserve. Familiar examples include the 1987 stock market crash; the wave of financial problems in many Asian and Latin American countries beginning in 1997; the near collapse of the LTCM hedge fund in 1998; the passage of the millennium from 1999 to 2000 (which many people feared would trigger widespread “Y2K” computer glitches); and many others.

In dealing with such events Greenspan and his colleagues treated financial markets more as delicate flowers requiring careful attention and nursing. Similarly, although he frequently makes clear in what he writes that he rejects Keynesian economics, both at the Federal Reserve and during his time in the Ford White House he consistently advocated a Keynesian stimulus (through tax rebates or lower tax rates) whenever he thought the economy needed a boost.

Friedman gives a good overview of the regulatory lapses, gaps, and missed opportunities that made the subprime mess possible:

Central banking involves more than just making monetary policy, however, and in these broader respects the Federal Reserve, and Greenspan’s leadership of it, do bear part of the blame for the subprime collapse and the wider damage to which it has led. As is becoming ever more apparent, many of the lending practices in the mortgage market during these years, especially in the subprime market, involved carelessness, deception, or both. Many people borrowed who had no prospect of servicing the loans they took out; they were hoping either to resell the house at a higher price, or to refinance it and draw on the appreciated value to make their payments. Some borrowers were apparently induced to buy houses they could not afford, or to take out loans they should not have been granted, by irresponsible brokers and other agents keen to make commissions on transactions despite knowing they were inappropriate.

Many of the banks that packaged these loans into securities also put them into complex investment “vehicles” that they did not understand, and sold them to investors who understood even less about them. The credit rating agencies, on which investors normally rely to inform them of such risks, were at best useless. Today the wreckage, consisting of abandoned houses, defaulted loans, displaced homeowners, banks making good on the billions of dollars of losses they had guaranteed, and uninsured investors marking down their portfolios, can be seen everywhere. The damage will surely get worse before it begins to abate.

Regulation of financial markets in the United States is both spotty and fragmented among numerous agencies. One problem, from which many individual homebuyers suffered, is a straightforward gap in existing regulation. For years, a stock broker who recommended that a client buy a security that was grossly unsuited for that person had been subject to regulatory sanction, or even redress by private litigation, under the suitability requirements of the National Association of Securities Dealers as well as the New York Stock Exchange’s “know your customer” rule. Both sets of rules operate under the aegis of the Securities and Exchange Commission. While they are far from being rigorously enforced, for real estate agents and independent mortgage brokers there are no such rules at all. In addition, poorly disclosed compensation arrangements for brokers, which would be illegal in the securities markets, have persisted in the mortgage market and give mortgage brokers substantial incentives to steer customers into loans that are excessively expensive or risky or both.

But in the buildup to today’s mortgage market mess, numerous potentially helpful government agencies also either dropped the ball or looked the other way. As early as 2001 the Treasury Department tried to get subprime lenders to adopt a code of “best practices” and to submit to monitoring, but the large lenders objected and the Treasury did not press the matter. The Department of Housing and Urban Development likewise proposed a set of rules for real estate transactions but then failed to follow through. As recently as 2006 there was an interagency initiative to regulate nontraditional mortgage products such as packaged subprime mortgages, but again nothing came of it. The Office of the Comptroller of the Currency, a bureau of the Treasury Department that is always solicitous of the desire of banks to escape supervision and regulation if they can, has actively thwarted state-level action.

And the Federal Reserve Board, which under the 1968 Truth in Lending Act and other legislation is also responsible for regulating interest rate disclosures (and especially high-cost mortgages), likewise failed to act. This neglect by the Federal Reserve was hardly the result of lack of awareness. Both at the staff level and higher, numerous eyes were squarely on the problem. Edward Gramlich, a member of the Board of Governors from 1997 to 2005, frequently testified before Congress on problems in home finance and called within the Federal Reserve for action to halt abuses and make lending in this market more rational. But Greenspan was consistently unsympathetic, and the Federal Reserve neither took action on its own nor supported action by other agencies. In his book, Greenspan writes:

I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidized home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk.

Gramlich died last September. His final book, Subprime Mortgages: America’s Latest Boom and Bust,[*] published shortly before his death, likewise welcomed the increase in home ownership that subprime mortgages have made possible—especially among low-income households, and especially among racial minorities. But Gramlich also called for a number of corrective measures. Most important, he argued, was to bring under federal regulation the state-chartered lending institutions that account for half of the subprime lending (but very little in the prime mortgage market). He also called for expanding existing legislation so that more borrowers could prepay their mortgages without penalties. A frequent problem today is that families who cannot meet their higher payments after the initially low two-year “teaser” rate is reset cannot afford to get out of the mortgage either. A third suggestion was to have the federal government fund many of the foreclosure prevention programs that already operate at the local level.

Today both Gramlich’s analysis and his proposals look even more incisive. Indeed, some policymakers have taken notice. Last summer the Federal Reserve Board and the Office of Thrift Supervision, a bureau within the Treasury Department, launched a limited program to coordinate state-level and federal regulation of mortgage lending. More recently the Bush administration has proposed a moratorium on foreclosures.

Greenspan’s opposition to such proposals was consistent with the admiration that he expresses for unfettered markets and the sanctity with which he regards property rights (which in this context really means private rights of contract) throughout his memoir. Both give rise to a systematic aversion to government regulation of private economic activity. For Greenspan, recognition that the workings of such markets sometimes destroy asset values, jobs, or even entire industries is still not ground for interference in the economy in the aggregate, or with individual transactions to which two or more private parties voluntarily agree.

Greenspan frequently appeals to the views of Joseph Schumpeter, the Austrian-émigré Harvard economist of the 1930s and 1940s, who labeled such economic developments “creative destruction.” In contrast to Greenspan’s careful nursing of the economy and the financial markets in his conduct of monetary policy, his rejection of regulation of the subprime mortgage market and of intervention in the built-up chain of financing that distributed the ownership of these securities (and the consequent risks) throughout the US economy and abroad was of a piece with the economic philosophy he espouses.

Alas, Schumpeter to the contrary, not all destruction is creative. And although Adam Smith (whom Greenspan also admires) explained that the desire to make money is mostly what leads people to undertake economically useful activity, not everyone who is making money is doing something economically useful. Just how much damage the widening ripples of the subprime collapse will inflict, on either the US financial markets or the American economy, is still unclear. But in hindsight one wishes that Alan Greenspan, as Federal Reserve chairman, had clung to his economic philosophy in regulatory matters no more closely than he did in his hands-on conduct of monetary policy. Or that in fulfilling this particular responsibility of the Federal Reserve he had simply listened to Ned Gramlich.

London’s edge over New York eroded Financial Times.

Treasury’s Paulson Says He Favors a `Strong Dollar‘ Bloomberg. How he can say this with a straight face is beyond me.

Facing Default, Some Walk Out on New Homes New York Times and Borrowers Abandon Mortgages as Prices Drop Wall Street Journal. Long form treatments of the trend. The Times also notes, as we have, that many buyers had so little equity their homes that they were effectively renters with a home ownership option.

The Charms of Wikipedia The New York Review of Books

Fed Watch: This Train Doesn’t Stop Economist’s View

Why the Fed is Compelled to Lie to Congress The Big Picture

‘Groin turns into no-go zone for luckless Italians’ Gristmill

Many observers have noted that the US is unwilling to take its medicine. In the Asian financial markets crisis of 1997, nations with large current account deficits and domestic asset bubbles saw their prosperity unravel as asset prices collapsed, leading to borrowers defaults, a contraction of credit which spiraled into a crunch, and withdrawal of foreign capital which led to sharp declines in their currencies. The IMF rescue packages required the recipients to slash government spending to bring budgets into balance, let foundering financial institutions fail, and raise interest rates sharply. The result was large scale bankruptcies, high unemployment, and riots.

Instead of performing radical surgery, the US instead is acting as if it can validate inflated asset prices, or at least keep them from falling too much. Like Japan after its bubble years, this means propping up diseased financial institutions, squeezing workers, and enduring protracted stagnation.

Tim Collins, a private equity investor who has considerable experience in Japan, elaborates in the Telegraph:

The US could be facing a “lost decade” like that suffered by Japan in the 1990s as the markets fail to respond to interest rate cuts and the US Federal Reserve runs out of options, the head of one of the leading private equity firms said today.

Tim Collins of Ripplewood Holdings, said the Fed was “running out of policy alternatives” as it attempted to prevent a long recession in the US.

Mr Collins….believed a “sharp repricing of assets” was the most likely outcome.

But he said: “My fear is that we will prolong it and suffer a death of a thousand cuts after we have exhausted all the options.”

“Even without a recession and with all of the policy tools available we still have hundreds of billions of dollars of losses.”

Japan has only recently emerged from a period of zero interest rates.

He said the future would not be clear until a recession had laid bare the true state of the financial system. “You have to wait for the tide to go out to see who is wearing a bathing suit,” he said.

But the chairman of Ripplewood, which last year completed the $2bn buyout of Readers Digest, rejected the argument, put forward by some at this year’s SuperReturn private equity conference in Munich, that Sovereign Wealth Funds would replace struggling banks to provide debt to private equity companies.

“The financial markets operate on the basis of the multiplier effect in the banking system and you cannot replicate that with what is effectively equity, not debt, from sovereign wealth funds.”

A dirty little secret of the bond insurer mess is that the rating agencies not only aided and abetted their ill-fated entry into the structured finance business but apparently prodded them in that direction.

Although I had been given this tidbit before, I hadn’t gotten independent verification, but it now comes via a report in Bond Buyer of a speech by New York insurance superintendent Eric Dinallo.

First, the initial reports, which are hoisted from comments on February 3 post:

RK said…
There was an interesting interview today on CNBC with one of the principals of Egan Jones, the private ratings firm. Gasparino was on as well and made an interesting point. He said that S & P and Moodys were telling the municipal insurers for the last several years that they NEEDED to get into the structured finance business, to MAINTAIN their AAA rating, and that a prospective entrant into the business was told that to GET a AAA they would need to participate. While this is so far only heresay, Gasparino has done some good reporting in the past based on apparently good connections.

realty-based lawyer said…
Not hearsay – it happened in Oct/Nov 2005 or thereabouts. The prospective entrant was a financial guarantor being established by DEPFA, an Irish bank with German links that was recently acquired by Hypo Real Estate. CEO was Michael Freed.

Now for the independent sighting in Bond Buyer in its article, “New Regs for NY Insurers“:

Insurance regulators did not stop hte financial guarantors from expanding their busineses out of the muni market, a dynamic that one of the moderators suggested could nevertheless play out in future business cycles. In response, Dinallo said his understanding of the current crisis was the the bond insurers were encouraged to expand into the structured finance by the rating agencies, who asked them to expand their books of business.

“From what I have learned so far, the bond insurers were encouraged by the rating agencies to improve their returns on equity and seek diversification through doing this structured business,” Dinallo said.

The article notes that the Standard & Poor’s has denied suggesting that the monolines increase their structured finance business; Moody’s and Fitch so far are silent. It also begs the question of what sort of management would take strategic advice from experts in credit.

But again, one cynically has to wonder. Given how important and profitable the structured finance business was to the rating agencies at the time, they clearly (and naively) thought it was great business. And having the monolines involved no doubt facilitated getting deals done.

Of course, this doesn’t excuse either the companies themselves or the regulators. Nevertheless, given (as we have seen) that threat of the loss of their AAA rating is a sword of Damocles over the monolines’ heads, they’d have to think hard about ignoring a rating agency’s recommendation.

This comment in the Financial Times by Harald Benink and George Kaufman, discusses a major shortcoming in Basel II, the new bank capital standards promulgated by the Bank of International Settlements, namely, that banks can use their own risk models to set minimum capital levels. That procedure allows them to tell the regulators how much equity they need to hold, putting the inmates in charge of the asylum.

This practice dates back to the mid 1990s, when derivatives started to become popular. The Fed adopted a “let a thousand flowers bloom” approach, allowing dealers to create and refine their own risk metrics, rather than having the central bank develop an independent understanding of the downside exposure. Admittedly, the Fed has tried to encourage banks to adopt what it considers to be best practices, but since it has little expertise in this area, it is hardly in a position to judge whether more sophisticated approaches are more effective, or merely create an illusion of greater understanding.

From the Financial Times:

Instability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today’s market turmoil, were a flashing yellow light to drive carefully.

Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.

However, recent events challenge the usefulness of important elements in the Basel II accord. The need to recapitalise banks reveals that the internal risk models of many banks performed poorly and greatly under-estimated risk exposure, forcing banks to reassess and reprice credit risk. To some extent, this reflects the difficulties of accounting for low-probability but large events.

A more fundamental problem is that Basel II creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be overoptimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity.

Bank capital-asset ratios are near historically low levels, typically at about 7 per cent of total assets (on a non risk-weighted basis). During the past five years, several so-called “quantitative impact studies” (QISs) have been conducted under the auspices of the Basel Committee on Banking Supervision to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50 per cent for some of the largest banks.

The turmoil on financial markets, which has caused large banks to take substantial losses and search for significant new capital, indicates that Basel II should not be implemented, if at all, without first making a number of important changes. We advocate the following improvements in order to correct some of its deficiencies.

First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.

Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements. Consistent with the FDIC chairman, we believe that it is important to have a minimal capital cushion in the banking system, even when risk-based Basel II capital rules indicate lower risk. Strong capital allows banks to recognise losses and put problems behind them in times like the ones we are now experiencing. And strong capital gives banks the flexibility to serve as shock absorbers to our economy during difficult times.

Third, we recommend that the Basel II approach using banks’ own risk models should be complemented by a credible and effective form of market discipline. While Basel II contains information disclosure requirements, at the same time it fails to create incentives for professional investors to use this information in an optimal way. As long as professional investors holding bank liabilities have the perception that large banks are too big to fail – or that all deposits will be fully protected against loss, as in the Northern Rock case – they will have the idea that their money is not really at stake. This will mitigate their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks’ incentives to reduce capital.

Treasury Secretary Hank Paulson has thrown a bucket of cold water on a number of proposals being floated in Washington to rescue troubled borrowers via the explicit use of public funds, such as the idea of reviving the 1933 Home Owner’s Loan Corporation to buy underwater mortgages and renegotiate them.

In some respects, Paulson’s tough stance is welcome, because many of these proposals would do more for banks and investors than borrowers. Many homeowners, including ones who are capable of servicing their mortages, are walking away because they deem them an unattractive investment. There is now a large class of nominal homeowners who in fact are more akin to renters with a home ownership option that is now deeply out of the money. And they can often rent more cheaply too.

But unfortunately, what is driving Paulson isn’t a pragmatic assessment of what measures might be cost effective and not involve undue moral hazard. Instead, he is guided primarily by the ideological imperatives of this Adminsitration, which is to favor so-called private sector solutions. But that construct is dishonest and limiting. For instance, the Journal reports that Paulson maintains that “market-based approach will be enough to keep the situation under control.”

If Paulson considers the worst housing market since the Depression to be under control, I shudder to think what an unmanaged situation would look like.

However, a grey area in “private sector solutions” is a willingness to rack up government contingent liabilities. The portfolio ceilings on Fannie Mae and Freddie Mac were lifted Wednesday, and OFHEO’s James Lockhart had said earlier this month that the two GSEs could add $100 billion in mortgages in the next six months without running into capital limits. The plan now in place is to keep Fannie and Freddie in remediation mode, setting aside reserves 30% higher than the usual minimum. However, fi the GSEs come under increasing pressure to take on weaker mortgages to salvage the housing market, even those higher reserves may prove insufficient.

Similarly, the Treasury has not nixed some proposals to increase the role of the FHA. The FHA is the historical source of mortgages to middle and lower income borrowers, so an increased role for the FHA could well make sense. But again, it may be subject to pressures to relax its standards and become a warehouse for mortgages on the brink.

The dead body in the room that Pauson has addressed only in part, by his cosmetic Hope Now Alliance plan, is that securitization impedes the traditional practice of having the lender restructure mortgages for those borrowers who can be salvaged. In fairness, due to high loan to value ratios on new mortgages and the heavy use of cash out refinancings and home equity loans, many of the stressed borrowers may in fact not be able to afford even a generous mod. That poses a conundrum: does the collateral damage to communities and lenders warrant rescuing them anyhow? This tradeoff isn’t discussed honestly, as it should be; instead all troubled borrowers are wrapped in the mantle of “about to lose their homes.”

And the problem with the failure to acknowledge the major impediment, in combination with the Administration’s ideological fixation, is that the best available solution is likely to be blocked. The Democrats have proposed changes to bankruptcy laws to give judges more authority to modify mortgages, While this may sound overreaching, in fact this simply puts residential mortgages on the same footing as commercial mortgages and vacation property. In effect, judges will do the mods that the mortgage services are either unwilling or unable to make. But the bill has already been watered down in the House and faces opposition in the Senate.

From the Wall Street Journal:

In an interview yesterday, Treasury Secretary Henry Paulson branded many of the aid proposals circulating in Washington as “bailouts” for reckless lenders, investors and speculators, rather than measures that would provide meaningful relief to deserving, but cash-strapped, mortgage borrowers….

Rep. Barney Frank (D., Mass.), chairman of the House Financial Services Committee and typically an ally of Mr. Paulson’s, said that, until now, he had supported the Treasury’s steps to address mortgage delinquencies and the credit crunch they have spawned. “But they’re not helping enough people,” Mr. Frank said yesterday. “We’re not going to get out of the crunch until we stop this cascade of foreclosures.”

The Fed’s Mr. Bernanke appeared to take a slightly more flexible position than Mr. Paulson, telling a congressional committee yesterday that the turmoil in the housing market doesn’t yet merit large amounts of public money. “I don’t think we’re at that point, but I do think it’s worthwhile to keep thinking about those issues,” Mr. Bernanke said….

Administration officials “have been willing to broker deals, but they haven’t been willing to put taxpayer money on the line,” said Mark Zandi, chief economist at Moody’s Economy.com, a West Chester, Pa., consulting firm. “I think they’re trying to stick to those principles, and now they’re running out of ideas that are consistent with those principles.”….

“I’m seeing a series of ideas suggested involving major government intervention in the housing market, and these things are usually presented or sold as a way of helping homeowners stay in their homes,” Mr. Paulson said. “Then when you look at them more carefully what they really amount to is a bailout for financial institutions or Wall Street.”

The secretary added one caveat: “It would be imprudent not to have contingency plans, but we are so far away from seeing something that would have me calling for a bailout that I don’t see it.”

Mr. Bush is threatening to veto a Senate bill that includes $4 billion to help states and localities redevelop abandoned and foreclosed houses. “I believe the evidence is clear that these [voluntary industry] initiatives alone will not steer enough families away from foreclosure or our country away from further economic weakening,” Mr. Reid wrote in a letter to the president yesterday, referring to the main element of the White House-backed industry plan. “In my view, the enormity of the foreclosure crisis requires a much more aggressive response.”

The Reid bill also includes a provision — opposed by many Republicans and the White House — that would allow bankruptcy judges to alter the terms of mortgages.

DealBreaker does some serious reporting today, informing us that some traders have told them that the failed auction rate securities market was always dependent on stabilization by dealers.

For anyone who has worked in the securities industry, the term “stabilization” pregnant with regulatory significance. Stabilization, as defined by the SEC, is

…transactions for the purpose of preventing or retarding a decline in the market price of a security to facilitate an offering….Although stabilization is a price-influencing activity intended to induce others to purchase the offered security, when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers.

So let’s be clear about this: stabilization is a form of market manipulation authorized by the SEC. Its main use is in public offerings of stocks. Immediately after the shares are issued, the syndicate manager will intervene in the trading, usually for the first day, to make sure (if possible) that the shares don’t fall unduly.

So the question with the ABS market is: did the market manipulation by the dealers fall within SEC guidelines? DealBreaker has doubts:

The immediate cause of the auction failures was the pullback of the banks and brokerages. In mid-February the financial institutions conducting the auctions stopped acting as principals or buyers of excess ARS inventory….

“Wall Street executives have defended their conduct, saying losses on holdings such as mortgage assets have curtailed their ability to use their balance sheets to support faltering markets,” the Wall Street Journal’s Randall Smith and Liz Rappaport report in their article today about a large bond marketer lashing out against Wall Street over the auction failures.

But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.

“The truth is there was no natural auction success rate. But for the banks acting as market makers, these auctions would have failed from the get go,” a bond trader told DealBreaker.

Rather than merely acting as buyers of the last resort, the financial institutions have been consistently called upon to stabilize the ARS market. In many cases, investors were lead to believe the market was much healthier than it has ever been. But with balance sheet capital at a premium due to recent losses, the banks decided that the fees received for structuring the auctions and managing clients money in ARS were did not justify deploying the capital necessary to support the market.

If these bond traders are correct about the way the ARS market operated, Wall Street may soon find itself the subject of yet another round of lawsuits and investigations by authorities.

And indeed, in 2006, the SEC’s chief of the Office of Municipal Securities, Martha Mahan Haines made remarks that now seem prescient, particularly where she suggests ABS should be called “BS Securities”.

Her discussion refers to a settlement reached with 15 broker dealers regarding alleged manipulation in the ARS market in 2005:

If you read between the lines of the Commission’s recent settlements involving auction rate securities and the “Best Practices” released by TBMA, it appears that the way rates are actually set on auction rate securities often may bear little resemblance to the way the process was described in offering statements…… The market for ARS bears little resemblance to the kind of so-called Dutch auctions known to most investors: those for U.S. Treasury securities…..

As a result, I believe that a few topics about the auction rate market generally avoided before now, should be aired and discussed. First of all, we should acknowledge that, although broker-dealers involved in this market generally claim that their intervention is for the good of the market as a whole, this has not been studied. In fact, the outcome of even a completely independent study would be dependent on one’s view of what is best for the market. It is true that, due in large part to BD intervention, there have been few “failed” auctions, resulting in windfall interest rates for investors until the next auction, or “all hold” auctions, resulting in below market rates briefly benefiting issuers. Broker-dealers also intervened when the rate that would be set was not, in that broker-dealer’s opinion, an appropriate market rate. (But wasn’t a determination of the market rate the very purpose of an auction?) We are told that this is in the best interests of both issuers and investors. But is it? ….. This intervention supported the rapid growth of this market to over $200 billion. Was it in the best interests of issuers and investors to be so heavily dependent on broker-dealer intervention to support the expansion of that market?….

Disclosure should make it clear that broker-dealers commonly intervene in auctions, bid with knowledge of other bids, submit bids after the internal bidding deadline imposed on other investors, and directly or indirectly influence or set the clearing rate with considerable frequency. I am not saying that this is necessarily good or bad, but it should be disclosed in plain language. ……Do not dance around this issue: describe what really happens flat out. If this is the way that investors and issuers prefer for the market to function, so be it. If not, perhaps practices should change to reflect their true preferences?

Secondly, it may not be accurate to call this an auction at all. In a true Dutch auction, no bidder has knowledge of the bids submitted by others. This protects the process from manipulation and ensures that the price set is truly reflective of the market. Perhaps consideration should be given to a different name for this type of security or of the process by which rates are set? “Managed auction process” and “bidding system” have been suggested to me….. I recognize that “BS Securities” is not an appealing acronym and I leave it to those more creative than me to come up with an alternative title….

Lastly, I would like to remind everyone that adherence to industry practices does not give anyone a pass under the securities laws. Although best practices and similar releases by industry organizations may be useful, it is important to keep the overarching requirements of the securities laws and its basic themes of disclosure, fairness and integrity firmly in mind.

The kind of disclosure Haines called for appears to have been neglected. For instance, in the widely reported case of the New Jersey Maher brothers, Lehman was given $600 million to manage and was told to put it temporarily in short-term liquid instruments while the brothers decided on their long-term strategy, $286 million went into auction rate securities and so far, the Mahers have been unable to access their cash. It’s a virtual certainty that they were not told how the auction process worked. And if very large customers are ill informed, there is no reason to think the small fry are treated any better.

Climate change threatens existence, Eskimo lawsuit says CNN

Indexed The Big Picture. Funny

The IRS Throws Down the Gauntlet on Executive Comp CFO

US efforts to scuttle Iran-UAE ties fail Asia Times

Poll: Taxpayers Not Planning To Spend Rebates Huffington Post

Clever, but also surprising (at least for those of us who don’t ponder these matters deeply). Hat tip Gristmill:

Left: All the water in the world (1.4087 billion cubic kilometres of it) including sea water, ice, lakes, rivers, ground water, clouds, etc.

Right: All the air in the atmosphere (5140 trillion tonnes of it) gathered into a ball at sea-level density. Shown on the same scale as the Earth.

Bloomberg tells us that the credit default swaps market does not see MBIA as anything remotely resembling an AAA:

Moody’s Investors Service and Standard & Poor’s say MBIA Inc. has enough capital to withstand losses and justify its AAA rating. MBIA’s debt investors aren’t so convinced.

Credit-default swaps indicating the risk that Armonk, New York-based MBIA’s bond insurance unit won’t be able to meet its obligations are trading at similar levels to companies such as homebuilder Pulte Homes Inc., which is rated 10 steps lower….

“Pardon me if I find this a little hard to believe,” said Richard Larkin, director of research at municipal-bond brokerage Herbert J. Sims & Co. in Iselin, New Jersey. “This is basically the same management that put MBIA into this hole in the first place.”

For the record, Pulte is rated BB+, which is junk.

Martin Wolf, in “Why Washington’s rescue cannot end crisis story,” tells us, push come to shove, the government can bail us out of our economic mess, but it would be unwise to stop there. Wolf argues that substantial steps need to be taken to rein in a financial sector that is beyond the understanding of not only the regulators, but the institutions themselves who were deemed to be capable of managing their own risks.

I’m not as optimistic as Wolf. Not that we might not muddle through, but the path out is no where near as simple as he suggests. He sees this as a banking crisis, and anticipates that the remedy would be a repeat of the Resolution Trust Corporation’s good bank/bad bank split and auction operation.

But this is only incidentally a banking crisis. As many commentators have observed, we are experiencing multiple sieze-ups in portions of the credit system remote from regulated banks, and even worse, operating across national borders. Pray tell, what relevance does a “good bank/bad bank” model have to municipalities suffering from the failure of the auction rate securities market? Or to dealing with the festering problem CDOs littered round the world now worth far less than their sales price?

The S&L crisis was confined to institutions that were large in aggregate but inconsequential individually. There were some noteworthy exceptions took hits due to their stupidity: Citigroup nearly went bankrupt due to its aggressive lending of junior debt to commercial real estate projects, particularly in Texas, that turned out to be “see through” buildings. First Boston got stuck with bridge loans that led it to get another equity infusion from Credit Suisse (it had been rescued by them before in the late 1970s) that eventually led to a full takeover.

With the S&L crisis you had similar organizations with similar exposures that wound up in the hands of federal banking regulators. You thus had a central intelligence managing the operation. Because many of the biggest financial institutions were not in terrible shape, there were buyers for the “good bank” franchises and assets. Speculators went for the “bad bank” piece.

Thanks to our new distributed financial model of “package and sell” you have damage occurring in sectors with little regulation or with multiple regulators and unclear mandates. The ability, as in the S&L collapse, for one body to step in and take charge, is largely absent. Look at the mess of the monoline rescue. The state insurance regulators lacked the clout to push the investment banks who were exposed to write checks; they also had limited authority to intervene directly with the monolines, since solvency is not an issue (surprisingly, all, including MBIA capitulated, but given possible problems with MBIA’s financial statements, more may be at issue here than former CEO Greg Dunton’s relationship with Eric Dinallo). That crisis is in abeyance because the rating agencies caved in and investors, understandably, would rather not have a meltdown play out. But how often will “See no evil, hear no evil, speak no evil” solutions work?

And also consider: the institutions are risk are not small fry, but include very large players who are vital to credit intermediation. Again, remember, it is the refusal of the dealers to buy in auction rate paper that precipitated the municipal bond crisis. The big players have already taken substantial writedowns but for the most part, have been able to compensate for the damage through equity infusions from foreign investors. It won’t be so easy for them to replenish their capital if they take further large losses. And more damage will lead to further restriction of their market-making activities.

So if things devolve, we will see rolling crises, most of which will not be easily addressed, which will further erode investor confidence and lead to continued impairment of liquidity.

The only upside is that continued distress increases the odds of the kind of root and branch reform that Wolf believes is necessary. The faith in our current financial structure is so well entrenched that it will take continued demonstration of its failings to build consensus around the need for major reforms.

From the Financial Times:

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis.

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit. Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the 2000s.

When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Indonesia’s gross domestic product fell more than 13 per cent between 1997 and 1998. Sometimes the fiscal cost has been over 40 per cent of GDP (see chart).

By such standards, the impact on the US will be trivial. At worst, GDP will shrink modestly over several quarters. The ability to adjust monetary and fiscal policy insures this. George Magnus of UBS, known for his “Minsky moment”, agrees with Prof Roubini that losses might end up as much as $1,000bn (FT.com, February 25). But it is possible that even this would fall on private investors and sovereign wealth funds.

In any case, the business of banks is to borrow short and lend long. Provided the Federal Reserve sets the cost of short-term money below the return on long-term loans, as it has for much of the past two decades, banks can hardly fail to make money.

If the worst comes to the worst, the government can mount a bail-out similar to the one of the bankrupt savings and loan institutions in the 1980s. The maximum cost would be 7 per cent of GDP. That would raise US public debt to 70 per cent to GDP and would cost the government a mere 0.2 per cent of GDP, in perpetuity. That is a fiscal bagatelle.

Because the US borrows in its own currency, it is free of currency mismatches that made the balance-sheet effects of devaluations devastating for emerging economies. Devaluation offers, instead, a relatively painless way out of a slowdown: an export surge. Between the fourth quarter of 2006 and the fourth quarter of 2007, the improvement in US net exports generated 30 per cent of US growth.

The bottom line, then, is that even if things become as bad as I discussed last week, the US government is able to rescue the financial system and the economy. So what might endanger the US ability to act?

The biggest danger is a loss of US creditworthiness. In the case of the US, that would show up as a surge in inflation expectations. But this has not happened. On the contrary, real and nominal interest rates have declined and implied inflation expectations are below 2.5 per cent a year. An obvious danger would be a decision by foreigners, particularly foreign governments, to dump their enormous dollar holdings. But this would be self-destructive. Like the money-centre banks, the US itself is much “too big to fail”.

Yet before readers conclude there is nothing to worry about, after all, they should remember three points.

The first is that the outcome partly depends on how swiftly and energetically the US authorities act. It is still likely that there will be a significant slowdown.

The second is that the global outcome also depends on action in the rest of the world aimed at sustaining domestic demand in response to a US shift in spending relative to income. There is little sign of such action.

The third point is the one raised by Harvard’s Dani Rodrik and Arvind Subramanian, of the Peterson Institute for International Economics in Washington DC, (this page, February 26), namely the dysfunctional way capital flows have worked, once again.

I would broaden their point. This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalism in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened. That would be a huge error.

Those who do not learn from history are condemned to repeat it. One obvious lesson concerns monetary policy. Central banks must surely pay more attention to asset prices in future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.

A more fundamental lesson still concerns the way the financial system works. Outsiders were already aware it was a black box. But they were prepared to assume that those inside it at least knew what was going on. This can hardly be true now. Worse, the institutions that prospered on the upside expect rescue on the downside. They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? If so, how does one sustain broad public support for what appears so one-sided a game?

Yes, the government can rescue the economy. It is now being forced to do so. But that is not the end of this story. It should only be the beginning.

A group of hospitals which has issued auction rate securities and are now choking on the “failed auction” rates have petitioned the SEC to allow them to buy back the debt. The notion is that they’d either hold the debt off the market until conditions normalize, or would retire it completely, replacing it with longer term debt.

The article on this topic in the Wall Street Journal doesn’t mention how the hospitals intend to fund these purchases (presumably via bank debt). It does note that some issuers are barred from pursuing this avenue because their indentures prohibit them from making bids for the debt.

So get a load of this:

The SEC is weighing the requests and hasn’t come to any decision, according to people familiar with the matter. The agency is evaluating concerns about whether a borrower’s participation in setting the clearing bid in an auction for its own debt would be market manipulation. Issuers of debt would have a strong incentive to support the market price to avoid triggering higher interest rates.

The SEC is worried whether this constitutes market manipulation while state and city finances go into crisis? Yes, this is market manipulation, except, guess what, there is no functioning market right now, hence no damage.

Certain types of market manipulation are routinely permitted and exempted, such as stabilizing transactions in a public offering or an underwritten call. And even though there were apparently concerns about manipulation in this market a few years ago; the Journal mentions a settlement reached with 15 brokerage firms that led to the development of best practices. Nevertheless, dealers were permitted to bid at auction without it being deemed manipulation; in fact, it’s the absence of deal bids that has elevated this situation to a crisis.

Here we have an SEC that, as Floyd Norris told us yesterday, pushed to weaken Sarbanes Oxley. Note this isn’t a trivial issue; the SEC is responsible for administering Sarbox. Even worse it shows no interest in blatant violations like late in the day leaks to the media that seem designed to kill shorts (most recent example: the Ambac “hey maybe we have a rescue” CNBC story that led to a 250 point rally in the Dow and more important, a 30% increase in Ambac’s stock price before the session finished).

The required way to handle material announcements during trading hours is to call a halt and make a statement or release the news after trading hours. Technically, this is a violation of the New York Stock Exchange’s rule, “Timely Alert Policy,” but the NYSE is under the SEC’s authority.

So for the SEC to suddenly be concerned about strict application of the rules seems rather out of character. It wouldn’t be all that hard to come up with a temporary, narrow, provisional carve-out. But small fry like hospitals clearly don’t rank very high in the SEC’s list of priorities.