"Character and Capitalism"

Steve Waldman is on a roll. He has an excellent piece today arguing that despite contemporary notions otherwise, capitalism and character (meaning moral fiber) have not and need not be contradictory.

Although Waldman makes a good case, the barriers to the return of character in commerce are more profound than he lets on.

A colleague of mine, Amar Bhide, a professor at Columbia School, did some field work in the early 1990s on the role of trust in business and was very disheartened with what he found. Power and economic self interest trumped considerations of morality. Business owners were willing to accept being screwed by customers because they felt they needed them. They resented it deeply, they grumbled, but they accepted that they lacked the leverage to demand better treatment (I will need to locate his article, which I think ran in the Harvard Business Review, but the title was something along the lines of "Why Be Honest?" and it concluded, with considerable reluctance, that there wasn't much upside in behaving well).

What makes it possible to have values is enforcement mechanisms, which usually boil down to prevailing standards. In a small town, if a store owner is unpleasant, tries to short change customers, or kicks his dog, word gets out and business suffers. But many of us mange our affairs in a impersonal way (think of Internet purchases). We have limited interactions with people. We might have a relationship with a firm, yet the account manager changes every couple of years. The standards thus reflect what is considered acceptable for the industry as well as the company. Great conduct in the credit card industry (if there even is such a thing) is not the same as great conduct from a hotel. Where is there opportunity for character to enter into either of these interactions? Even if someone goes the extra mile for you, you might never see that person again. Their effort will probably go unrewarded, or worse, might be against policy.

Now I am digressing a bit; Waldman meant character in a narrower Victorian sense, as being a person of one's word. But even then, the drive to efficiency that has become pervasive in American businesses has made it well-nigh impossible for that to be operative. The reliance on FICO scores in place of more nuanced credit decisions is merely the logical result of processes that have been in play for many years.

One of my favorite banking industry factoids is that despite the widespread belief that bigger banks are more efficient, every study of commercial banks ever done has found that they have a slightly increasing cost curve once a certain size threshold has been achieved. Where the increasing costs (per dollar of assets) kicks in varies, but the highest point I saw (this was some years ago) was $5 billion in assets. One study found the break point was $100 million.

Now this flies in the face of most logic. Banking is all about automated, repeatable transactions. Moreover, big banks enjoy tremendous cost advantages in funding (big bond issues and other capital markets sources are much cheaper than relying primarily on deposits). Big banks are also more likely to be in pure fee businesses like M&A and loan servicing which require nothing in the way of assets beyond desks and phones.

My pet theory is that old-fashoned lending, the know-your-borrower types, is much more efficient on an all-in basis than the interpersonal, multi-layered credit scoring processes used in every type of loan product in a large bank. Yes, it costs you a lot more to source the loan. But they probably make it up in lower loan losses (a combination of lower default and more success with loss mitigation, since if you know the borrower, he will probably feel a greater obligation to repay. In addition, if he does experience real duress, your knowledge of him and the community will enable you to make a more informed assessment of his ability to repay, again improving the odds of a successful restructuring.

No academic has ever investigated my pet theory, but as of the last time I read the literature, no one had come up with an explanation. But there is anecdotal evidence. My colleague Doug Smith (no relation) in an article in Slate, pointed out that not-for profit lenders had provided subprime loans, yet experienced losses no worse than on prime loans, precisely because they screened borrowers in the traditional manner, in person, and assessed, among other things, their understanding of the loan and their degree of commitment.

So why, when we have had a resounding failure of impersonal methods of assessment, am I pessimistic about the revival of interest in character? Because it appears our society is unwilling to go back on the false economy of preferring anonymous, rule-based approaches. These methods do broaden the market of possible counterparties, which is seen an entirely beneficial, when there are hidden costs in having only superficial proxies about the people you interact with. If anything, I see ample evidence this attitude is becoming more pervasive.

Some examples: it has become common practice to put vendors to large corporations through a formal approval process. I have found them to be inappropriate and often misguided. For instance, one company required its vendors (which included big ticket law firms and consulting firms) to certify that their employees had gone through drug screening recently (the logic apparently was that if they had a drug habit, they might steal Big Corp's secrets, as if they learned anything that might indeed be that easily traded upon). If you work for a good firm, the idea that you have to get tested to work on XYZ account is a non-starter.

Now a firm like McKinsey can usually escalate matters to a level of management where can get an exemption from this nonsense (a McKinsey partner told me that on a study where it came up, there was absolutely no useful intelligence the firm would be party to, plus, as pointed out, "We pay people well enough for them to afford their own drugs."). But a smaller vendor would be unable to escape this and other cookie cutter demands that are often both intrusive and irrelevant. I've pretty much written off having large corporations as clients (I used to work for them quite frequently). It isn't worth the indignity of going through that process. In fact, it seems destined (ex the firms that can wriggle their way out of it) to assure negative selection: only firms who really need the business will put up with these demands.

Similarly, it's become increasingly common to use credit reports as part of the new hire screening process, even for very low level jobs. Again, I'm not sure what that proves, I can think of plenty of reasons why an otherwise conscientious person might have a bad credit record (say needing to support an ailing parent and becoming overextended). In close calls where there was a particular reason to think it might be helpful, I could see resorting to it, but to use it as a proxy for character is silly.

From Waldman:

Via the indefatigable Mark Thoma, our attention is drawn to an odd piece by Robert Skidelsky. I was left mostly bewildered by the article, but I was intrigued by the author's discussion of the virtues that are and are not inculcated by market capitalism:

Consider character. It has often been claimed that capitalism rewards the qualities of self-restraint, hard-work, inventiveness, thrift, and prudence. On the other hand, it crowds out virtues that have no economic utility, like heroism, honor, generosity, and pity. (Heroism survives, in part, in the romanticized idea of the “heroic entrepreneur.”)

The problem is not just the moral inadequacy of the economic virtues, but their disappearance. Hard work and inventiveness are still rewarded, but self-restraint, thrift, and prudence surely started to vanish with the first credit card. In the affluent West, everyone borrows to consume as much as possible. America and Britain are drowning in debt.

One thing to remember is that there is no such thing as "capitalism". In the real world, there are actual practices and institutions, the details of which bear consequentially on both moral and economic outcomes. There are infinity of possible capitalisms, and at any given moment we are living just one. A stylized graph of supply and demand always hides more than it reveals.

The capitalism we are living right now is rather a nightmare, due to a credit, um, event. So it seems a propos to remember that credit analysis traditionally includes an explicitly moral component. Remember the "5 Cs of Credit"? Character, capacity, capital, collateral, and conditions. Character.

Here's a famous bit of financial history, as recounted by Jean Strouse in the New York Times:

Asked by the lawyer for a congressional investigating committee in 1912 whether bankers issued commercial credit only to people who already had money or property, [J. P. Morgan] said, "No sir; the first thing is character." The skeptical lawyer repeated his question and Morgan, in Victorian terminology, elaborated on his answer — "because a man I do not trust could not get money from me on all the bonds in Christendom."

If you think Morgan, the arch plutocrat, was just telling a nice sounding, self-serving lie, think again. Think about a world in which there was no SEC, FDIC, or Federal Reserve; in which there was no technology sufficient to prevent a person from simply disappearing, changing his name, starting over somewhere else. Morgan invested vast sums, and though he was a powerful man, he could always be taken. When parting with a dollar, he could not be so lazy as to presume a courtroom would ensure its repayment. Morgan had to trust.

Since Morgan's day, in pursuit of efficiency and safety, we've built up institutions designed to automate and certify the evaluation of character. When we lend money, we don't ask to meet the person who promises to repay us. We look for a nod by a regulator, the AAA brand provided by S&P or Moody's or Fitch, perhaps a FICO score. But those are not markers of character at all. We don't take them to be. We understand that banks engage in regulatory arbitrage, finding ways to stretch their balance sheet as far as possible for yield despite whatever regulatory regime is in place. We know that credit issuers (and bond insurers) do what they need to and no more for their rating, that perfectly dishonorable individuals attend to their FICO scores to maintain access to credit. Actual character is completely washed out of these proxies. The capitalism we have is one that presumes that all actors are sharks, that business is business, and that it is irrational to take any less than you can get away with unless you will "incur costs" from decertification. I'm not sure that J.P. Morgan would be willing to lend to any of us, and it's not because we're worse people. We just live in different times, a different world.

We shouldn't go back to the world as it was at the turn of the century. When character evaluation was a personal exercise, it necessarily depended upon social connections, whether someone you know and trust can vouch for someone you don't yet know, whether you can be sure that disgrace and dishonor would be costly. And we definitely should not adopt a moralistic attitude towards debt nonrepayment right now, just when a throng of irresponsible lenders are demanding "responsibility" from borrowers whose calls they would not even take a year ago. (For the record, I think that "jingle mail" is perfectly acceptable under present circumstances, and that the recent "bankruptcy reform" was a cruel mistake.)

But I do think that it's an interesting technical question, going forward, whether we couldn't set things up so that the criteria by which investors decide where to put their money map more closely to what we would recognize as trustworthiness or character. "Abolish the SEC and the Fed and the ratings agencies!" is not a sufficient proposal. Crises due to misplaced trust long predate those institutions, and are a large part of why they came to be in the first place. Morgan was successful not because he did what everybody did, but because he did what almost nobody did, despite the lack of ratings by S&P to stand-in for due diligence. Investors have always been hopeful and lazy in good times.

T.S. Eliot once wrote, "It is impossible to design a system so perfect that no one needs to be good." Perhaps the art is to come up with a system, however imperfect, under which being good is the best way to succeed.

"Financial system must tap the taxpayer"

Krishna Guha in the Financial Times argues that US banks need new equity ASAP to prevent the operation of a "financial accelerator," which is basically, just as leverage feeds on itself, so to does deleveraging: falls in prices lead to margin calls, which lead to forced selling, which lead to more margin calls. We now have the institutional version of that phenomenon, which is that asset price falls lead to mark to market losses, which for banks holding similar assets on their balance sheets, generates an equal markdown of equity, which leads to deleveraging, further depressing asset prices.

Guha argues that private sources probably won't step forward to provide the needed equity; therefore the government must, otherwise it will resort to monetary stimulus, which given the already worrisome uptick in inflation, isn't such a hot idea.

I am not at all sure this is the right way to go about it. I have a problem with rescuing the institutions that caused the train wreck, particularly since in US style bailouts, the perps typically retain their former roles.

If the worry is a widespread run on financial firms, I'd much rather see measures that protected the customers. FDIC deposits insurance is what keeps dodgy banks still able to sell CDs (although rumor has it it actually takes a long time to get paid if the firm goes belly up. The powers that be need to remedy that). Measures that put a floor under customer exposures, rather than under the firms, seems less prone to moral hazard and a far more direct way of stemming mass customer exodus (although how you tailor this so that, say, the Fed doesn't attempt to do something utterly implausible, like become the backstop for the credit default swaps market, would take some thought. You would probably need to identify the sort of counterparty risks that seemed to pose the greatest dangers to the market, and figure out if there was a way to put limits under them, in return for greater supervision and possibly specific restrictions on operations or gearing).

Otherwise, there seems to be a conflict in what Guha is arguing. He claims that housing prices (and presumably other inflated asset prices) need to fall. That implies losses to whoever lent against those assets. But for the government to keep trying to fill the bathtub while the drain is still open is politically fraught. Moreover, it also does not address the lousy psychology. How does it look if, say, the government puts $5 billion into, say, Lehman this quarter, only to have them come back next quarter for more?

Conversely, as Gillian Tett has argued (and I think she is correct here) there is money sitting on the sidelines that would come in and make investments, including recapitalizing banks, once investors had confidence that the bottom had been reached. Thus flushing out the losses is a vital to returning to some semblance of normalcy.

John Dizard has suggested the use of regulatory forbearance, which is code for letting the firms operate in some sanctioned manner with less than the normally required levels of equity (presumably with much closer oversight).

From the Financial Times:

The notion that the US could suffer the kind of deep and protracted recession that plagued Japan in the 1990s no longer looks as far-fetched as it did a month or two ago.

House prices are in free-fall, spreading losses through the universe of mortgage-backed securities and making it very difficult for financial markets to stabilise. The labour market is cracking, with three consecutive months of job losses in the private sector. Consumer sentiment has soured and spending is faltering.

Financial markets have taken another lurch downward – triggering emergency responses, including Thursday’s rescue of Bear Stearns, the Federal Reserve’s $436bn liquidity support package and proposals in Congress for $300bn in housing loan guarantees.

A “financial accelerator” is taking hold as banks react to losses and falls in the value of collateral backing loans by pulling back on their capital at risk, intensifying the credit crunch and aggravating the economic downturn. The pull-back in credit lines is transmitting distress from the banking sector to hedge funds – which are being forced to reduce leverage and sell assets into markets at firesale prices to meet margin calls in a classic case of financial contagion. As hedge funds cut leverage they are amplifying the effect of the contraction in bank balance sheets on the economy. This “great unwinding” is putting enormous stress on the financial system, including the market for mortgages guaranteed by Fannie Mae and Freddie Mac. Mortgage rates are much higher now than they were when the Fed resorted to emergency interest rate cuts in January.

The Fed cannot halt this negative spiral through monetary policy, even if it can mitigate its severity. Interest rate cuts have been largely offset by the rise in risk spreads. And there are limits to how much further rates can be cut amid concerns about inflation.

The good news is that as long as inflation pressures remain, the US cannot get stuck in an outright debt-deflation trap as Japan did in the 1990s. Indeed, the more inflation, the less nominal house prices will have to fall to deliver a required change in real house prices. But asset prices could still fall far enough to generate a vicious contraction in credit – at a time when wealth is declining and inflation is eating away at real income growth. That could be a recipe for a severe contraction in demand.

Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.

What needs to be done? There is no silver bullet. Whatever happens, house prices will have to fall further to reach a fundamental equilibrium. But the key challenge now is to stop the financial accelerator in its tracks. That means one thing above all: additional capital for the financial system to stop the process of balance sheet contraction. That capital can come from one of two places – the private sector or the public sector.

By far the best solution would be for banks and Fannie Mae and Freddie Mac to raise large amounts of new private capital quickly – allowing them to treat estimated losses as sunk costs and start expanding their balance sheets again. There is more than enough private capital (and foreign sovereign capital) available. But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.

Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets. Meanwhile, their cost of capital is very expensive. It may be in their shareholders’ interest to hunker down, preserve capital and ride out the storm rather than raise expensive new capital to provide additional cover for losses that may never fully materialise.

If this is the case, the new capital will have to come from somewhere else: the public sector and ultimately the taxpayer, as the International Monetary Fund pointed out this week. The public sector could provide capital to the private financial system – for instance, by purchasing preference shares on terms more favourable than those available in the market. Or it could deploy its own balance sheet directly: intervening either in the mortgage securities market or the housing market itself.

This could be done through the Fed (which took a half-step in this direction by offering to swap $200bn of mortgage securities for Treasuries) or the government, either on balance sheet or through a special purpose vehicle. There would be severe costs either way. Public money for the banks would bail out existing shareholders. Direct intervention would require the public sector to set a price for mortgage securities and/or houses themselves. Either would foster moral hazard and expose the taxpayer to large potential losses.

But the costs of not providing public funds could be greater. Japan showed that incremental policy initiatives may not work. Rising inflation risk signals the dangers of addressing the problem through ever greater macroeconomic stimulus rather than – albeit large-scale – microeconomic intervention.

For those who oppose the use of public money, time is running out to prove that the private sector can recapitalise and calm the credit crunch without taxpayer funds – the best solution. Meanwhile, advocates of public intervention must determine how much money is needed and how to employ it to greatest effect.

Links 3/15/08

The Bear Necessities Roger Ehrenberg

Millionaire Call Girl: Spitzer's Hooker Rakes In A Fortune Online From Her Music Huffington Post

Robert Rubin Still Doesn't Know that People Warned About the Bubble Dean Baker. It was and is convenient for Rubin not to know that such people existed....

Calls for 1-point rate reduction grow louder MarketWatch. I thought the whole point of having an independent central banks was to keep monetary policy from being a democratic process.

Credit Cards Are Frothy, Not Bubbly Joe Nocera, New York Times. Nocera argues that credit card issuers won't be as badly hurt as gloomsters predict. While he may be narrowly correct, in that the damage might not be quite as deep as forecast, I think he has spent too much time with folks in the industry. He has underestimated the impact of a legislative backlash and the fact that this recession, and the consumer debt levels going into it, are so far beyond any historical precedent as to make it likely that reality will overshoot rather than undershoot forecasts.

Antidote du jour:

"Debt Reckoning: U.S. Receives a Margin Call"

I rarely feature Wall Street Journal articles in long form because I figure most readers will find them on their own. But the Journal's Saturday edition isn't as widely read, and this is an exceptionally good piece, particularly given that the Journal is not the best source on credit market reporting. The ongoing crisis seems to have put them in catch-up mode.

Readers will recognize many themes discussed here and in like-minded venues: the unsustainability of "global imbalances" (code for nice savers in China, Japan, and the Gulf States funding our profligate consumption); the deep downside of deleveraging; the fact that the Fed has been aggressively using the wrong playbook, treating the credit crunch as if it were a liquidity crisis rather than a solvency crisis.

Although the Journal does not draw this comparison, the US is in very much the same boat as Thailand and Indonesia in 1997, during the emerging markets crisis. And although the US arguably has a more diverse economy, the main things that differentiate us from them is the dollar's reserve currency status (which means if we implode we do a great deal of collateral damage) and our nukes. We also like to think that because the US has been the biggest buyer of global exports, we are effectively too big for our cash rich trading partners to allow us to fail. Even if they accept that proposition (not clear, BTW), it's not obvious in practical terms how they might act on it.

The last time the Journal had such a downbeat piece on its first page over the weekend, I was convinced that it alone would push the market down on Monday. Yet for some reason I cannot now recall, it staged a peppy rally.

With Bear in play and the Fed likely to pull more tricks out of its sleeve, it's hard to know what the next week will bring, save volatility.

From the Wall Street Journal:

The U.S. is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.

The unfolding financial crisis -- one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks -- appears to be broadening further. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer.

Recent days' cascade of bad news, culminating in yesterday's bailout of Bear Stearns Cos., is accelerating the erosion of trust in the longevity of some brand-name U.S. financial institutions. The growing crisis of confidence now extends to the credit-worthiness of borrowers across the spectrum -- touching American homeowners, who are seeing the value of their bedrock asset decline, and raising questions about the capacity of the Federal Reserve and U.S. government to rapidly repair the problems.

Global investors are pulling money from the U.S., steepening the decline of the U.S. dollar and sending it below 100 yen for the first time in a dozen years. Against a trade-weighted basket of major currencies, the dollar has fallen 14.3% over the past year, according to the Federal Reserve. Yesterday it hit another record low against the euro, falling 2.1% this week to close at 1.567 dollars per euro.

Lenders and investors are pushing up the interest rates they demand from financial institutions seen as solid just a few months ago, or demanding that they sell assets and come up with cash. Banks and Wall Street firms are so wary about each other that they're pulling back. Financial markets, anticipating that the Fed will cut rates sharply on Tuesday to try to limit the depth of a possible recession, are questioning the central bank's commitment or ability to keep inflation from accelerating.

There are other symptoms of declining confidence. Gold, the ultimate inflation hedge, is flirting with $1,000 an ounce. Standard & Poor's Ratings Services, a unit of McGraw-Hill Cos., predicted Thursday that large financial institutions still need to write down $135 billion in subprime-related securities, on top of $150 billion in previous write-downs. Ordinary Americans are worried: Only 20% think the country is generally headed in the right direction, nearly as low as at any time in the Bush presidency, according to the latest Wall Street Journal/NBC News poll.

"Clearly, the whole world is focused on the financial crisis and the U.S. is really the epicenter of the tension," says Carlos Asilis, chief investment officer at Glovista Investments, an advisory firm based in New Jersey. "As a result, we're seeing capital flow out of the U.S."

That is a troubling prospect for a savings-short, debt-heavy economy that relies on $2 billion a day from abroad to finance investment. It is raising the specter of the long-feared crash in the dollar that could further rattle financial markets and boost U.S. interest rates.

Though the risks of an unpleasant outcome are worrisome, the effects of Fed interest-rate cuts and fiscal stimulus have yet to be fully felt by the U.S. economy. Moreover, the combination of a weakening dollar -- which remains the world's favorite currency -- and still-growing economies overseas is boosting U.S. exports and offsetting some of the pain of the housing bust and credit crunch.

But while cash continues to pour into the U.S. from abroad, this flow has been slowing. In 2007, foreigners' net acquisition of long-term bonds and stocks in the U.S. was $596 billion, down from $722 billion in 2006, according to Treasury Department data. Americans, meanwhile, are investing more of their own money abroad.

Hopes are fading fast that the U.S. economy was suffering from a thirst for liquidity that standard Fed remedies could quench. Former Treasury Secretary Lawrence Summers, speaking in Washington yesterday, said he sees "an increasing risk that the principal policy tool on which we have relied -- the Federal Reserve lending to banks in one form or another" -- is like "fighting a virus with antibiotics."

Bob Eisenbeis, a former executive vice president of the Federal Reserve Bank of Atlanta, says the problem is more than an inability to find ready buyers for assets. "It is time to step back and recognize that the current situation isn't a liquidity issue and hasn't been for some time now," said Mr. Eisenbeis, the chief monetary economist for Cumberland Advisers. "Rather, there is uncertainty about the underlying quality of assets -- which is a solvency issue, driven by a breakdown in highly leveraged positions."

President Bush, speaking in New York and in a television interview yesterday, showed little appetite for further action. Detailing the steps the administration has already taken, the president in a speech knocked a couple of pending proposals. "Government policy," he said, "is like a person trying to drive a car on a rough patch. If you ever get stuck in a situation like that, you know full well it's important not to overcorrect -- because when you overcorrect you end up in the ditch."

But few in markets and elsewhere are convinced that the worst is over for the U.S., as each player moves to protect its own interests against potential calamities seen as improbable just a few months ago. Bear Stearns reassured investors earlier this week that it was solvent, but speculation that Bear faced a liquidity crunch had some traders and hedge funds moving to limit their exposure to it. Yesterday, J.P. Morgan Chase & Co. and the Federal Reserve Bank of New York offered emergency funds to keep the troubled investment bank afloat.

The loss of confidence is now spreading beyond the biggest banks, with their well-publicized losses on subprime and other risky assets, to regional and small banks. In the fourth quarter, U.S. banks reported their smallest net income -- a total of $5.8 billion -- in 16 years, according to the Federal Deposit Insurance Corp.

There's little sign yet that the worst is past. The "moment of recovery" is when forecasters turn out to be too pessimistic, says Mr. Summers. That point hasn't likely arrived. A Wall Street Journal survey of more than 50 economic forecasters in early March found a profound shift toward pessimism: About 70% say the U.S. is currently in recession, and on average they put the odds that this recession will be worse than the past two mild, short recessions at nearly 50%. Most expect house prices to decline into 2009 or 2010.

This couldn't come at a worse time for U.S. homeowners. American household debt has more than doubled in a decade to $13.8 trillion at the end of 2007 from $6.4 trillion in 1999, the vast majority of it in mortgages and home equity lines, according to Fed data. But the value of U.S. householders' biggest asset -- their homes -- is now falling.

The response of the Republican White House, Democratic Congress and Federal Reserve have been substantial. President Bush and Congress, with remarkable speed, agreed to a $160 billion fiscal-stimulus package that will put money in consumers' wallets soon. The Fed already has cut interest rates by 1 1/4 percentage points this year, and markets anticipate another 3/4 point cut on Tuesday. The Fed has moved to buy $400 billion worth of mortgage-backed securities for its $800 billion total securities portfolio in an effort to jolt that crucial market back to life and prevent rising mortgage rates from further depressing the U.S. housing market.

While there is continued debate about how to treat the current disease, there is a consensus emerging on the causes. "Soaring delinquencies on U.S. subprime mortgages were the primary trigger," the heads of the Treasury, Federal Reserve and Securities and Exchange Commission said in a lessons-learned report. "However, that initial shock both uncovered and exacerbated other weaknesses in the global financial system."

Kenneth Rogoff, a Harvard University economist, says the current difficulty has many mothers -- the housing bubble, the subprime problem and the fact that the value of U.S. imports has long outstripped the value of exports. The current account deficit -- the broadest measure of the trade deficit -- burgeoned, and the U.S. needed to borrow ever larger amounts of cash from abroad to fund it.

For years, Mr. Rogoff and like-minded economists harped that the U.S. current account deficit was unsustainable. But despite the belief that it would necessarily reverse, it kept growing through the first part of this decade, going from 3.6% of gross domestic product at the end of 1999 to a record 6.8% at the end of 2005. Lately, the deficit has seen a slight narrowing, but the combination of credit crisis and the economic downturn may have proved the catalyst for a faster, and potentially more dangerous, adjustment.

Pressures in one market spread rapidly to other, often more distant markets. "The dollar and subprime -- they're two sides of the same coin," says Princeton University economist Hyun Song Shin. Many U.S. hedge funds and financial institutions were speculating in mortgage-related securities with money that was ultimately borrowed in Japan, where interest rates have been low for years. He notes foreign banks' net liabilities in the yen interbank market surged between April 2006 and April 2007. As investments bought with money borrowed in Japan get sold and converted back into yen, he says, "we see both a fall in asset prices and a fall in the dollar."

The resulting blow to confidence threatens to further weaken lending, borrowing, spending and investment in the U.S. economy. "Hedge fund blowups have so far been one-off situations. One worry is that we'll cross some line and there'll be a systemic wave of fund failures. It's a reason why the market is so nervous," says John Tierney, credit derivatives strategist at Deutsche Bank.

Banks also are increasing the collateral they demand when they lend to hedge funds that hold municipal bonds. One hedge fund manager described what appears to be a coordinated effort by big investment banks to reduce their risk as they faced quarter-end pressures to cleanse their balance sheets. Lenders declared "by fiat," he said, that municipal-bond-fund managers needed to post more collateral to back their borrowings.

As a result, funds run by Blue River Asset Management, 1861 Capital Management and others circulated lists of assets to raise cash. The sell-off flooded the market with municipal bonds, making it more expensive for municipalities to borrow and upending the traditional relationship between tax-exempt municipal bonds and taxable U.S. Treasury bonds. For the first time in memory, yields on tax-exempt municipal bonds jumped above yields on taxable U.S. Treasury debt.

Now, many hedge fund managers say, access to borrowed money, essential for many of their investment strategies to work, has become virtually impossible.

Mohamed El-Erian, co-chief executive officer of Allianz SE's Pacific Investment Management Co., says the hedge-fund community is unwinding its leverage. "This will push more of them into 'survival mode,' further accentuating distressed sales and nervousness among the prime brokers," he wrote to his colleagues Thursday morning. "In such a world, the quality of the assets matters less than whether you can finance them [or] how liquid they are."

Bear Death Watch: Why It Failed

As I am sure you all know by now, Bear Stearns started coming spectacularly unglued last night, and called JP Morgan, who in turn tapped the Fed, who sent examiners who stayed at the firm all night. In the morning, a plan was announced by which the central bank would assume the risk of lending to Bear against collateral which would be posted at JP Morgan (it's mechanically easier for the Fed to work through a member bank; the JPM loans are back-to-backed with the Fed).

The firm nevertheless unraveled with surprising speed. When CEO Alan Scwartz dismissed concerns about liquidity on Monday, he wasn't fibbing. The SEC, in what appears to be a CYA statement late Friday. From CNN (hat tip Alea):

SEC officials said in a statement that they had been monitoring Bear Stearns' financial situation on a daily basis in recent weeks, and had no cause for alarm earlier in the week. Bear's holding company capital exceeded regulatory standards at the end of February, and information supplied by Bear Stearns to the SEC on Tuesday showed the holding company had a "substantial capital cushion," according to the SEC. As of that date, the firm had more than $17 billion in cash and unencumbered liquid assets, the SEC said.

"Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns' excess liquidity rapidly eroded," the statement says....The SEC division that oversees U.S. markets said it is continuing to monitor Bear Stearns' condition and believes its registered broker-dealers "remain in compliance with commission capital rules."

Lazard Freres has been engaged by Bear to try to find suitors, but the believe is that unless someone emerges over the weekend (odds low), a few choice pieces, like Bear's headquarters building, its prime brokerage and its asset management businesses, will be sold, and the rest liquidated (it is remotely possible that JP Morgan, who has inside knowledge via its involvement in the bailout, could make a deeply discounted bid for the entire firm, in effect getting the good bits and doing the liquidation itself). JC Flowers, Citadel, and some other private equity funds are expected to have a look, but if I were in their position, I'd be loath to bid against JP Morgan, given their information advantage.

The interesting thing about this collapse is that the general conditions that made Bear vulnerable are pretty clear; the immediate triggers less so. Let's go through both lists.

BEAR'S WEAKNESSES

High leverage, high exposure to risky credit businesses. The firm was widely seen to be, like Lehman, both highly geared, heavily dependent on credit market businesses, and therefore less stable.

Not well liked. This is not a trivial matter. Maintaining decent relationships with the Street is important. Bear created a lot of ill will in 1998 by refusing to chip in to the rescue of LTCM; it also incurred a lot of ire in its handling of its failed hedge funds last June (it planned to let them collapse, which would have left its counterparties with losses, until they ganged up on Bear).

Poor liquidity management. Bear should have known it was vulnerable due to its high gearing and the continuing crisis in the credit markets, Yet astonishingly, the firm was ill prepared for sudden cash demands. As the Wall Street Journal recounts:

Brokerages amass large cash piles -- often called liquidity reserves in their financial statements -- that are meant to see them through rocky periods in the markets....

Compared with other brokerages, Bear's cash reserve gives it the least cushion for a cash crisis....

Brokerages break out the size of this emergency cash in their financial filings with the Securities and Exchange Commission. To gauge its sufficiency, the reserve can be compared to the main type of debt that brokerages rely on to finance their operations. This debt is called collateralized borrowing, because to get the loans the brokerages have to pledge assets as security to the creditor. If these creditors pull back sharply, a brokerage is in deep trouble....

Bear would have been particularly exposed to this withdrawal, because its emergency cash pile was small compared to this debt. On Nov. 30, that cash reserve of $17 billion was only about 17% of the $102 billion owed through secured financings.

The same measure is 38% for Goldman, 39% for Morgan Stanley, and 34% for Merrill Lynch.

Possible worries about management. Bear had been perceived to be a tightly run ship under Ace Greenberg; by contrast, his successor James Cayne (who stepped down as CEO in January but remains chairman) had never been a trader and current CEO Alan Schwartz was formerly an investment banker. While I haven't seen this raised specifically as a concern, the image that Bear was a savvy, well run trading firm suffered a great deal in the last year. The risk management failings that led to the implosion of the subprime hedge funds was a shocker; just as troubling, for those who've been in the securities business, was the sloppiness in procedures (e.g., the inattention to taking the steps to prevent squabbles about the hedge funds' legal domicile) and possible failure to supervise fund manager Ralph Cioffi adequately in his personal dealings with the funds. And then we had the stories in the Wall Street Journal of both ousted co-president Warren Spector and Cayne himself spending a good deal of time on recreational pursuits when the firm was under duress.

POSSIBLE TRIGGERS

Elevated concern about counterparty risk. Remember that the first two eruptions of the credit crisis (August-September, then November-December) showed high stress in the bank lending markers, with banks hoarding liquidity, reluctant to engage in what would at other times be routine transactions.

This sort of widespread distrust has now infected the securities markets. The near-cessation of the auction rate securities market was the one result of this new sensitivity to risk. Investment banks have gotten tough on the terms they extend to hedge funds who borrow from them, increasing the haircuts on collateral. Less visibly, they have also evidently become more cautious in taking on routine trading risk.

As the Wall Street Journal noted:

Word began to spread among fixed-income traders nine days ago that European banks had stopped trading with Bear. Some U.S. fixed-income and stock traders began doing the same on Monday, pulling their cash from Bear for fear it could get locked up if there was a bankruptcy.

The pullback in Europe began around the time that Carlyle Capital started to founder, so the prospect of a Carlyle liquidation (remember, the hedge fund was a big MBS player) may have raised doubts about Bears' balance sheet.

Hedge fund flight. This to have accelerated the crisis. If a brokerage firm fails, customer assets are frozen which if you are a trader is already a terrible thing. Worse, as a reader told me, is that margin accounts become part of the bankruptcy, to be divided among all the creditors. While there is some debate on this point, Jim Rogers' Beeland fund had a considerable amount of assets custodied at Refco which went belly up when its CEO was found to have embezzled on a grand scale, and he took big losses as a result. The Journal indicates that Renaissance Technologies moved several billion of assets away from Bear this week. As the Financial Times's Lex column notes:

Counterparties either reduced their exposure to the firm or ratcheted up collateral requirements. The need for a rescue became self-fulfilling.

The New York Times provides a good synopsis:

[Bear] is also among the biggest firms in the prime brokerage business, or the financing of hedge funds. In recent weeks, nervous fund managers have scrambled to protect themselves. Robert Sloan, who is the managing partner at S3 Partners, a financing specialist that works with hedge funds, has shifted $25 billion out of Bear Stearns accounts in the last two months, he said.

“The problem is the financing of the hedge fund industry is very concentrated and very brittle,” Mr. Sloan said. “If they go under, you will have thousands of funds frozen out,” he said, adding that everyone might then have to wait for a court to name a receiver before business could resume.

But that still fails to explain why so many counterparties got an itchy trigger finger now. Recall that the SEC statement said the agency had been monitoring Bear's liquidity daily over the last few weeks. There must have been an event or rumor back then, and who knows, if word of intensified SEC oversight got out, that alone could have been very damaging.

But how would that affect Bear's liquidity? The specter of hedge fund accounts leaving no doubt was seen as confirmation of the possibility that Bear would go under. One would think that hedge fund customers paying off collateralized loans would improve Bear's liquidity, but by all accounts, the migration made matters worse (anyone who knows the operational details or valuation issues that might have played a role is encouraged to speak up).

Carlyle/TSLF collateral damage. This theory is hoisted from comments, and makes a good deal of sense:

The TSLF probably had the perverse effect of killing Carlyle Capital, the exact opposite of what was intended (Robert Peston @ BBC, via Alea). The TSLF gave creditors every incentive to seize Carlyle Capital's collateral in order to present it at the Fed window in exchange for "lovely liquid Treasuries", something which Carlyle Capital itself couldn't do. Bear, on the other hand, is allowed to use the TSLF... but the TSLF doesn't go live until March 27.

This suggests two things: first, the Bear bailout is much less significant than meets the eye, because it's just a Bear-only jumpstart to the TSLF which would have saved Bear anyway. In other words, it's nothing really new or different from the TSLF itself.

And secondly, an awful conspiracy theory presents itself: were Bear's creditors trying to deliberately hasten its demise (a la Carlyle) before Bear could take advantage of the TSLF, so they could grab Bear's collateral and turn it into desperately needed liquidity for themselves?

I'll go with a variant of the conspiracy theory: the collapse of Carlyle no doubt heightened worries about everything mortgage-related, and thus probably accelerated hedge fund withdrawals.

Alt-A losses. This comes from the Times (hat tip Michael Shelock):

Banking sources speculated that Bear Stearns could have been hit by last night's collapse in value of so called alt-A, or low-end prime mortgage securities.

"The Alt-A market fell out of bed last night and Bear would have been completely caned by this. They hold a bunch of these securities," one investment banking source told Times Online.

"Against what you might normally expect, the sub-prime market rallied, but alt-A sold off."

Given what we learned about the timing, it doesn't seem this factor was operative. Remember, Bear concluded that it was in trouble as of 4:30 pm on Thursday; it called James Dimon at JP Morgan at 6:00 pm., who immediately called the Fed, which then sent a team of examiners over to Bear that worked through the night. One has to wonder if the Alt-As collapsed because the rumor of Bear's extreme duress got out.

Regardless, this is a sad day. The Bear Stearns of old was a meritocratic place where someone from the wrong side of the tracks could be extremely successful. Ace Greenberg also made very generous donations and insisted his partners do so as well (my recollection is that the expected level was 5 or 6% of income). But as firms went public and started running on other people's money rather than putting partnership capital at risk every day, they became slicker and more reckless. I don't know the contermporary Bear all that well, but it is a casualty of the Street's sorry devolution.

Bear Bailout: Is No One Too Small to Fail?

The news that Bear had to run to the Fed for help with its rapidly deteriorating cash position, and JP Morgan has been muscled into assisting in the rescue is a sign that Bear was deemed too big to fail. The Fed is lending against Bear's collateral (I haven't seen an estimate as to how large this operation is).

First Countrywide, now Bear. Why did the Fed not let Bear collapse? You can attribute it to the Fed's tendency to take responsibility for problems it can't and shouldn't fix, but this one is a trickier call than Countrywide.

Bear is a large prime broker, which means it lends to hedge funds. It is also a significant counterparty in enough different credit markets that its collapse would have at a minimum caused panic as to who might have been hurt. You'd have a further scramble for liquidity and reluctance to lend, which is precisely the condition the Fed has been trying to alleviate.

In particular, according to Bloomberg, Bear was the second largest underwriter of mortgage bonds, The lead manager (I'm assuming Bear was also a significant lead manager) is the only one who knows where the bonds went and is thus in the best position to trade them. So Bear's role as an important market-maker may have played into the calculus.

But the answer to the question of whether Bear should have been allowed to tank depends on how long it would take the crisis to pass. Swap spreads were elevated a full year after the LTCM rescue, but here the relevant metric would be how long the acute phase might take. If it was two weeks or a month, and no one save maybe some middling sized hedge funds (or a lot of teeny ones) would fail, that would have been acceptable. But the Fed couldn't assess this in a 24 hour period. (However, some parties believe that the Fed's $200 million TLSF was in part to assist Bear; if so, they've had at least a week to evaluate this risk. But in that case, I'm not certain they asked the right questions).

I still think Bear should have been permitted to fail. Now every the same size or larger knows the Fed will ride into the rescue. This is a terrible precedent. It also increases the odds of the Fed running out of firepower long before the crisis is over.

I also wonder what Bear employees were paid in bonuses last year (I assume the checks went out in late December or January) and whether cutting that number by 50% would have saved Bear's hide. (CEO Alan Schwartz's blaming the crisis on "market rumors is classic and should be heavily discounted, although one also has to wonder if Bear would have survived if the TSLF had been operational this week).

Analysts believe that JP Morgan may wind up owning parts or all of Bear. It isn't easy to hive off pieces of trading firms, which Bear is. As we have said before, Bear has such a sharp-elbowed, entrepreneurial culture that it's difficult imagining that anyone could manage it successfully, This bailout (which is almost certain to leave the banks owning Bear, given the dearth of other capable and interested parties) has high odds of being a value destroying exercise for JP Morgan.

For the curious, Bloomberg also describes how the Fed has the authority to rescue a non-bank:

The loan to Bear Stearns required a vote today by the Fed's Board of Governors because the company isn't a bank, Fed staff officials said. The central bank is taking on the credit risk from Bear Stearns collateral, lending the funds through JPMorgan Chase & Co. because it's operationally simpler to accomplish than a direct loan, the staff said on condition of anonymity.

Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allows it to loan to corporations and private partnerships with a special Board vote. The Fed chief probably sought to stave off a deeper blow to the financial system from a Bear Stearns collapse, former Fed researcher Keith Hembre said.

``The Fed really doesn't have any obligation to help a non- bank aside from its role or responsibility to keep the financial markets functioning,'' said Hembre, who helps oversee $107 billion as chief economist at FAF Advisors Inc. in Minneapolis. ``They made a judgment, probably an accurate one, that they're not going to function very well if you've got a full-blown crisis with a major Wall Street firm.''

Krugman: Fed is Running Out of Tricks

Krugman, in his New York Times op-ed today, "Betting the Bank," reminds us that the Fed is much like the Wizard of Oz: the perception of its power vastly exceeds reality. In normal times, the limited tools central bankers have at their disposal can be used to great effect, but extreme conditions reveal their impotence.

Krugman points out that the Fed's aggressive and inventive measures haven't and can't fix the underlying problem, namely, that a very large number of people not only bought houses that they couldn't afford, but also did so at high prices. Interestingly, Krugman says that the Fed cannot and should not try to stem the resulting losses.

While it is good to see a Serious Economist tell the Fed in a highly public venue that it is destined to fail, I wish Krugman had also addressed the collateral damage resulting from the central bank's frantic reflation efforts, namely a collapsing dollar and commodities price inflation (obviously worse in dollar terms, but operative even in economies with currencies rising relative to the dollar, such as China). What is even more worrisome is that Bernanke may deem a continued slide in the dollar to be entirely a good thing. As Mark Gilbert pointed out in Bloomberg on Thursday:

In November 2002, when Bernanke was merely a Fed governor, he gave a speech about ``Deflation: Making Sure `It' Doesn't Happen Here.'' More than five years on, the text provides a step- by-step guide to the Fed's reaction to the current credit crisis, and hints at the tricks left up the central bank's sleeve.

The speech is relevant even though two of its premises -- a general decline in consumer prices and a benchmark central-bank rate that's close to zero -- don't currently apply to the U.S. experience. Bernanke detailed the Fed's likely response once the blunt instrument of cutting borrowing costs had lost its potency to revive the economy -- which is exactly the situation the central bank finds itself in now.

``When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates,'' Bernanke said. ``By moving decisively and early, the Fed may be able to prevent the economy slipping into deflation.....

``Another option would be for the Fed to use its existing authority to operate in the markets for agency debt,'' he said. It could offer ``fixed-term loans to banks at low or zero interest, with a wide range of private assets, including, among others, corporate bonds, commercial paper, bank loans and mortgages deemed eligible as collateral.....

``The U.S. government has a technology called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost,'' Bernanke said. ``A determined government can always generate higher spending and hence positive inflation. Sufficient injections of money will ultimately always reverse a deflation.....

``It's worth noting that there have been times when exchange-rate policy has been an effective weapon against deflation,'' Bernanke said, citing the 40 percent devaluation of the dollar against gold enacted in 1933 to 1934. ``The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Monetary actions can have powerful effects on the economy.''

The problem with this line of thinking is that it contradicts another premise he mentioned:

``A healthy, well-capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks.''

The international capital markets are looking very wobbly. Bernanke, however, is looking at our credit mess as if our economy exists in isolation. Tanking the dollar has led to a massive unwinding of the carry trade, which exacerbates the deleveraging already underway. And his 1933-1934 remedy is dangerous medicine at this point. By then, the Depression was a well entrenched, international phenomenon. Moreover, Great Britain had abandoned the gold standard In 1931; the US was merely following suit.

But most important is that in 1933, the dollar was not the world's reserve currency. There are tremendous advantages to being the reserve currency, namely, you can borrow without incurring foreign exchange risk, which is a non-trivial matter. Moreover, a rapid decline in the reserve currency creates tremendous international instability, and can damage financial institutions in other countries, thus further imperiling capital markets functioning. But that doesn't seem to have occurred to Bernanke.

As ECB president Jean-Claude Trichet noted:

”On exchange rates, particularly against the dollar, I reaffirm that disorderly movements in exchange rates are undesirable from the point of view of economic growth.”

It appears that at least some of the commodity bubble is due to speculation, and the more the Fed engages in desperate measures, the more grist for the commodity bulls. So there will be increasing political hostility to the Fed's course of action, particularly if gas goes to $6 a gallon and bread prices double.

We are in a very similar position to the weaker nations hit by the emerging markets crisis in 1997. George Friedman of Stratfor (ironically in a 2006 article, "The Looming China Crisis") described the known ways out:

Asia has been here before. Japan encountered this problem around 1990, and East and Southeast Asia encountered it in 1997. Roughly three models for dealing with the problem exist:

* Japan model: Use reserves and formal and informal measures to avoid actions that would trigger massive bankruptcies and unemployment. Accept economic stagnation for the better part of a generation.

* South Korea model: Move rapidly to restructure the economy, using economic and political means. Control social unrest with security measures. Move out of the problem in a matter of years.

* Indonesia model: Lacking resources to manage the crisis, suffer both financial dysfunction and political strife among the elite and between regions.

Japan was able to do what it did because it is a highly disciplined, cohesive society, in which shared pain is viewed as preferable to social dislocation. South Korea was able to do what it did because the magnitude of its crisis was relatively less than Japan's, and because the state had the means for suppressing unhappiness. Indonesia failed to do what it needed to do because it lacked resources and political power.

Other countries have fallen somewhere along this continuum. China will make its own path. However, it should be pointed out that China is not socially similar to either Japan or South Korea. Like Indonesia, China is a diverse and divided nation. The Communist Party lost its moral standing in the 1970s. As with Suharto's government, its legitimacy now derives from the fact that it has created prosperity. When prosperity slows down or stops, the Party cannot fall back on inherent legitimacy, as was the case with the system in Japan. And the wildly diverse levels of economic development make a single, integrated solution, as was used in South Korea, unlikely. The most likely direction for China, therefore, is massive social and political instability.

Although the US is not as "diverse and divided" as China, faith in our government is falling as fast as the value of the greenback and will decline further. if we enter a serious, prolonged slump. Indonesia's GDP fell 17% in 1997 (reader CrocodileChuck reminded me; he was on the ground there); we won't fall anywhere near that far. But we could well come out somewhere between South Korea and Indonsesia on Friedman's list, which is an ugly place to be.

From Krugman:

Four years ago, an academic economist named Ben Bernanke co-authored a technical paper that could have been titled “Things the Federal Reserve Might Try if It’s Desperate” — although that may not have been obvious from its actual title, “Monetary Policy Alternatives at the Zero Bound: An Empirical Investigation.”

Today, the Fed is indeed desperate, and Mr. Bernanke, as its chairman, is putting some of the paper’s suggestions into effect. Unfortunately, however, the Bernanke Fed’s actions — even though they’re unprecedented in their scope — probably won’t be enough to halt the economy’s downward spiral.

And if I’m right about that, there’s another implication: the ugly economics of the financial crisis will soon create some ugly politics, too.

To understand what’s going on, you have to know a bit about how monetary policy usually operates.

The Fed’s economic power rests on the fact that it’s the only institution with the right to add to the “monetary base”: pieces of green paper bearing portraits of dead presidents, plus deposits that private banks hold at the Fed and can convert into green paper at will.

When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands.

This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs.

But sometimes the magic doesn’t work. And this is one of those times.

These days, it’s rare to get through a week without hearing about another financial disaster. Some of this is unavoidable: there’s nothing Mr. Bernanke can or should do to prevent people who bet on ever-rising house prices from losing money. But the Fed is trying to contain the damage from the collapse of the housing bubble, keeping it from causing a deep recession or wrecking financial markets that had nothing to do with housing.

So Mr. Bernanke and his colleagues have been doing the usual thing: printing up green paper and using it to buy bonds. Unfortunately, the policy isn’t having much effect on the things that matter. Interest rates on government bonds are down — but financial chaos has made banks unwilling to take risks, and it’s getting harder, not easier, for businesses to borrow money.

As a result, the Fed’s attempt to avert a recession has almost certainly failed. And each new piece of economic data — like the news that retail sales fell last month — adds to fears that the recession will be both deep and long.

So now the Fed is following one of the options suggested in that 2004 paper, which was about things to do when conventional monetary policy isn’t getting any traction. Instead of following its usual practice of buying only safe U.S. government debt, the Fed announced this week that it would put $400 billion — almost half its available funds — into other stuff, including bonds backed by, yes, home mortgages. The hope is that this will stabilize markets and end the panic.

Officially, the Fed won’t be buying mortgage-backed securities outright: it’s only accepting them as collateral in return for loans. But it’s definitely taking on some mortgage risk. Is this, to some extent, a bailout for banks? Yes.

Still, that’s not what has me worried. I’m more concerned that despite the extraordinary scale of Mr. Bernanke’s action — to my knowledge, no advanced-country’s central bank has ever exposed itself to this much market risk — the Fed still won’t manage to get a grip on the economy. You see, $400 billion sounds like a lot, but it’s still small compared with the problem.

Indeed, early returns from the credit markets have been disappointing. Indicators of financial stress like the “TED spread” (don’t ask) are a little better than they were before the Fed’s announcement — but not much, and things have by no means returned to normal.

What if this initiative fails? I’m sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but there’s only so much the Fed — whose resources are limited, and whose mandate doesn’t extend to rescuing the whole financial system — can do when faced with what looks increasingly like one of history’s great financial crises.

The next steps will be up to the politicians.

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.

How Will Washington Finesse a Bailout?

Gillian Tett ponders the conundrum that, given the dearth of logical suspects to replenish US bank equity if credit markets continue to deteriorate, the Federal government will have to step into the breach. But bailouts are profoundly unpopular even in the best of times, and an election year is a particularly ill-fated juncture for this problem to arise.

Tett believes that the folks in DC will resort to under-the-radar mechanisms such as greater reliance on Freddie, Fannie, and the Federal Home Loan Banks. However, they are no longer as unnoticed as she might think. As readers know well, the increase in agency spreads is largely due to the market's negative reaction to the idea of filling up Freddie's and Fannie's not all that wonderful balance sheets with refinancings of stressed borrowers. When you have negative coverage in Barron's, it isn't the same as having the same story run in USA Today, but it's sufficient bad PR to add to the negative reaction among investment professionals. Similarly, the Federal Home Loan Banks have already doled out enough cash to dodgy banks that their efforts are eliciting criticism. From Greg Ip in the Wall Street Journal Economics Blog;

Nouriel Roubini, a New York University economist better known now through his research service, Roubini Global Economics, cast an unflattering light on a little-discussed risk to the financial system in testimony to the House Financial Services Committee yesterday: The Federal Home Loan Banks, 12 federally banks (like Fannie Mae and Freddie Mac) that are privately owned and primarily lend to their owner-banks against illiquid collateral such as mortgages.

Mr. Roubini said:

The widespread use of the FHLB system to provide liquidity — but more clearly bail out insolvent mortgage lenders — has been outright reckless. Countrywide alone — the poster child of the last decade of reckless and predatory lending practices — received a $51 billion loan from this semi-public system; in the absence of this public bailout Countrywide would have ended up where it should, i.e. into outright bankruptcy. And the largesse of the FHLB system does not stop at Countrywide. A system that usually provides a lending stock of about $150 billion has forked out loans amounting to over $750 billion in the last year with very little oversight of such staggering lending. The risk that this stealth bailout of many insolvent mortgage lenders will end up costing massive amounts of public money is now rising.

While Roubini may be early (as usual) in calling attention to the downside exposure of the FHLB, its role in the rescue of Countrywide has come into view. Senator Charles Schumer was so upset he called for an investigation (although it was in large measure due to his well founded view that Countrywide is a bad actor not worthy of salvaging).

So Freddie, Fannie, and the FHA are increasingly in the spotlight, and the formerly closeted FHLB is finding it harder to hide. So Tett's notion that the powers that be can craft a backstage solution may be wishful thinking. I suspect we will see more desperate measures from the Fed, more "free market" non solutions from the Treasury, and increasing difficulty in resorting to covert financial rescues, given the heightened scrutiny of everything mortgage and housing related. If things deteriorate sufficiently in the next two to three months, it's possible we'll get a hail Mary pass of a radical reform package too close to elections to get passed, just so the Republicans can blame the Democrats.

Yesterday, David Wessel in the Wall Street Journal also discussed options for shoring up banks, including nationalization (mind you, to be limited to ones truly too large to fail). Of the many suboptimal solutions, I find that less offensive than others, provided the existing shareholders are wiped out and management is put on lean salaries (they can get performance bonuses, but not overly lavish ones. Frankly, they should be grateful they are not going to jail or having their previous comp clawed back, and if they could be given that stick along with a bit of carrot, they might go along. If not, I don't believe that people who are capable of running banks are as scarce a commodity as search firms would lead you to believe. If someone with as little relevant experience as Vikram Pandit can head Citigroup, there is a large universe of candidates.). The advantage, aside from greater acceptability to the public, is that the government will get the full upside of its risk-taking when the banks are re-privatized.

While I differ with Tett's conclusion, the bulk of her piece is analysis, which is very much worth reading. From the Financial Times:

When is a bail-out not quite a bail-out? When it occurs in a US election year, it might seem. Or that, at least, is the cynical thinking floating around some well-informed market minds.

For as the credit crunch grinds on, pressures in the financial system are rising by the day. Never mind the fact that hedge funds are now imploding; in a sense that is only to be expected (and arguably overdue).

Instead, what is really worrying investors, ahead of the release of broker results next week, is the risk that serious capital pressures will emerge at some banks if they are forced to mark their books to (ever falling) market prices. There is also growing concern about the capital position of housing behemoths, such as Fannie Mae and Freddie Mac, as mortgage defaults rise.

Thus the trillion-dollar question haunting the markets is where on earth will the capital to plug these potential gaps come from? Will private sector investors (such as sovereign wealth funds) step to the plate again? Or will the next chapter in this saga entail the US taxpayers footing the bill, through covert or overt means?

Unsurprisingly, this latter scenario is not something that anybody in Washington is keen to debate in public right now. And the Federal Reserve, for its part, is working overtime to avoid this worst-case scenario by devising ever-more creative measures to tackle pockets of market illiquidity.

But while this week’s $200bn Fed package should earn points for lateral thinking, the Fed now seems to be running to keep still: as soon as it announces one set of confidence-boosting measures, a fresh set of market brushfires break out.

Even if the Fed’s measures ease liquidity pressures, they cannot by themselves solve the most fundamental source of capital pressures on banks. After all, the banks’ woes do not entirely stem from mark-to-market accounting practices; behind the drama of tumbling securities prices there are tangible credit losses.

And whether you think these credit losses will eventually total $300bn or four times that level (which is roughly the range of current forecasts), what is clear is that losses will exceed the $60bn to $100bn of capital injections so far garnered from sovereign wealth funds. It is also clear that these funds have growing qualms about writing new blank cheques. Hence the rising question about how to plug the capital gap.

So will the US government step in instead? Not in a classic sense anytime soon, I suspect. After all, no politician in his (or her) right mind wants to be seen rescuing greedy Wall Street bankers right now – or not unless it is presented as a collective action plan in which plenty of bankers go to jail.

But producing a coordinated deal between multiple stake holders looks hard right now, particularly given the US election. Thus the US faces the reverse of Japan’s problem a decade ago: where Japan was hobbled by an excess of collectivism, the US is now hobbled by extreme individualism. Forging proactive plans requiring shared pain and sacrifice is not something that comes easily in America now.

Of course, this situation might change if a full-blown financial fiasco erupts. Further ahead, the next administration may find it easier to take radical steps by blaming the problems on the past.

But in the meantime, I expect to see the intensified use of more subtle forms of public support, via ill-understood institutions such as the Federal Home Loan banking system or Fannie Mae and Freddie Mac. There could soon be more measures to help subprime borrowers to stay in their houses (which helps the banks by reducing future mortgage defaults).

Perhaps these subtle approaches will quell the crisis or even turn sentiment sufficiently to enable the banks to attract more capital from private sources. But the longer the turmoil lasts, the greater the risk that sooner or later, taxpayer money will end up propping up the system. The only uncertainty is just how many euphemisms will be invented in the coming months by whizz-kids in Wall Street or Washington who want to avoid saying “bail-out” in an election year.

Links 3/14/08

The Fed's Bank Bailout The Onion

Bear convicted for theft of honey BBC

Drug Import Mess Getting Deeper and Deeper All Things Whistleblower. This is pretty scary. There is no way to insure the safety of drugs imported from China. My advice: stay healthy.

Central bank intervention … unprecedented in scale and scope Brad Setser. An excellent post, discussing how that isn't true (emerging market central bankers have gone to more extreme and larger interventions) and he discusses which the Fed might consider next.

Debt Collectors Try to Put on a Friendlier Face New York Times

Fears Mount Over Bear Stearns' Exposure FT Alphaville

Did Eliot Spitzer Get Caught Because He Didn't Spend Enough on Prostitutes? Slate. I am most assuredly out of touch with the market for high end personal services.

Antidote du jour:

"War costs and costs and costs"

Joseph Stiglitz gives the high point of the findings of his new book, The Three Trillion Dollar War, in a comment today in the Guardian.

I wish Stiglitz has gone on at more length about the horrific corruption and featherbedding in the Iraq contracting process. All the traditional rules were thrown out the window. This Vanity Fair article details some of the pilferage:

In (attorney Alan] Grayson's view, a nightmare combination of jacked-up bids, waste, kickbacks, and inflated subcontracts means that as much as half the value of every contract he has seen "ends up being fraudulent in one way or another." He adds, "Cumulatively, the amount that's been spent on contractors in the four-plus years of the war is now over $100 billion. Pick any number between 10 percent and 50 percent—I don't think you can seriously argue that the scale of the fraud is less than 10 percent. Either way, you're talking cumulatively about something between $10 and $50 billion."

Indeed, in February, the House Committee on Oversight and Government Reform got the news from Pentagon auditors that contractors in Iraq had claimed at least $10 billion—three times more than previous official estimates—in expenditures that were either unreasonably high or unsupported by proper documentation. Of this amount, $2.7 billion had been billed to the government by KBR.

While this number pales when compared to Stiglitz's $3 trillion, the money that the government permitted to be purloined could have instead gone to assuring the safety of the troops, who often were lacking in the basics, such as adequate body armor. That sort of stinginess produces huge human and financial costs down the road, in terms of costly disabilities.

From the Guardian:

With March 20 marking the fifth anniversary of the United States-led invasion of Iraq, it's time to take stock of what has happened. In our new book The Three Trillion Dollar War, Harvard's Linda Bilmes and I conservatively estimate the economic cost of the war to the US to be $3 trillion, and the costs to the rest of the world to be another $3tn - far higher than the Bush administration's estimates before the war. The Bush team not only misled the world about the war's possible costs, but has also sought to obscure the costs as the war has gone on.

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