Bear/JP Morgan: The Rashomon Defense

While there have been dark mutterings about how Bear shareholders were cheated in the sale of the firm to JP Morgan, I don't have much sympathy for that view. Plenty of businesses fail every day; equity investors usually lose their entire stake and employees are fired. While it is sad on a human level to see people take such a reversal, it happens all the time in Darwinist America. The only difference between Bear's share owners and those of most other companies facing liquidation is that in going though the five stages of grief over their loss, they took the bargaining phase literally.

What does have me agitated (and this blogger prefers to stay detached) is the Fed's $29 billion subsidy to JP Morgan's purchase of Bear and the utter lack of candor and accountability about it. Paulson came up with an excuse to run away to China to avoid testifying at the Congressional hearings on the Bear bailout this week (perhaps, having been a staffer to John Erlichman, he is acutely aware of the danger of committing perjury before Congress). In the end, Paulson's absence probably made no difference, because the key actors executed a brilliant strategem, the Rashomon defense.

As in Kurosowa's masterwork, certain basic elements are not in dispute: in the movie, a rape; in the financial world, a rape an unprecedented commitment on the Fed's part that appears to be well beyond authority. (While the Fed can lend against all sorts of collateral in exigent and unusual circumstances, I have been advised those loans are for a maximum of 28 days. It might have been possible to arrange overlapping loans that would have achieved the same end, but the Fed couldn't be bothered to observe the niceties.)

In both performances, the witnesses tell stories that simply cannot be reconciled. The SEC insists Bear had sufficient capital. Bear CEO Schwartz maintains there was no action he could have taken to save the firm. Bernanke and Geithner claimed that the deal was necessary to preserve the financial system because Bear was going to have to file for bankruptcy (they indicated the big worry was the credit default swaps). Dimon said his firm is sound and the fact that he did the deal means he thought it was good for shareholders.

So we have at least three possible scenarios, with no way to sort them out:

1. Bear really was solvent but did not manage the crisis or its cash levels defensively enough

2. Bear was worth either not much or nothing dead, but JPM used the panic and the possibility of a Lehman-on-the-ropes further ratchet down to extract big concessions from the Fed. Put more simply, JPM played what were real risks to the max and exploited the Fed and Treasury's desperation to get a deal done

3. There was a black hole in Bear's balance sheet (I mean this in sense of either serious negative equity in liquidation or an information void). The possibility of losses to JPM was real (although Dimon still could have overplayed it)

What makes me even more keen for disclosure is that the de facto subsidies to JPM were even greater than previously disclosed. From "Fed Loosens Capital Rules for JPM." in Alea (boldface his):

Up to $220 billion of Bear Stearns assets can be excluded from J.P.Morgan’s risk-weighted assets.
Up to $400 billion of Bear Stearns assets can be excluded from the denominator of the tier 1 leverage capital ratio.

JPMC also has requested that the Board provide JPMC with relief from the Board’s risk-based and leverage capital guidelines for bank holding companies.

Specifically, JPMC has requested that the Board permit JPMC, for a period of 18 months, to exclude from its total risk-weighted assets (the denominator ofthe risk based capital ratios) any risk-weighted assets associated with the assets and other exposures of Bear Stearns, for purposes of applying the risk-based capital guidelines to the bank holding company. In addition, JPMC has asked the Board to permit JPMC, for a period of 18 months, to exclude from the denominator of its tier 1 leverage capital ratio any balance-sheet assets of Bear Stearns acquired by JPMC, for purposes of applying the leverage capital guidelines to the bank holding company.

The Board has authority to provide exemptions from its risk-based and leverage capital guidelines for bank holding companies.

JPMC has agreed to several conditions that would limit the scope ofthe relief request.

First, JPMC proposes to exclude from its risk-weighted assets, for purposes of applying the Board’s risk-based capital guidelines for bank holding companies, the risk-weighted assets of Bear Steams existing on the date of acquisition of Bear Stearns by JPMC, up to a total amount not to exceed $220 billion.

Second, JPMC proposes to exclude from the denominator of its tier 1 leverage capital ratio, for purposes of applying the Board’s tier 1 leverage capital guidelines for bank holding companies, the assets of Bear Stearns existing on the date of acquisition of Bear Stearns by JPMC, up to an amount not to exceed $400 billion.

These regulatory capital exemptions would assist JPMC in acquiring and stabilizing Bear Stearns and would facilitate the orderly integration of Bear Stearns with and into JPMC. The Board notes that (i) JPMC would be well capitalized upon consummation of the acquisition of Bear Stearns, even without the regulatory capital relief provided by the exemptions; and (ii) JPMC has committed to remain well capitalized during the term of the exemptions, even without the regulatory capital relief provided by the exemptions.

Note that the existence of this huge and ugly-looking concession says that someone thought there was risk here, but it still doesn't indicate conclusively how much of this was needed to overcome JPM's hesitation versus a sign of the depth of the Fed/Treasury's panic.

Or did JPM need regulatory relief irrespective of the Bear transaction, and the deal provided a much-needed fig leaf? According to Institutional Risk Analytics:

To understand the grim outlook for JPM, start the analysis with derivatives. Because of its huge market share in all manner of OTC derivatives, JPM represents a "super sample" of overall OTC market risk. In terms of total size vs the bank's balance sheet, JPM's derivatives book is more than 7 standard deviations above the large bank peer group.

Because of this huge OTC derivatives book, the $1.6 trillion asset bank can tolerate just a 15bp realized loss across its aggregate derivatives position before losing the equivalent of its regulatory Risk Based Capital (RBC). And much like the GSEs, JPM's positions are too big to hedge - despite what Mr. Dimon may say to the contrary about laying off his bank's risk. And note that we have not even mentioned subprime assets yet.

Look at the balance sheet of JPM's three main subsidiary banks and the mounting stress from loans losses is apparent. At the end of 2007, JPM aggregated 97bp of gross loan charge offs, 1.25 SDs above peer, and produced a Loss Given Default of 85%, likewise well above peer. The Exposure at Default calculated by the IRA Bank Monitor using data from the FDIC was 202%, more than 2 SDs above peer.

At the end of 2007, JPM's Tier One Risk Based Capital held by its subsidiary banks was just $88.1 billion, a tiny foundation for the bank's vast trading operations. The Economic Capital ("EC") simulation in The IRA Bank Monitor generates an EC benchmark of $422 billion for JPM or a ratio of EC to Tier One RBC of 4.79:1, suggesting that JPM needs almost five times current capital levels to fully support its economic risks (boldface ours).

If that isn't ugly enough, consider another element: while none of the principals was likely to have admitted it out loud, they may have recognized privately that the inmates are running the asylum at all of the major trading operations on Wall Street. No one in authority, including the firms' own management, knows the score. As Michael Lewis noted last week in Bloomberg:

There is, of course, a reason that the market doesn't understand Wall Street firms: The people who run Wall Street firms, and who convey news of their inner workings to the outside world, don't understand them either...

Late last November, in a superb account of the demise of Citigroup CEO Charles Prince, Carol Loomis of Fortune magazine revealed that Prince resigned after he was informed of the consequences of liquidity puts...Liquidity puts were about to make Citigroup the new owner of $25 billion of crappy mortgage securities at par, cost Prince his job, and put the company into the hands of Robert Rubin....

Rubin said he had never heard of liquidity puts.

To both their investors and their bosses, Wall Street firms have become shockingly opaque. But the problem isn't new. It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They're incredible.)

The profits came from financial innovation -- mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.

Ever since then, when extremely smart people have found extremely complicated ways to make huge sums of money, the typical Wall Street boss has seldom bothered to fully understand the matter, to challenge and question and argue.

This isn't because Wall Street CEOs are lazy, or stupid. It's because they are trapped. The Wall Street CEO can't interfere with the new new thing on Wall Street because the new new thing is the profit center, and the people who create it are mobile.

Anything he does to slow them down increases the risk that his most lucrative employees will quit and join another big firm, or start their own hedge fund. He isn't a boss in the conventional sense. He's a hostage of his cleverest employees.

At this point you have to at least wonder if Wall Street firms should be public companies. Their complexity renders them inherently opaque. Investors are right now waking up to this fact: They will demand to be paid for opacity, and also for volatility.

The firms have been revealed to be so treacherous in bad times that the only way they survive as public companies is to make outrageously huge sums in good times. That is, as public companies, to be economically viable they are likely to be socially problematic.

If they aren't about to go under, they are making so much money that everyone else hates them

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Back to the premise. The witnesses in the Congressional hearings no doubt chose not to attempt to reconcile their organization's version of events with other accounts, cleverly leaving the panel and the wider world the impossible task of trying to come up with a consistent, coherent picture.

But per Lewis, the main actors may also unwittingly be victims of their own incomplete understanding. While they may all be trying to script Rashomon, the real story may be the blind men and the elephant, each only able to discern a piece and unable to grasp the whole.

Beware of the Bank Stock Rally

Bank stocks enjoyed a nice bounce from the fact that UBS announced a first quarter loss equal to 5% of Switzerland's annual GDP. The logic evidently was if things are that bad, they can't get much worse, ergo, a bottom must be at hand. But this credit contraction has produced a number of head fakes (remember, when banks reported scary writedowns for the third quarter 2007, the entire market rallied on the belief that the purging had been so extensive that the financial firms had put the past behind them.

Neil Hume in the Financial Times argues that there are plenty of reasons to be cautious about the implicit upbeat forecast for banks. While the discussoin focuses on the UK, many of the observations apply to the US too:

At first glance, the sector, which has fallen by 22 per cent in the past year and has seen several constituents shed 40 per cent of their market value, appears cheap.

Domestic banks – this excludes Standard Chartered and HSBC, which make most of their profits overseas – trade on a prospective price earnings ratio of around 7.6 times earnings, according to estimates from Goldman Sachs.

However, it has been cheaper. In the period before the last recession in the UK, the sector was trading on a forward multiple of 5-6.

In any case, p/e ratios are of limited value when there is no visibility of earnings. And for a number of reasons that is certainly the case at the moment.

For example, profits are very sensitive to the cost of funding. The gap between base rates and the three month sterling inter-bank rate has doubled since February and predicting where it will be in two months time is a mugs game.

By the same token, no-one knows when the securitisation market will fully re-open for business. If it remains effectively shut lending will have to be reined in further.

On top of that there is no clarity on bad debt charges, which could rise sharply if the economy and the housing market continues to slow.

Further losses on portfolios of risky mortgage assets are also possible if the US housing market continues to decline.

Of course, there are other ways to value banks. Many analysts use price to book value or price to tangible book value, which excludes things like goodwill. But even on this measure the sector does not look cheap. Domestic UK banks trade on 1.3 times book value and 1.7 times tangible book value, according to Goldman Sachs.

“This compares to 1.0-1.2 in the early 1990s when goodwill was written off against reserves, so making it more comparable to price to tangible book vale today,” the broker says.

As with p/e ratios, it is worth questioning how useful book value is. After all, Northern Rock was nationalised at a fraction of its year-end book value.

Dividend yields are also misleading. On paper they look appealing, with the prospective yield for the domestic banking sector at about 8 per cent. But there is no guarantee expected payouts will not be reduced.

Graham Secker of Morgan Stanley says the banking sector is caught in a bear market rally, that has already run half its course.

He says investors should note the events of the early 1980s - the last time UK banks performed as badly as they have in the past year. After bottoming in November 1982, the sector outpaced the market by 18 per cent in the next four months, then underperformed for six years.

“We believe that the banks are going to struggle to generate any meaningful earnings growth over the next few years and, more likely, will suffer contraction” he says.

The credit crisis has done irreparable damage to the originate and distribute model which helped banks make record profits of late. Add to this the likelihood of a regulatory backlash and a slowing economy and it is difficult to be excited by the prospects for the domestic banks. Yes, the sector may have bottomed but sustained outperformance seems unlikely. If Mr Secker is right, any bear market rally is one worth selling into.

Voting is Rational After All

One of the hobbyhorses of the rational-choice economics types is that voting is irrational. The odds of your vote making a difference are ludicrously small, so why bother?

Readers may recall that the New York Times picked up on the argument by Lloyd Cohen of George Mason Univerisity that, contrary to widely held views, buying a lottery ticket is not irrational. The problem is that most analysts saw the payoff as the likelihood of winning, which is indeed ludicrously small. But Cohen argued that that view missed the main motivation completely. The real point is fantasizing about what one would do with the winnings, which you can't do meaningfully with no skin in the game. Thus, playing lotto is a consumer disposable, similar to buying a lifestyle magazine.

Andrew Gelman and Noah Kaplane compare define the outcomes differently than most rational choice economists, who focus on personal benefits Just as in lotteries, the likelihood of your vote swinging an election is pathetically small. But the payoff is vast. Just imagine the costs (and lives) that would have been saved if Gore had won and America's Iraq misadventure has never come to pass. Differences among policies by major candidates often total tens of billions, if not hundreds of billions, of expenditures. which even divided by large numbers of voters, still equates to a large potential payoff per act of voting.

From Vox EU:

Voting behaviour seemingly confounds rational choice theory. But this column shows that voting can be perfectly rational, if voters are concerned with social benefits and not merely personal gains. Rationality and selfishness are not the same.

About fifteen years ago, I attended a lecture by venerable pollster Mervyn Field, who told us that when he started in the business in the 1950s, there was a lot of concern about nonvoters. What was going on with these people who were too alienated to participate in society in this most basic way? But, recently, Field continued, the question has become, Who are these “voters”? What makes them tick? Who are these unsung heroes who make our democracy work by bothering to show up on election day?

Voter turnout is lower in the United States than in Europe. What would happen if all the Americans eligible to vote did so? According to opinion polls, nonvoters, when forced to declare a preference, are slightly more supportive of Democratic than Republican candidates, and Highton and Wolfinger (2001) estimate that, under 100% turnout, the Democrats would receive about 3 percentage points more of the national vote—not a lot, but enough to have swung the two most recent presidential contests. But election campaigns are not static. Jonathan Nagler and Jan Leighley (2007) show that nonvoters care about different issues than voters, and they conjecture that increased turnout would raise the profiles of these issues in the campaign. From the other direction, it has been argued that low turnout is a good thing, so that the election is decided by the most well-informed voters.

But what if voting is done not by the serious citizens, but rather the most foolish—or by the people who have nothing better to do on a Tuesday? This is what would seem to be implied by a straightforward decision-theoretic calculation. In the notation of Riker and Ordeshook (1968), the utility U gained from voting can be written as the sum of three terms,

U = p*B - C + D,

where p is the probability that your single vote is decisive, B is the benefit you gain from your preferred candidate winning the election, C is the cost incurred by going to the trouble to vote, and D is the direct benefit of voting irrespective of the outcome. C – D is the net cost of voting.

For a large election, the probability p can only be estimated as extremely small in any national election. A quick calculation: suppose there are 100 million voters choosing between two candidates, each of whom is expected to receive between 45% and 55% of the vote. The probability that your vote will swing the outcome of the election is then 1 in 10 million. (Analysis becomes more complicated when using real election forecasts for America’s two-stage presidential voting system, but the final number doesn’t change much.) Even for a benefit B that is fairly large, for example, $10,000, the product p*B is tiny. Given that the act of voting has a nonzero cost, voter turnout is thus usually attributed to some mix of irrationality, confusion, and the direct gratifications of voting (including the performance of a civic duty); that is, a negative net cost of the act of voting. However, these motivations do not explain observed variations in voter turnout between elections. In addition, voting is an act with large-scale consequences beyond any immediate satisfaction it gives to the voter. At the very least, many voters seem to consider their voting actions with more seriousness than other low-cost consumption decisions. This is why voter turnout has been called “the paradox that ate rational choice theory” (Fiorina, 1990, Green and Shapiro, 1994).

But here's the good news. If your vote is decisive, it will make a difference for tens of millions of people. If you think your preferred candidate could bring the equivalent of a $100 improvement in the quality of life to the average person in your country—not an implausible hope, given the size of national budgets and the impact of decisions in foreign policy, health, the environment, and other areas—you’re now buying a billion-dollar lottery ticket. With this payoff, a 1 in 10 million chance of being decisive isn't bad odds.

And many people do see it that way. Surveys show that voters choose based on who they think will do better for their country as a whole, rather than their personal betterment. Indeed, when it comes to voting, it is irrational to be selfish. The probability of your vote being decisive is roughly inversely proportional to the size of the electorate (see Gelman, King, and Boscardin, 1988, Gelman, Katz, and Bafumi, 2004, and Mulligan and Hunter, 2002, for details and empirical evidence), and your personal benefit remains flat, but the “social benefit”—the total gain for the country that you would anticipate, if your candidate wins—is proportional to the population, so that the product p*B approaches a constant, not zero, as the number of voters increases. (It is not necessary for this social benefit to be accurately perceived—see Caplan, 2007—for it to determine people’s votes.)
In “Voting as a rational choice: why and how people vote to improve the well-being of others,” co-authors and I show how this reasoning implies a feedback mechanism: if turnout declines, then the probability of a tied election increases, which in turn implies that, on the margin, it then becomes rational for some people to vote. The feedback with voter turnout is why voting is not a simple free-rider or prisoner’s dilemma problem: the more people who free ride (by not voting), the higher the expected benefit to you of voting, and so extremely low turnout is not an equilibrium.

In addition to predicting nontrivial turnout rates among rational voters, the model also explains the rationality of giving money to a candidate: Large contributions, or contributions to local elections, could conceivably be justified as providing access or the opportunity to directly influence policy. But small-dollar contributions to national elections, like voting, can be better motivated by the possibility of large social benefit than by any direct benefit to you. Such civically motivated behavior is consistent with both small and large anonymous contributions to charity. In two laboratory experiments on college students, Fowler (2006) and Fowler and Kam (2006) found that voters are more likely than nonvoters to behave altruistically (as is consistent with the social-benefit utility model) and display delayed-gratification behaviour (as is consistent with the fact that the costs of voting are immediate whereas the benefits are delayed).

The social motivation from voting also explains declining response rates in opinion polls. In the 1950s, when mass-opinion polling was rare, we would argue that it was more rational to respond to a survey than to vote in an election: as one of 1000 respondents in a national poll, there was a real chance that your response could noticeably affect the poll numbers (for example, changing a poll result from 49% to 50%). Nowadays, polls are so common that a telephone poll was done recently in the US to estimate how often individuals are surveyed (the answer was about once per year). It is unlikely that a response to a single survey will have much impact.

Thus far, we have primarily emphasised our theory as explaining the “mystery” that people vote. However, it also has implications for vote choices. Why you vote and how you vote are closely connected. If you are voting because of the possibility that you will decide the election and benefit others, then you will vote for the policy that you think will lead to the largest average benefit. There is no reason to vote for a policy that has idiosyncratic benefits to you because the individual-benefit term in your utility is essentially irrelevant for large electorates. This could be one reason why the rhetoric of politics tends to be phrased as benefits to society generally or to large deserving groups, rather than naked appeals to self-interest. No doubt many people are biased to think that what benefits them will benefit others, but we predict that most people will try to vote to benefit society at large or some large affinity group. Our contention therefore runs contrary to much of the political-economy work of the past few decades. Except in very small elections, a rational person who votes will choose the candidate or party with the best perceived social benefits to the population.

In surveys, voters say they are motivated by national conditions, and their turnout is consistent with this assumption, so perhaps we should believe them. Conversely, rational and purely selfish people should not vote. We have rescued rational choice theory from the voter turnout paradox, but at a price, by formally decoupling rationality from self-interest (except in the uninteresting tautological sense that anything you do must be in your self-interest because otherwise you wouldn’t be doing it).

As theorists have noted previously (for example, Margolis, 1981), rationality need not imply selfishness. At some level, this is obvious: consider, for example, a volunteer fire department deciding how best to spend its annual capital improvements budget. But in common discourse, even (or especially?) among economists, the two concepts go together, so much so that psychologists have found that people overly attribute self-interest as a motivation even for their own actions (Miller, 1999).
Voting and vote choice (including related actions such as the decision to gather information in order to make an informed vote) are an interesting example of decisions that are rational in large elections only to the extent that voters are not selfish. This in turn has implications for how people gather and weigh information in deciding their votes.

Links 4/5/08

Bank of England predicts credit squeeze will tighten its grip in next quarter Guardian

Foreign banks flee Spanish property debt Telegraph

Sex and Financial Risk Linked in Brain Huffington Post. So now we know why markets are irrational.

Should Anyone Care If Investment Banks Move to England? Dean Baker

"The next time we have Black Monday" Andrew Leonard, Salon

Housing Bust Duration Calculated Risk

The poor are financing the profligate Brad Setser

Antidote du jour:

Fitch Downgrades MBIA to AA

Readers may recall that MBIA tried the "just say no" strategy with rating agency Fitch, trying to shut out the number three firm, obviously due to its less than charitable view of the industry (Fitch downgraded Ambac to AA while Moody's and Standard & Poor's maintained the sham of a top grade). MBIA requested that Fitch cease publishing ratings and return information previously provided it.

We had observed that this move by MBIA was great PR for Fitch and the firm would be well served to continue to rate MBIA. While Fitch is at a disadvantage by no longer having access to management, the business can't have changed much in a mere month. And Congressional pressure for bond arbiters to rate municipalities on the same grading scale as coporates was a death warrant to bond guarantors, eliminating their historical free lunch low risk business.

Conventional wisdom when the bond insurer crisis was put in abeyance by the affirmation of MBIA's and Ambac's AAAs by both agencies for at least three, hopefully six months. This may move monoline worries back to the front burner.

From Reuters:

MBIA Inc's insurance arm on Friday lost its top rating from Fitch Ratings, which also cut the parent company's ratings due to capital adequacy concerns.

MBIA Insurance Corp, the insurance arm of the world's biggest bond insurer, saw its ratings fall to "AA," the third highest, from a top rating of "AAA." Fitch also cut the parent company by three notches to "A," the sixth highest, from "AA."

MBIA shares fell 4.5 percent to trade at $13.65 after the rating cuts.

"The market is already somewhat discounting the value of the franchise," said Evan Rourke, portfolio manager with M.D. Sass in New York.

Tom Spalding, portfolio manager at Nuveen Investments in Chicago, said prices of municipal bonds insured by MBIA are unlikely to cheapen after the Fitch downgrade but price improvement will slow.

"Retail will still buy MBIA insurance, but I don't think institutions are going to be quite as aggressive," Spalding said.

Prices of MBIA-insured munis have been edging higher since Standard & Poor's and Moody's Investors Service affirmed the guarantor's triple-A rating, Spalding said.

Some municipal issuers started using MBIA again because rival Financial Security Assurance, owned by Dexia, which boasts untainted top ratings from three agencies, has gotten too expensive, Spalding said....

"Fitch does not believe it will be possible for MBIA to significantly improve its credit profile until the company can more fully reestablish momentum in the financial guaranty market, especially in the core U.S. municipal finance sector," Fitch said in a statement.

Additional detail from Bloomberg:

Fitch Ratings cut MBIA Inc.'s insurance rating to AA from AAA, saying the bond insurer no longer has enough capital to warrant the top ranking....

``It will be difficult for MBIA to stabilize its credit trend until the company can more effectively limit the downside risk'' from collateralized debt obligations, Fitch said in the report....

MBIA's suspension of its structured finance business, which includes CDOs and asset-backed securities, may help to boost the company's rating back to AAA in the future, Fitch said today.

MBIA will have losses on CDOs backed by subprime mortgages of as much as $4.9 billion after taking into account that they will be paid over time, Fitch said.

The analysis assumes that subprime mortgages backing securities sold in 2006 will experience losses of 21 percent and those originated in 2007 will lose 26 percent, Fitch said.

Banks Backlogged by Foreclosures, Let Defaulting Borrowers Stay in Homes

We had read earlier of banks failing to foreclose in Dade and Broward counties because the marker was so glutted with properties for sale that there was simply no point. We heard yesterday of discussion in Cleveland of plowing largely vacant subdivisions back to farmland.

A third indicator of the degree of real estate stress: some banks are so backed up that their normal foreclosure process is falling behind. This means that the foreclosure statistics paint a more positive picture than the reality on the ground.

From Bloomberg:

Banks are so overwhelmed by the U.S. housing crisis they've started to look the other way when homeowners stop paying their mortgages.

The number of borrowers at least 90 days late on their home loans rose to 3.6 percent at the end of December, the highest in at least five years, according to the Mortgage Bankers Association in Washington. That figure, for the first time, is almost double the 2 percent who have been foreclosed on.

Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody's Economy.com, a unit of New York-based Moody's Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market.

``We don't have a sense of the magnitude of what's really going on because the whole process is being delayed,'' Zandi said in an interview. ``Looking at the data, we see the problems, but they are probably measurably greater than we think.''

Lenders took an average of 61 days to foreclose on a property last year, up from 37 days in the year earlier, according to RealtyTrac Inc., a foreclosure database in Irvine, California. Sales of foreclosed homes rose 4.4 percent last year at the same time the supply of such homes more than doubled, according to LoanPerformance First American CoreLogic Inc., a real estate data company based in San Francisco

``Some people stay in their houses until someone comes to kick them out,'' said Angel Gutierrez, owner of Dallas-based Metro Lending, which buys distressed mortgage debt. ``Sometimes no one comes to kick them out.''

Banks are reluctant to foreclose on homeowners for a variety of reasons that include the cost, said Peter Zalewski, real estate broker and owner of Condo Vultures Realty LLC, a property consulting firm in Bal Harbour, Florida.

Legal fees and maintaining a vacant property while paying the mortgage, insurance and taxes can add up to as much as 15 percent of the value of the home, and it may take months for the foreclosure to work through the legal system, he said....

``Some of the banks just don't want the houses to be empty, especially if it's in an area where there's a lot of theft or there are five other houses empty on the street,'' said Kapsalis, who works at Added Value Realty LLC in Livonia, Michigan, another Detroit suburb. ``They'll lose toilets, plumbing, appliances, everything. Banks are getting wise and allowing people to live there longer.''.....

Five million existing homes were sold in February, down 31 percent from the peak of 7.25 million in September 2005, data compiled by the Chicago-based National Association of Realtors show. More than 4 million existing homes were on the market in February, 53 percent more than the 2.6 million average of the past nine years, the Realtors reported.

``Excess inventories pose the biggest risk to the market,'' Michelle Meyer and Ethan Harris, New York-based economists at Lehman Brothers Holdings Inc., wrote in a report last month. ``As long as inventories are high, home prices will fall.''....

State laws determine the length of time between the filing and an auction of the house. In most states, it's two to six months, according to Foreclosures.com. In Maine, it can be up to a year and in New York, 19 months; in Georgia, it's as quickly as one month, and in Nevada, it can be 35 days, according to the database.

The Goldilocks Markets, Revisited

Gillian Tett of the Financial Times perhaps a bit wistfully, looks back on the days when market participants could tell themselves that everything could bubble along at a "just right" level. She now wonder whether despite the troubling prospects, we might somehow stumble through in a way that avoids the worst extremes (the equity markets seem to subscribe to this view).

Schylla and Charybdis seems a more fitting image. And we had termed the Goldilocks fantasy-past-its-sell-by-date as the Tinkerbell market, but to each his own.

Tett sounded early alarms that the debt boom could end badly, and she is similarly not optimistic about finding a clear path though the credit contraction. From the Financial Times:

In recent years, the concept of a “Goldilocks” recovery has permeated the policymaking world. For after decades of painful economic booms and busts, politicians and central bankers have become wedded to the idea of chasing a growth rate that is neither “too hot, nor too cold, but just right” .....

Instead, the hot new topic of debate in financial circles is the “l” word: namely leverage; or, perhaps more accurately, the “d” phrase – “deleveraging”, as the process of cutting debt is called.

In particular, what financiers are urgently trying to work out is whether there is a way to cut debt levels in the banking sector at a pace that is fast enough to reassure investors – but not so fast that sparks a wider market meltdown and credit crunch.

Can Wall Street, in other words, deliver a wave of “Goldilocks deleveraging” that is neither too hot, nor too cold – but somehow “just right” – or, at least not too wrong?

It seems a fiendishly difficult task. The credit crunch has demonstrated with painful clarity in recent months that the financial sector has become dangerously over-levered this decade, to a degree that almost nobody realised before – partly because the normal metrics to measure leverage are pretty useless.

Western policy makers are now eager to see this leverage reduced. And stock market investors agree: the banks that have suffered most badly in the equity markets in recent months are those – such as Lehman Brothers – which are highly levered, relative to peers.

But while deleveraging has got under way in the hedge fund world in recent weeks, one dirty secret of today’s financial sector is that most banks have not yet followed suit; on the contrary, many are still seeing their leverage levels rise because assets are rolling back on to their balance sheets on a large scale.

One obvious way to rectify this would be to raise more capital. Banks such as Lehman Brothers and UBS are now doing precisely that.

But many other banks are finding it hard to follow suit. After all, many private investors remain wary of putting money in banks.

Meanwhile, my recent conversations with US policymakers leave me convinced there is little chance of direct public fund injections either.

That consequently implies that banks will have to slash leverage the hard way: namely by cutting assets. But if the banks cut credit lines to “real economy” borrowers, this will hurt growth; and if they sell securities, this will further depress prices.

Indeed, it seems that one key reason for last month’s turmoil was that large investment banks were trying to cut leverage through the easiest route available – slashing their repo operations with credit funds.

Wall Street executives are now urgently trying to explore other options, such as copying the “ringfencing” idea unveiled by UBS this week, which would essentially spin bad assets into a separate vehicle.

Some also want to create an industry-wide fund to absorb troubled securities, which might be backed by a multilateral group such as the International Monetary Fund.

But I doubt whether these multilateral ideas will fly any time soon – or not unless another downward lurch occurs.

So the essential question remains this: can banks really cut their leverage levels effectively and calmly via furtive asset sales or ringfencing? Or are we heading for more stop-start turmoil?

Personally, I would love to believe in the Goldilocks scenario.

However, history is sadly not on the side of this fairytale. After all, very few episodes of deleveraging have occurred in the banking sector before in a manner that was “just right”.

Stand by, in other words, for plenty more market lurches – accompanied by plenty more growling from the credit bears, as investors are scalded and frozen, all at once.

Bear Hearings: A Charade

Because I was distracted today (houseguest, plus preparing for out of town trip), I haven't spent as much time as I would have like on the Congressional hearings into the Bear bailout.

Judging from the media reports, it seems that the assertive presentations by the perps, um participants in the deal were not met with aggressive questioning by the assembled Congressmen. But the lack of sparks flying does not necessarily mean that they were persuaded. Supreme Court watchers warn that the demeanor of the Justices is seldom a reliable guide to how the court will rule. That observation may apply here.

Nevertheless, there were some priceless moments in self-delusion and dissembling artful presentation. :

First is Bear CEO Alan Schwartz saying in retrospect that there was nothing he would or could have done differently; Bear had "adequate capital and liquidity." The facts prove conclusively otherwise. Reading between the lines of the later testimony, that JPM and the Fed hint at a solvency problem (and not merely because Bear was on the verge of filing for bankruptcy). Schwartz came out of the investment banking side. He is highly unlikely to have been able to judge the quality of Bear's riskier positions.

This is also a man who did not do well under pressure. Not only did his manifest discomfort during an investor presentation help seal the bond trading firm's fate, but he mis-heard the deal that he got on Thursday from the Fed via JPM. It was an overnight loan so they could get into the weekend, while he thought it was for 28 days.

MarketWatch summed it up:

Taking Schwartz at face value, there was no real reason for Bear to collapse other than gossip. Merrill and Citigroup's efforts to shore up confidence and their ability to meet obligations with capital infusions will not protect them. Bear, despite its failed hedge funds, quarterly losses and ousted chief executive, was in fantastic shape. "Adequate capital," remember?
Except that there wasn't. "There was a failure to understand the gravity of the problem," according to Christopher Dodd, D-Conn., the committee chairman.

Second is the SEC soft-shoe, a bookend to Schwartz's "everything was fine, really, it was those evil shorts." According to the SEC, Bear did have adequate capital, that is, regulatory capital. When I started out on Wall Street, in the day of stone tablets and abacuses, even junior dweebs understood that SEC capital requirements were not often the consideration that dictated how much the firm was geared. And as debt instruments have become more complex and derivatives have skyrocketed, the SEC has remained primarily concerned with equity markets. So I'd expect regulatory capital requirements to be a binding constraint even less often than in the past.

In the New York Times, Floyd Norris pillories the SEC for its insistence that a failed metric is adequate. The SEC's logic reminds me of LTCM chief John Meriwether's stance after his fund failed. He continued to maintain that his models were fine. The problem was reality.

From Norris:

Bear Stearns never ran short of capital. It just could not meet its obligations.... “At all times,” wrote Christopher Cox, the S.E.C. chairman, in the aftermath of the collapse, “the firm had a capital cushion well above what is required to meet supervisory standards.”....Does it sound a little like a doctor emerging from a funeral to proclaim that he did an excellent job of treating the late patient?

“That kind of statement is a condemnation of the kind of supervision that the S.E.C. did,” said one expert on financial regulation, Edward J. Kane, a finance professor at Boston College, in an interview this week. “If there is good capital, you should be able to convince your counterparties of it.”

The S.E.C. assumed that Bear, or any other investment bank, could always borrow against securities it owned. It assumed that lenders would put up at least 93 percent of the value of those securities, and as much as 97 percent for the safer ones.

In a working paper for the National Bureau of Economic Analysis, prepared for a conference to be held next week at Cambridge University, Mr. Kane assigned some of the blame for the current credit crisis to international regulatory competition, in which national regulators, fearful of seeing business go overseas, dared not be too tough.

Instead, regulators from around the world agreed on common capital standards, the latest version of which is known as Basel II. That standard has loopholes that allowed banks to add lots of leverage, some of it pushed off balance sheets in ways that obscured the risks that remained and minimized the apparent need for capital. ...

“A severely overleveraged banking system may be portrayed as an accident waiting to happen,” Mr. Kane wrote. “A regulation-induced crisis occurs when misfortune impacts a banking system whose managers have made their institutions vulnerable to this amount and type of bad luck.”

For now, market revulsion is limiting leverage in the system and driving banks to raise more capital if they can. Mr. Cox told a Senate hearing Thursday that the Basel committee should think more about liquidity. But there has been no admission from regulators that they erred in letting leverage get so far out of hand that a “well capitalized” company could not find anyone willing to lend it money without government help.

Third is "the assets the Fed took are fine." Steve Waldman, who took the trouble to read and parse an attachment to Timothy Geither's presentation that set forth the terms and conditions for the operation of the LLC that will hold these positions., focuses on the disclosure that some of these assets included related hedges, which are derivatives. More important, Waldman concludes that the Fed isn't on the hook for just $29 billion but could wind up stumping up more:

It's official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality. Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed's maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort.

Looking simply at the behavior of the main actors, Michael Shedlock concludes these instruments can't be all that hot. From Shedlock:

This is galling. Everyone is praising the quality of the assets offered to the Fed as collateral, but JPMorgan would not take them outright. Why not? And while the Fed is on the hook for fallout from those assets, what about the other assets JPMorgan picked up for next to nothing? What are those worth? Was JPMorgan acting like a "responsible corporate citizen" or a vulture financing corporation?

Fourth was Geithner's presentation. Geithner is generally very well regarded, yet I have come to the view that as head of the New York Fed, he was in a position to have seen what was going awry, yet remained blind alternative courses of action.

He gave a very long speech, parts of which seemed designed to run out the clock so as to reduce the time available for questions (does the panel really need a discussion of the history of the Fed?). Read this section, which came at the beginning:

This was a period of rapid financial innovation—particularly in credit risk transfer instruments such as credit derivatives and securitized and structured products. There was considerable growth in leverage, greater reliance on ratings on structured credit products and a marked deterioration in underwriting standards.

The innovation in financial products was accompanied by a dramatic increase in the amount of financial intermediation occurring outside the core banking system. The importance of securities broker-dealers, hedge funds, and mutual funds in the financial system rose steadily. Off-balance-sheet vehicles of various forms proliferated, and increased concentrations of longer-dated assets were held in funding vehicles with substantial liquidity risk.

In a speech he gave a bit more than a year ago, Geithner covered much the same ground (without the road kill details we now have) framed more positively, and pointed out that only 15% of the non-farm credit extension was via banks. We noted at the time:

Geithner has no objective foundation for his rosy view. He has essentially admitted the Fed and other regulators lack a complete, or even good, picture of what is happening. We've had money supply growth well in excess of GDP growth, and loose monetary conditions can obscure underlying weaknesses. His argument boils down to,"Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK." I don't find that terribly convincing.

And in that speech, he in effect said it was OK for regulators to supervise only in the most minimal way:
We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.

These issues are the principal focus of day-to-day supervision and market oversight in the major financial centers around the world. The Federal Reserve is actively involved in a range of efforts, working closely with the primary supervisors of the major global financial institutions and the critical parts of the financial infrastructure, to encourage further progress. In this context, we are working to put in place a stronger regulatory capital regime and to strengthen the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated and more conservative management of credit exposures in over-the-counter derivatives and structured financial products, as well as of exposures to hedge funds. And we are encouraging a range of efforts to modernize the operational infrastructure that underpins the over-the-counter derivatives markets, and to improve the capacity of market participants to manage a major default.

How can you "encourage" behavior changes among parties you don't regulate? Where you don't have enough of a view of what they are doing to even suggest where they might need to trim their sails?

Yet today, the Fed's and Treasury's message to Congress was: we withstood this test, the system works, butt out.

They should consider the warning of General Phyrrus: "One more such victory, and we are lost."

The Ethics of Harvard MBAs

Bloomberg had a odd article on the varying fortunes of Harvard MBAs (and some alumni of other Harvard graduate programs). It duly notes that they range from unquestioned successes like Lou Gerstner to more controversial figures, such as Jeff Skilling, Paul Bilzerian, Henry Paulson,, Stan O'Neal, and of course, George W. Bush

Generalizing about HBS graduates is tricky. It is the largest graduate school program in the world, turning out roughly 900 MBAs a year, which almost guarantees some heterogeneity in the population, Thus it might be more useful as an indicator of business behavior generally, in part because force of numbers gives Harvard MBAs some sway, in part because the program more so than others sets out to create CEOs, and finally because only a few MBA programs, such as Yale School of Management's, are highly distinctive (Yale has a strong emphasis on not-for-profit management.

After the accounting scandals of 2002, where Skilling and other Harvard MBAs played high-profile roles, the school studied what it could do to improve the conduct of its graduates. It concluded that students' ethical compasses were set before they got there, which one could view either as accurate or a way of punting. Thus, the school gave some motherhood statements about changing its admissions policies.

So what has happened? Consider this section of the Bloomberg article:

Harvard Business School's two-year program instills confidence ``to go out and aim high and to think you can work on the world's stage,'' said Scott Snook, an associate professor at the school. Yet, not all students mature psychologically while at Harvard, he said.

Snook studied 50 students from before they enrolled until they graduated in 2006. Using psychological tests and interviews, he found that one-third were still, in respects, stuck in adolescence, and had trouble empathizing.

Snook found another third inclined to define right or wrong in terms of what everybody else is doing. That might explain why even well-educated executives have fallen prey to the subprime- mortgage debacle, he said. Snook said the study will be published this year.

``They can't really step back and take a critical view,'' he said. ``They're totally defined by others and by the outcomes of what they're doing.''

The subprime-lending spree shows that Harvard and other elite schools fail to mold managers who look beyond self- interest, said Rakesh Khurana, an associate professor at Harvard Business School.

``Business schools as an institution have not effectively addressed this issue of creating a profession that has the capacity for self-regulation,'' said Khurana, author of ``From Higher Aims to Hired Hands'' (Princeton University Press, 2007).

Hhm. It looks that post 2002 study was wrong, or that Harvard did a lousy job of changing its admissions policies.

A final tidbit:

Bush, the first U.S. president with an MBA, has written that Harvard gave him ``the tools and the vocabulary'' of the business world. Now, in his final year in office, Bush faces a slumping economy and an unpopular war. His approval rating is 32 percent, according to USA Today/Gallup Poll research in March.

``Usually, if you've got a sitting president who graduated from your school, you'd talk about it all the time,'' Snook said. With Bush, he said, ``It's almost studiously ignored.''

81% of Americans Say Country Headed the Wrong Way

A New York Times/CBS poll found Americans the most dissatisfied they have been about their country's direction since 1992. And two things are particularly noteworthy about the survey. First is the unhappiness was as universal as you ever see in a large-scale study, cutting across party, gender, age, and geographic lines. The second is that public sentiment is lagging indicator, worsening as the economy deteriorates and not improving until there are clear signs of recovery. For the collective mood to be this negative when the US is at the beginning of a downturn points to at least a couple of culprits. One is that the public believes that this is no ordinary recession in the making. Second is that the unhappiness is about more than the economy, but also about the US's fallen standing in the world and the patent, unabashed dishonest of many government and business leaders.

It's also noteworthy that the respondents saw inadequate regulation as the main cause of America's economic woes. Yet the powers that be have devoted a great deal more effort to throwing money at the problem than at addressing the root problems.

From the New York Times:

In the poll, 81 percent of respondents said they believed “things have pretty seriously gotten off on the wrong track,” up from 69 percent a year ago and 35 percent in early 2002.....

The poll found that Americans blame government officials for the crisis more than banks or home buyers and other borrowers. Forty percent of respondents said regulators were mostly to blame, while 28 percent named lenders and 14 percent named borrowers.

In assessing possible responses to the mortgage crisis, Americans displayed a populist streak, favoring help for individuals but not for financial institutions. A clear majority said they did not want the government to lend a hand to banks, even if the measures would help limit the depth of a recession.

“What I learned from economics is that the market is not always going to be a happy place,” Sandi Heller, who works at the University of Colorado and is also studying for a master’s degree in business there, said in a follow-up interview. If the government steps in to help out, said Ms. Heller, 43, it could encourage banks to take more foolish risks.

“There are a million and one better ways for the government to spend that money,” she said.....

More than 70 percent said their financial situation was fairly good or very good, a number that has dropped only modestly since 2006.

Yet many say they are merely managing to stay in place, rather than get ahead. This view is consistent with the income statistics of the past five years, which suggest that median household income has still not returned to the inflation-adjusted peak it hit in 1999. Since the Census Bureau began keeping records in the 1960s, there has never been an extended economic expansion that ended without setting a new record for household income.....

Charles Parrish, a 56-year-old retired fireman in Evans, Ga., who now works a maintenance job for the local school system, said he was worried the country was not preparing children for the high-technology economy of the future. Instead, the government passed a stimulus package that simply sends checks to taxpayers and worsens the deficit in the process.

“Who’s going to pay back the money?” Mr. Parrish, an independent, said. “We are. They are giving me money, except I’m going to have to pay interest on it.”

Links 4/4/08

HRC's Odd Economics Robert Reich

One Ring, to rule them all rdan, Angry Bear

Peace is for losers part, 2 John Quiggin

Traders Who Sell Short Stocks Are Well-Informed PhysOrg. They'd better be, You can take a beating even if you've done your homework.

Neuromarketing could make mind reading the ad-man's ultimate tool Guardian

Senate Rejects a Proposal to Allow Bankruptcy Judges to Alter Home Mortgages New York Times. This was an opportunity lost.

Antidote du jour. From reader Mike:

Some Japanese Banks Reluctant to Lend to Foreign Banks

As the Financial Times points out today, we are witnessing a replay of the pattern seen during Japan's credit bust, except in reverse. Western banks were leery of extending credit to the Japanese and charged a premium over normal interbank rates. Now that the Japanese credit markets are more liquid than many others, foreign bank borrowers now find that some Japanese banks require a higher rate.

From the Financial Times:

Western banks have seen the credit crunch increasingly choke off their usual funding lines in capital markets and among themselves and so have been forced to scour global markets for alternative sources of money.

Some have been turning to the yen money market, attracted by the relative stability of the markets so far.

However, some regional Japanese banks appear increasingly reluctant to lend to foreign institutions through the yen money markets as the fallout from the subprime crisis brings anxiety about creditworthiness to yet another shore.

A significant portion of the demand in the yen market for three-month term money is from foreign institutions raising money that is converted into currencies such as dollars, sterling or euros, says Masayuki Ebira, director of money markets at Barclays Capital in Tokyo.

This is pushing up the rates at which all banks lend to each other in the money markets as measured by the Yen Libor rate, or the local Tibor rate.

"There is a lack of credit access from Japanese banks to non-Japanese banks," Mr Ebira says.

If the Japanese banks were to increase their limits, it would be easy for the others to borrow but "they are so conscious about credit conditions at banks that about half the regional banks never lend money to non-Japanese".

A post on the Wall Street Journal Economics Blog, "U.S. Situation Could Be Worse Than ’90s Japan?" suggests these concerns may be valid:

“People say the U.S. isn’t like Japan 10 years ago,” Societe Generale strategist Albert Edwards wrote in a note to clients today. “I agree. Actually it’s WORSE!”

Mr. Edwards has been making Japan comparisons ever since the dot-com bubble burst. Many people disagreed with such assessments, pointing out that U.S. banks and real estate were in far better shape. That’s not the case anymore, says Mr. Edwards, who also notes that Japan didn’t experience a real credit crunch until years after the bubble burst in 1990. And while there’s a view that Japanese banks were glacial when it came to writing off bad loans, part of the problem was that bad loans kept on turning up as the situation worsened. Sound familiar?

What could make the U.S. situation worse, he says, is that Japan’s citizens had deep reserves of saving to tap into, whereas the U.S. personal savings rate is near zero. And Japanese companies were unwilling to fire people, which, while it may have made for a sclerotic economy, helped prop up spending.

Meantime, CLSA Asia-Pacific Markets strategist Christopher Woods, who writes as “GREED & Fear,” thinks that the U.S. will need to swallow the same sort of bitter pill that Japan eventually did. The Fed’s actions, in his view, amount to nothing more than a Japan-style staving off of the inevitable.

“[T]he stock market has now embarked on a rally driven by the view that the Fed will now ‘do anything’ to prevent a systemic problem,” he wrote in a note today. “If the moral hazard trade remains as seductive as ever, GREED & fear remains firmly of the view that the Fed’s unprecedented action has only delayed market clearing Japanese style and certainly does not mark a definitive bottom. Investors should, therefore, use any classic bear market rally led by the financials to sell any Western financial stocks they still own.”

Soros Lambasts Paulson, Call for Intervention

George Soros, in today's Financial Times, joins a long list of critics of the Paulson financial services reform plan, although even to dignify its bureaucratic legerdemain with the label "reform" is singularly misleading.

Soros departs from his peers in sketching out where he thinks regulators went wrong and offers two specific proposals, I am particularly keen about his idea of moving credit default swaps to an exhange; as I've discussed before, that is one of the cleanest and most sensible options available, and it would be viable in a large, active market like CDS.

From the Financial Times:

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

Orwell Watch: Wal-Mart CEO Wants Business to Influence Health Policy

How dare the CEO of Wal-Mart, the company that makes such a studied practice of paying workers so badly that taxpayers subsidize its prices, say he and big business should influence health care policy? The US has the most costly healthcare in the world while failing to produce materially better results than countries with varying degrees of so-called socialized medicine. Large corporations are the most powerful buyers in the health care system, yet their efforts to improve delivery and lower costs have been singularly unproductive. So why should a crowd that has consistently failed have any say in reform?

And Wal-Mart promoting this line is particularly heinous. The Bentonville giant is known for keeping workers just below the number of hours to qualify them as full-time, precisely to avoid giving benefits such as health care. Thus if workers are single or married to spouses who similarly lack coverage, the likelihood is high that they will upon occasion turn to emergency rooms for health care, which is an extraordinarily high cost delivery system that comes out of the collective purse.

And listen to this from CEO Lee Scott, quoted in the Financial Times:

I think government is going to be engaged after this election regardless of who wins, and I think business should be more involved in the discussion. I think it has long-term ramifications for our global competitiveness.

Hhhm. Most (read all) of our advanced economy trade partners have more generous public payment for health care. They also have lower current account deficits than we do. While correlation is not causation, tell me why I should believe the reverse is true, that a single payer system would be bad for competitiveness? There seems to be a dearth of evidence to support this view.