The Economist's Cheery View of Credit Default Swaps

It's remarkable how attending an industry love-fest can distort one's perception. The Economist seems to have fallen hook, line, and sinker for International Swaps and Derivatives Association view that counterparty risk in the credit default swaps market isn't all that big an issue.

Its article, "Clearing the fog." while mentioning the little problem that led to Bear's gunshot wedding, manages to quickly brush by it. It does provide useful detail on the plans to establish a clearinghouse, but fails to mention that this initiative is to forestall regulation.

Nevertheless, several aspects of the story struck me as odd, and I'm curious to get a sanity check from informed readers:

1. It says that the amount of CDS outstanding at the time of the Delphi bankruptcy was 30X the face value of cash bonds. The number I've seen repeatedly is 12X. Has anyone seen/heard this 30X from a credible source?

2. The clearinghouse would provide netting of "offsetting" contracts. While that is a standard clearinghouse function, will that be easier said than done given the offsets are often pretty approximate? Put it more simply, are the valuation issues related to a netting operation generally trivial or not?

3. The article mentions rather casually that 13% of the CDS trades were unconfirmed as of last December. That strikes me as a horrific number.

4. The piece (at least as I read it) fails to give readers a sense of how manual the settlement of CDS trades often is.

And then we have the big question that is only indirectly triggered by the article:

5. Why are CDS outstanding growing so quickly? The Financial Times reported they grew from $34.8 trillion to $62 trillion outstanding in a single year.

Structured credit and CDO issues, which can use CDS for credit enhancement, slowed down considerably in the second half of 2007 and is close to moribund this year. There hasn't been much in the way of corporate bond issues. One motivation for more CDS activity would be the expectation that more corporations, particularly the ones that already have junk ratings, might default or at least become distressed. That would lead to much more CDS issuance on existing reference entities.

But the increase is still attention-grabbing. Is the main reason simply that firms are adjusting their risk exposures in light of the new nervous environment, and it's easier to do that via entering into new CDS contracts than by trying to trade your way out of your position(s)? If so, the amount CDS written will inevitably mushroom, even though the underlying credits expand no where near as rapidly. Although I can't prove it, a market like that seems destined to fall over.

From the Economist:

Bankers gathering in Vienna this week for the annual bash of the International Swaps and Derivatives Association (ISDA) had some big numbers to celebrate. The overall market for over-the-counter derivatives shot up to $455 trillion at the end of 2007. Some $62 trillion of that were credit-default swaps (CDSs), whose supercharged growth continues in spite of the crunch. But the emphasis this year was as much on playing down dangers as playing up volumes. ISDA was quick to point out that actual credit exposure was a mere 2% of the notional value of all contracts.

This coyness is hardly surprising. Regulators have been fretting since 2005 that the market's infrastructure was not keeping up with its growth. Then, in March, came the sudden implosion of Bear Stearns, a top-ten actor in CDSs, rescued partly because of the fear of chaos if such a large counterparty were to fold. The market's overseers may not agree with Christopher Whalen of Institutional Risk Analytics, a consultancy, when he describes off-exchange derivatives as an “act of Satan”. But they want to see more robustness, especially in credit derivatives, and have hinted that they will impose their own solution if the market does not.

Conceived in the 1990s as a hedging tool, CDSs soon took off as a way to speculate on the likelihood of a firm going bust without having to trade its underlying bonds. For much of this decade, they have been celebrated as a means of spreading risk around the financial system. However, their rampant success led to processing backlogs and errors. Under pressure from the Federal Reserve Bank of New York and others, the industry accelerated trade automation and clarified the rules of engagement (for instance, making sure banks were notified when the firm on the other side of the trade sold its interest to another party).


But problems remain. A rise in late confirmations accompanied the spike in trading last summer, suggesting that the plumbing still lacks scalability (see chart). As of December, 13% of outstanding CDS trades were unconfirmed. Technology vendors say solutions exist, but banks and supervisors have been slow to adopt a standard. “It's like the world is starving and we're just standing here with the rice,” says the chief executive of one derivatives-software firm.

Regulators also want to see cash settlement, rather than physical delivery of bonds, built into standard documentation. Physical delivery could distort prices as defaults rise, because the value of derivative positions far exceeds the face value of the corporate debt they reference—by 30 times in the case of Delphi, a car-parts maker that filed for bankruptcy in 2005

Major dealers, responding to regulatory threats in March with a letter to the Fed, gave themselves an ambitious set of targets to be reached this year. They include reducing the backlog of contracts still unconfirmed after 30 days and increasingly “warehousing” data about trades with the Depository Trust Clearing Corporation (DTCC), for added safety.

Another goal is to move towards reducing counterparty credit risk by clearing deals though a central counterparty—the sort of job DTCC does in American cash markets. A group of large dealers plans to start offering such a service later this year through the Chicago-based Clearing Corporation. Kevin McClear, the firm's chief operating officer, points to several benefits: a credible counterparty, regulated by the Commodity Futures Trading Commission, at the heart of every trade; more scope to reduce the overall amount at risk by “netting” offsetting contracts; and greater capital efficiency, since if the exchange were the counterparty, the banks' exposure could have a zero risk weighting.

Exchanges, for whom this sort of thing is bread and butter, spy an opportunity too. NYSE Euronext and CME Group, which runs the biggest futures exchange, are among those working on plans to offer over-the-counter clearing for credit derivatives. The CME has already made modest headway in interest-rate swaps.

Ultimately, the bourses hope to turn credit derivatives into exchange-traded products. The potential benefits—including transparency and much lower transaction costs—are clear. But there are formidable obstacles: the big dealers will fight it, because it will rob them of the outsized fees they get from bespoke deals—over 90% of their total derivatives-trading revenue, by one estimate. Also, fixed-income derivatives tend to be more arcane than shares, are traded in larger sizes, and there are many more varieties of them. Thus, in many cases, they might be resistant to the sort of standardisation that is necessary for exchange trading. Past attempts to trade credit derivatives on bourses have flopped.

Still, that is the direction in which the market is inching, with a (for now) gentle helping hand from regulators. Mr Whalen thinks moneymen will get better at replicating complex CDSs using exchange-traded credit products combined with options. “It's no slam dunk,” says the CME's Kim Taylor. “But it looks like a great long-term opportunity.”

Links 4/19/08

Man hypnotises himself before operation BBC. As in "Look Ma, no anaesthetic!"

Financial crisis forces Britons into austerity Telegraph

Cat Desktop Bed Is a Good Idea, But Cats Will Never Go For It Gizmodo (hat tip Kevin Drum). This is really unnecessary. Contrary to public opinion, cats can be trained to stay off keyboards (although weaning them off "distract the human" strategies is another matter).

Eagle owl terrorising village's pets and children Telegraph

How cheap are US banks? Macro Man. Not bad at all for a quick and dirty analysis.

Surplus countries depreciating when they should be appreciating Brad Setser

Ultra-Bears: I take it back! Accrued Interest. AI asks his bears what they'd need to see to go long. The comments are quite good.

The foreclosure 'discount' Calculated Risk. You must go and see what $640,000 bought at the peak of the market. Yikes.

Krugman's conundrum Economist (hat tip Mark Thoma)

CDS may undermine debt governance -law professor Reuters (hat tip Michael Panzner)

Antidote du jour:

John Authers Poses Four Financial Passover Questions

John Authers of the Financial Times uses Passover as a pretext for discussing four perplexing questions related to the markets. They've been bugging me too, so I appreciate him having a go at them.

From the Financial Times:

Passover starts tonight. The world's Jews gather to commemorate the Hebrews' flight from Egypt and eat a stylised dinner known as the Seder .

Central to the undertaking are four questions, which must be asked by the youngest participant, on the meaning behind different Passover traditions.

In the Passover spirit, here are four questions that demand to be asked about the confusing state of the markets, and some attempts to answer them. The answers to the Passover questions are straightforward; the problems with the markets, less so.

* Why has the S&P 500 barely fallen 10 per cent from its all-time high, when other markets are behaving as though the world were in deep crisis ?

Stocks' resilience is often cited by bulls. There was a (questionable) perception as the crisis started that stocks were cheap. If brokers' estimates for this year's earnings are accurate, they are much cheaper now, as earnings are supposed to grow at double digits starting in the next quarter.

Then there is a widespread belief that the fire sale of Bear Stearns last month was a moment of catharsis. Folk wisdom is that such moments are the ideal moment to buy.

The argument is self-contradictory: so many people believe this that it is obvious the market has not reached catharsis.

Also, stocks are not as resilient as they look. International indices tend to be quoted in dollars and are inflated by the dollar's weakness. In local currency terms, world industrial stocks are down 17 per cent from their top, and consumer discretionary stocks are down 26 per cent, according to MSCI.

Mining and energy stocks, buoyed by commodity prices - which have their own issues - help mask this.

* Why are money markets sinking into severe trouble again, when central banks have done so much to force them them to return to normal?

When they are working, nobody notices the money markets, which banks use to lend to each other. One of the painful lessons of the past months is that any sign of their malfunctioning must be taken very seriously.

The clearest indicator of trouble is when the Libor rate - the benchmark at which banks lend to each other - rises significantly above the official government interest rate. This indicates banks are hoarding cash or are unprepared to lend to each other.

Co-ordinated action by central banks in December was meant to address this, and the spread of Libor over official rates came down.

But since the Bear Stearns debacle, which should have been an emphatic signal that the Federal Reserve was there to stand behind dodgy-looking collateral from other banks, money markets have seized up again.

Libor's spread over official rates has widened by about 0.25 percentage points.

It is hard to explain this unless the bankers are afraid of something that has not yet reached the light of day. It strikes a bizarre contrast with the returning confidence in other sectors.

* Why are commodity prices rising when, with people so worried about the economy, we should expect them to be falling?

This is also critical, on many levels. In the aftermath of the Bear Stearns debacle, commodity prices tumbled, with the main indices for the sector falling more than 10 per cent in less than a week. But that turned out not to be a turn but merely an interruption.

Oil has regained its losses to set all-time highs. Other commodities have regained about half of their lost ground. The S&P GSCI commodity index is back at an all-time high, and up more than 11 per cent since its post-Bear low.

No explanation is encouraging. The sector may be in a bubble as investors look for an inflation hedge. Or they are reacting to scary signs that global supply of commodities from oil to rice is knocking up against capacity constraints. That would depress economic activity.

* Why do so many believe that the US economy will make a swift recovery, when the credit problems are only just starting to affect the real world?

In the US, no indicators yet show anything more than a light recession. If employment falls more, that will change. But the bulls' argument is that the US is getting such a jolt - from tax rebates, base rate cuts and the weak dollar - that it can scarcely help recovering.

Further, the precipitous decline in housing activity, with starts down almost 60 per cent in two years, cannot go on much longer. It has taken a huge bite out of economic growth. If it merely stabilises at a low level, that will be enough for growth to start improving.

The arguments against are clear: the credit squeeze has yet to hit Main Street, while the wealth effects from lower house prices and higher food and fuel prices could kill off the consumer.

Traders hope the economy can make a V-shaped recovery. If there is clear evidence of this, shares will go far higher. If it is only a U, or even the dreaded L, watch out.

Mortgage Rates on the Rise

With all the cheery talk about how our credit crisis is a thing of the past, mortgage rates, as reader Scott reminds us, are moving up again. From his message:

You’ll recall that some time over the last month or so, bullish commentators noted that with mortgage rates falling, resets of ARMs were no longer a problem. (Note in this regard that in addition to resets, so-called recasts—option arms that have reached the limit of their negative amortization, the point at which the principal has climbed to its maximum allowable amount, and the mortgage morphs into a fixed rate at a much higher payment schedule [This is what Wamu, First Fed, Downey, and Golden West/Wachovia wrote tons of] are an additional huge problem irrespective of where mortgage rates are.) In any event, mortgage rates have skyrocketed yet again.

More commentary from the Financial Times:

US mortgage rates soared this week after a dramatic sell-off in the Treasury market that hit housing sector recovery hopes even as it suggested investors were growing more confident in the medium-term US economic outlook.

The yield on the 10-year Treasury rose as high as 3.85 per cent on Friday from less than 3.50 per cent last week as investors sold bonds on expectations that the Federal Reserve could soon end its rate-cutting cycle...

Rates on 30-year fixed-rate mortgages rose to 5.87 per cent from 5.63 per cent a week ago, Bankrate.com said. Jumbo mortgages, those of more than $417,000, rose to 7.19 per cent from 7.06 per cent.

“The back-up in yields is a concern as it will damage the economic outlook,” said Jane Caron, strategist at Dwight Asset Management.

The three-month London interbank offered rate – Libor – increased to 2.91 per cent from 2.71 per cent this week, indicating underlying stress in the financial system.

Stocks rallied, said Anthony Conroy, head of equity trading at BNYConvergEx, because “the equity market is focused on a second-half recovery...and is not

Buiter on the Failure of Financial Capitalism

We have the rare spectacle of Willem Buiter admitting he doesn't have an answer, but in fairness, he is looking at a throny problem.

Buiter considers the question of what to do about the financial sector once the crisis has passed. He provides a scathing assessment of the workings of financial capitalism, but is pessimistic that regulation can be effective. Highly paid traders will outsmart supervisors; regulators, out of prolonged contact with their charges, will be corrupted intellectually, identifying overmuch with the industy's world view; the minders will be inclined to one of two extremes, either to restrict bank activity unduly, or to go too far overboard in their salvage operations should anything bad happen.

There is a flaw in Buiter's reasoning, however: he assumes the status quo ante will return in the absence of government intervention. Enough pieces of critical infrastructure are hopelessly impaired that I doubt that will happen.

The biggest, and one that poses a major conundrum, is that private securitization has ground to a halt. It depended on credit enhancement, which is now suspect, and has also become scarce and costly. The monolines are no longer in that business; with bank balance sheets impaired, there are far fewer credit default swaps protection writers. Plus, given concerns about counterparty problems leading to more generalized failures in the CDS market, it's not clear how receptive investors would be to CDS as the means for providing credit enhancement.

Plus with so many investors burned directly or indirectly by supposed AAA paper that fell rapidly from grace, it may take a generation before memories fade and willingness to buy the product returns.

So in the US, we see Fannie and Freddie stepping into the credit enhancement breach, even though that will soon create problems of its own.

That is a long-winded way of saying that the industry is already losing important businesses that led to high profits, swagger, and outsized pay. Give it two more bonus cycles, with the attendant job cuts, and you'll see a humbler, easier to contain players.

The critical step seems to be to recognize that banks (both the investment bank type as well as traditional commercial banks) are wards of the state and to treat them accordingly. That in turn means not being hesitant to restrict the scope of their business. If you want to take risks, fine, go be a private partnership and don't expect any help if you screw up.

My short list (some of them cribbed or adapted from a proposal by Amar Bhide) of what to do would be:

1. Force as much OTC activity as has reasonable trading volume onto exchanges. That means at a minimum interest rate swaps, currency swaps, and credit default swaps. Yes, this will require standardization and some buyers will lose access to variants they might have liked. Too bad. Protecting the economy and the taxpayer is more important than indulging every investor's pet need.

This of course will also considerably lower the profitabilty of the industry. Again, too bad. They screwed up and cost the populace a ton of dough. There are consequences for mistakes of that magnitude. They should consider themselves lucky not to have been subject to public beheadings.

Lower profits for banks has positive consequences. It means less talent and other resources are sucked into the FIRE economy (and remember, the FI in that equation are at best service providers to the real economy, and worse, when they become too large, parasites).

2. Prohibit off balance sheet vehicles.

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets.

Hedge funds would continue to be unregulated. I might also prohibit any unregulated entity from going public. Speculators playing with investors' money is tempting enough; having them have even less skin in the game via a public floatation makes it easier for them to get so large as to pose a danger. Yes, this can create problems of succession, but Wall Street dealt with it for a hundred years or so. These guys ought to be smart enough to figure it out.

I'd also have pretty draconian penalties for breaking the rules, the sort that can have individuals involved and their supervisors forfeit a lot of dough and go to jail.

Thus I'm not as pessimistic about the ability to leash and collar the industry, perhaps because I lived in it briefly when it was more heavily regulated and it functioned much better for society as a whole than it does now. And the bankers still made a very nice living, although nowhere near as egregious as the pay scales of late. The real constraint is political will, and I don't think things have gotten bad enough yet for the public to demand an end to rule by finance. But that attitude will change if real estate prices fall another 10%.

From Buiter:

The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.

I believe that the Western model of financial capitalism - a convex combination of relationships-based financial capitalism and transactions-based financial capitalism - has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere.

The key policy issues created by the recent excesses of the financial sector, once the immediate financial crisis has been euthanised, are those of governance and regulation. Governance issues include prominently the question of remuneration for top managers and superstars. I will not address this issue here. Regulation (and public ownership) inevitably become issues in all industries where widespread, systemically significant externalities, free rider problems and public goods features ensure that decentralised, competitive outcomes are inefficient. They are especially acute in the area of financial intermediation, because leverage permits the scaling up of financial activity to astronomical levels in no time at all. The damage that can be done by a rogue individual, a rogue firm or a rogue instrument is unparalleled among legal business activities.

Financial intermediation is playing with fire; there is no escape from this. Any economic activity undertaken for profit or power which has trust and information as its two key inputs is bound to be vulnerable to abuses, distortions, excesses and deception.

Effective financial intermediation is also a key and necessary feature of any economic system capable of delivering sustained increases in material well-being. If every economic agent were required to be financially self-sufficient, we’d all still be living in trees.

Getting ex-ante financial surpluses from economic agents whose planned saving exceeds their planned capital formation matched efficiently with the ex-ante financial deficits of economic agents whose planned capital formation exceeds their planned saving can, given time, increase the productive efficiency of an economy by orders of magnitude.

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

The financial system that during the first decade of this century ruled the roost in the US, the UK, increasingly in continental Europe and in its outposts in Australia, New Zealand, Iceland etc., combined many of the weaknesses of the transactions-based system (opportunism, myopia, lack of commitment), with the worst features of the transactions-based system - a dreadful clubbiness and homogeneity of outlook and perspective, and a ruthless closing of ranks when the sector as a whole was threatened with legislation or regulation. Let me just remind you of some of of the issues that prompted vigorous lobbying: the taxation of non-doms; taper relief under the UK capital gains tax for private equity magnates; tax havens; proposals for reporting obligations, transparency and audited accounts for highly leveraged financial entities above a certain size, regardless of their legal nature and regardless of what they call them selves; anti-cyclical capital adequacy requirements and liquidity requirements for highly leveraged entities.

It’s time to learn from these lessons and to act on what has been learnt. Acting now would not mean rushing into hasty if-it-moves-stop-it forms of regulation. We have had 20 years to think about this. It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs. General equilibrium and adding-up constraints are not the markets’ forte.

So is tighter regulation of the financial sector, and especially of highly leveraged entities above a certain size the answer? It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations. Here, however, I hit a blind wall.

Quis custodiet ipsos custodienses?
Who polices the police or, more to the point, who regulates the regulators? No doubt they are formally accountable to some departmental minister or even to Parliament/Congress. But does that fill me with confidence their their actions will promote efficiency and fairness? No, it does not. If regulation is to be effective, it may have to be hands-on and quite intrusive, if only for the regulator to acquire the information (s)he requires to make an informed judgement.

Effective supervision runs into some rather impenetrable obstacles.
First, a $5 million dollar a year trader will run rings around a $150,000 a year regulator.

Second, regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates. We cannot just appoint ethical Vestal Virgins to be regulators, regulators who start out pure and stay pure despite their daily associations with people who don’t instinctively play by the rules of the House of the Vestals

Third, even if (1) and (2) don’t apply, regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

I don’t know the solution to this conundrum. To minimise the risk of the first two problems emasculating regulation, any regulation will have to be as much arms-length and impersonal as possible, rather than invasive, intrusive and hands-on. A further key requirement is that institutions that are deemed too big and too systemically important to fail should be de-coupled from their owners and their top management if a publicly organised and/or funded rescue effort is mounted.

So any institution-specific support operation should require that the entire board and top management resign and leave without even a bronze handshake, the minute an agreement is reached. A special resolution regime (along the lines the FDIC runs for insured deposit-taking banks) with Prompt Corrective Action and a special form of regulatory insolvency that can be invoked by the regulator before the financial entity at risk is balance sheet insolvent or cash-flow insolvent. The shareholders should get nothing up front, but would have to take their place at the end of the line of claimants to whatever value can be realised under the special resolution regime.

The regulator as deus ex machina, doing his philosopher king bit in the disinterested pursuit of the public good is a dangerous fiction. Attributing competence and disinterested benevolence to regulators is as sensible as relying on self-regulation by the financial sector. So there will have to be a messy compromise. Clearly, things got badly out of hand in the private financial sector this past couple of decades, and the sector’s capacity to take on excessive risk will have to be restricted severely if we are to avoid another credit orgy of the kind we saw during the years 2003-2006. But am I confident that regulators will do more that bolt the door after the horse has bolted – never to return? I am not. But I am ready to be pleasantly surprised.

A Possible Approach to the Mortgage Mess

On a post yesterday on how well (or more accurately, how badly) various state efforts to rescue homeowners were faring, reader Richard Kline offered a suggestion.

Note that while I still favor the apparently destined-never-to-see-the-light-of-day idea of permitting bankruptcy judges to write down mortgages to the current market value of the collateral (the rest becomes unsecured), Kline's idea is elegant. One change I'd recommend is to have his markdown from the index vary by either state of MSA.

Hoisted from Kine's comments:

I don't mean to frown any excessive frowns on the issue, but there is simply NO solution to the bad mortgage problems that exist as they are presently constituted. The problems are too diverse; there are too many lenders, and worse diffused standing with respect to the actual mortgates; the volume of property is, well, vast. That's just on the lender side. Borrowers have many and various problems so there is no one-size or even middle-of-the-curve solution to implement. These mortgages need to be, literally, re-negotiated one at a time. But it gets worse: with asset values plunging to well south of the face value of many loans there is no sane way to 'save the loan' as written. You want the lender to eat 40% of the loan? It might be easier for them to walk away---or there may be no 'lender' to walk away, they're dead. For troubled mortgage holders, it's a big blot on their credit, a life-changing event. For lenders, it's often going to be a blot on an x-ray; a life-ending event.

Don't expect a fast resolution to this issue; three years from now, we'll still be unwinding it, in my view. Federal legislation does nothing to solve the problems. 'The guvmint buys all notes?' They don't got that kind of dough.

The government can't solve the problem---but the government just might be able to change the problem. Here is the outline of a coherent solution process; it won't happen, and I'm not going to propose offhand the means to get there, but since this all is a mess, and we'll have some time to kick arouond issues, here is one way to go about it.

Take the market or appraised value of the property as of a set, market top date; oh, March, '07 for an index. Now take 60% of that: this is the new value of the property. Take the loss, and apportion it between mortgage holder and lender based on their equity shares as of today; this means most, but not all of the writedown goes to the lender. Many mortgage holders will end up with negative equity, but at much lower total dollar value; the property is worth less, but by the same token the amount which will have to spend to pay it off and own it clear is much less, too. That's a situation which may keep an owner willing to stay in the property and pay off that smaller negative equity; they take some loss, but they can end up with whole credit and a home, not a bad outcome. Refi the loan into a traditional loan structure. If the owner can't meet that payment, well the loan is dead anyway, we've done all we can. The advantage to the lender is that they now have an asset again, rather than a rotting, unoccupied structure against which they owe taxes after foreclosure costs in a horrible property market without viable mortgage lenders and huge inventory overhangs.

No one forces this solution on either party to a locked up, upside down squat, but it's a package deal, go/no-go, with little or no side dickering over terms: you go to court and say, "We both agree to this change in our pre-existing contract by the terms of the Somebody Help Me Jesus Act of '09," judge raps the gavel, ever'body clap hands, and walk out the door with chins up and best foot forward. Once a mortgage holder at a viable payment is signed on, the lender can sell the package or hold it to term, but the mortgage is a tradable instrument again at known value. This is for first liens only. I have no solution to propose for second and third mortgage situations other than the Darwinian solution: stupidity means your equity dies stillborn without reproducing.

Rather than a total loss-loss, cut cards and do a re-deal, but 'automate' the process with shared pain.

Don't like it? Let's hear your plan.

He also offered an addendum for borrowers in severe negative equity land but able to service the debt, but I figured we'd stick with the base case for now.

Links 4/18/08

Morgan Stanley predicts one in ten homeowners ‘facing negative equity’ Times Online

I underestimated the threat, says Stern Guardian

Why new oil price highs? James Hamilton, Econbrowser. A nice little post. Hamiltion looks at some data, most importantly that all commodity prices are increasing, and the oil price rise is less than the average. He argues that only half the rise can be attributed to the fall of the dollar; he believes negative interest rates and the prospect of further Fed cuts (ie, even worse real returns from holding short-dated financial instruments) is a major culprit.

Lakes of meltwater can crack Greenland's ice and contribute to faster ice sheet flow PhysOrg versus Greenland's disappearing lakes leave giant ice sheets largely unmoved Guardian. Um, these two stories are reporting on the same research, and I don't have time to go read the study myself to see which account is closer to the truth.

Fed Vice Chairman Kohn Warns on CRE Concentrations at Small banks Calculated Risk.

Investment banks eye CDS clearing house Financial Times

Central Bankers Guessing Everywhere Michael Shedlock. Mish applauds the hard-line stance of Australia's Reserve Bank.

Royal Bank of Scotland in fresh cash plea Telegraph. The bank is looking for at least £5 billion via a rights issue. Rights issues are generally a sign of desperation. John Dizard of the Financial Times said to meet the Fed's target of $200 billion in replacement equity in six months, we'd need a Wachovia sized funding a week. With Wachovia, JP Morgan, and RBS, we are right on schedule, but expect investor resistance, reflected in funding costs, to start rising.

Antidote du jour:

"Let Britain’s housing bubble burst"

I wish we had someone as well regarded as the Financial Times' Martin Wolf giving the same message in the US. Wolf stresses that prosperity built on overpriced homes is illusory. He pans some ideas that are already being road tested in the US, and says attenuating an inevitable fall in prices is unsound. And he gives himself license to get worked up, which he does quite colorfully.

From the Financial Times:

What has happened to British phlegm? Instead of greeting news of falling house prices and tightening lending with aplomb, people shriek that the sky is falling. Steven Crawshaw, chairman of the Council of Mortgage Lenders, warns that it is “a real possibility . . . that net lending in 2008 could reach only half last year’s level unless additional funds become available”. Smaller mortgage lenders, dependent on their ability to sell mortage-backed securities, could even be forced out of the market. In sum, the time has come for a bail-out.

I have three answers to this cacophony of special pleading: first, anybody who thinks it is a duty of the state to help keep housing expensive is crazy; second, policymakers should respond only to clear market failures; and, third, with a floating exchange rate and an independent central bank, the UK can weather the storm if it keeps its head.

It is high time the British realised a people cannot become rich by selling ever more expensive houses to one another. According to the International Monetary Fund’s latest World Economic Outlook UK house prices are more overvalued, relative to economic fundamentals, than those of almost any other high-income country. At long last, investors in mortgage-backed securities, all too aware of what has happened in the US, have realised the dangers in the UK.

They must understand that it becomes extraordinarily difficult to know what such securities are worth as soon as house prices start to fall. They must also be aware that UK house prices have risen by a good 150 per cent since 1996, in real terms. Indeed, It would take a 25 per cent fall in real prices to put them on to the 1971-2007 trend line, last hit in January 2002. Such a decline is conceivable. Prices might overshoot downwards, but they are nowhere near that position now.

Peter Spencer, chief economist of the Ernst & Young Item club, argues that the government should step in, by borrowing to fund the mortgage market. With great respect, I think this notion is mad. It is wrong for the government to fund people to purchase houses at what may well prove the beginning of a long slide in prices. It is tantamount to the financial debauching of minors. As important, if you believe, as I do, that house prices probably must fall, it is better for this adjustment to be swift than be dragged out over many years.

So should the government do nothing at all? No. Since mid-March, spreads between rates on interbank and official three-month and six-month lending have been some 20 to 25 basis points higher in the UK than in the US or eurozone. This, it is argued, reflects the illiquidity of mortgage-backed securities. Lenders, argues Mr Crawshaw, hoard cash because they are not sure whether they will be able to borrow in future.

Whatever the source of the problem, a case exists for further action by the Bank of England in its role as lender of last resort. At present, it is working, in conjunction with the Treasury, on a scheme to swap high-grade mortgage-backed securities for government debt for terms of one to three years, after a sensible “haircut”. But credit risk would still remain with the banks.

This facility would be available at all times, but would be limited to securities created up to the end of last year. All that is now needed is for the Treasury to agree to create the needed gilts. The aim of this would be to remove liquidity constraints, not provide a bail-out or reopen the market in mortage-backed securities. The latter may well be gone forever, as can happen to markets in lemons.

In all, this looks sensible. If it succeeds, net mortgage lending may remain lower than before. Yet even if it were to halve, as some fear, the nominal stock of outstanding mortgage debt would grow by a bit over 4 per cent this year, or much the same rate as nominal gross domestic product. The idea that the stock should grow faster than GDP forever is nonsense.

After house prices peak, I would expect the ratio to fall, not just cease rising. Those arguing for still higher growth in net mortgage lending are arguing that the government must subsidise even more house-price inflation and the lenders who have fuelled it. This is demented.

Yet, some will protest, this is a recipe for a recession. This is false. Even the IMF argues that the economy will continue to grow this year and next, at about 1.6 per cent. After 62 quarters of sustained growth, would that be a tragedy? Moreover, the real reason for slower growth is the need to hit the inflation target. The country needs lower inflation, whereupon the Bank will have room to cut interest rates.

The adjustment of the economy towards exports and away from domestic spending is now, at last, under way. Fortunately, the exchange rate is taking much of the strain. In eight months, competitiveness has improved by 16 per cent against the UK’s eurozone partners, something Spain or Italy will only achieve painfully, after years of disinflation.

A combination of close attention to the liquidity logjam and flexible monetary policy is all that is needed. It is not the government’s job to reflate house-price bubbles. It would have been a good idea if it had done more to prevent them, instead. Now it must let events undo that mistake, rather than try to compound it.

Quelle Surprise! Underemployment is Hurting the Economy

The New York Times, in "Workers Get Fewer Hours, Deepening the Downturn," presents data and anecdote that indicate that low unemployment masks a deteriorating labor market. Some employers are cutting their workers' hours; the self employed are finding less demand for their services.

While this article provides some useful insight into the state of the economy, it fails to acknowledge that underemployment is a problem separate and apart from the economic slowdown. There is often perilous little difference between being self employed and unemployed, but that distinction is rarely captured. As I have mentioned before, a large number of people in my peer group are either retired but would prefer to be working full or part time, or have their own businesses but are less busy than they would like to be. In this narrow sample, underutilization has been widespread since the dot com bust.

From the New York Times:

Not long ago, overtime was a regular feature at the Ludowici Roof Tile factory in eastern Ohio. Not anymore. With orders scarce and crates of unsold tiles piling up across the yard, the company has slowed production and cut working hours, sowing worry and thrift among its workers.

“We don’t just hop in the car and go shopping or get something to eat,” said Kim Baker, whose take-home pay at the plant has recently dropped to $450 a week, from more than $600. “You’ve got to watch everything. If we go to town now, it’s for a reason.”

Throughout the country, businesses grappling with declining fortunes are cutting hours for those on their payrolls. Self-employed people are suffering a drop in demand for their services, like music lessons, catering and management consulting. Growing numbers of people are settling for part-time work out of a failure to secure a full-time position.

The gradual erosion of the paycheck has become a stealth force driving the American economic downturn....While official unemployment has risen only modestly, to 5.1 percent, the reduction of wages and working hours for those still employed has become a primary cause of distress, pushing many more Americans into a downward spiral, economists say.

Moreover, this slippage is a critical indicator that the nation may well be on the verge of a recession, if not already in one.

Last month, the hours worked by those on American payrolls dropped, compared with six months earlier, according to an index maintained by the Labor Department. The last time the index moved into negative territory was February 2001, when the economy was on the doorstep of recession. A similar slide emerged in August 1990, one month into what proved an even more severe downturn.

From March 2007 to March of this year, the average workweek reported in the private sector slipped slightly to 33.8 hours, from 33.9 hours, while overtime for manufacturing workers fell by a larger margin.

At the end of last month, more than 4.9 million people were working part time either because they could not find full-time jobs or because their companies had cut hours in the face of slack business, according to a Labor Department survey. That represented an increase of 400,000 since November.

And on Wednesday, the government reported that average earnings slipped in March after accounting for the rising costs of food and fuel — the sixth consecutive month that pay failed to keep pace with inflation.

As people bring home paychecks that do not go as far, they are forced to economize, eliminating demand for goods and services that once captured their dollars, spreading pain to providers like auto dealers and lawn care providers. They, too, must trim their outlays on pay, shrinking working hours more and furthering the slowdown

“It means spending slows going forward,” said Robert Barbera, chief economist at the trading and research firm ITG.

Paychecks are diminishing just as millions of Americans are finding their access to credit constricted as well. Borrowing against the value of real estate — a crucial artery of household finance in recent years — has been pared back as home prices have plummeted and as banks have tightened lending standards in the aftermath of the collapse of the housing bubble.

“At this point, those avenues are blocked,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute in Washington. “Consumption going forward is going to be in large part a good old-fashioned function of paychecks and incomes.”

Even before the rollback in working hours, pay was barely keeping up with the rising costs of gas and food. From February to September of last year, the average hourly earnings for workers in the private sector was still growing at a slightly faster clip than the pace of inflation, according to the Labor Department. But from November through March, as employers began to scale back in a variety of ways, wage growth fell below the pace of inflation, meaning that paychecks were effectively shrinking.

Now, work opportunities are themselves declining, as the downturn snuffs out business.

Why the Happy Talk About the Credit Crisis?

I am frequently mystified at what goes on in the markets. I am even more mystified when people who ought to know better make pronouncements that appear to be profoundly counter-factual. Even if they are talking their own book, the high odds of being revealed as bald-faced liars proven wrong ought to make them worry about damaging their credibility.

Is this wishful thinking? Delusion? A hope that that a united front can change perceptions and therefore reality? (see this as Tinkerbell behavior: if we all clap together, the markets won't die).

In the last week, we've had the CEOs of Goldman, Morgan Stanley and JP Morgan say that they see an end in the not-too-distant future to the credit crunch. Similarly, Mark Mobius of Templeton argues that all the bad news is already priced into stocks, while private equity investor Wilbur Ross plans to spend $4 billion buying banks (although he professes to be picky)

Mind you, the optimism among the financial services leadership is far from universal. Lehman thinks recovery won't come till 2009; Paul Calello, CEO of the investment bank Credit Suisse expressed considerable uncertainty as to when the crisis might be over. And the industry's own analysts, who have strong incentives to argue the bull case, have been far more downbeat than industry executives. Goldman has forecast an "awful" earnings season across the board; Meredith Whitney of Oppenheimer is calling for continued large losses at banks.

I could go through a litany readers know well (and can no doubt improve upon): the housing market is continuing to deteriorate and based on precedents here and abroad, there is no reason to think it will bottom before 2010 or 2011; we are some distance from a typical bear market low of a 30% fall in the S&P (and with the severity of this crisis, we may overshoot); the US has to wean itself off its credit habit, and none of the ways out are pretty; non-government guaranteed securiization has fallen off a cliff and appears unlikely to come back any time soon, yet banks lack the equity to fill the gap with on-balance-sheet intermediation; counterparty risk in the credit default swaps market hangs over the financial services industry like a sword of Damocles.

But let's put these long-term considerations aside. It's bizarre to see this upsurge of cheery chatter given the counterevidence in the money markets. Widening TED spreads suggest we are on the verge of another crisis:



The overnight index swap rate has also indicated bank reluctance to lend to each other. Jeff Frankels provided an update yesterday, with a chart from the Institute of International Finance:



And the report yesterday that banks were fudging on their reporting of Libor is making maters worse. From Across the Curve:

I have related the thoughts of a money market trader at a large shop who has been modestly constructive on his market. The story in the Wall Street Journal this morning which suggetst that banks have been understating the true cost of funding and the true Libor rate has turned this veteran trader less optimisitic. My source believes that this story and the subsequent report that the British Bankers Association will mete out harsh punishment to those found dealing in untruths will lead to an excess of caution over the near term. My trader source reports that inquiry further out on the money market curve has dried up this morning and the only business he has printed is in overnight sector. He thinks the imbroglio could add 5 basis points to 10 basis points to Libor in the near term

Separately, the 5year swap spread is currrently at 92.5 basis points. It has essentially retraced the entire post Bear Stearns rally. On the Friday evening of March 14 the 5 year swap spread finished trading at the 93.75 level. In the rally which followed it reached 77 basis points. It has slowly moved wider so that it currently sits just a basis point from the pre Bear level.

Central bankers have thrown a lot of firepower at the problem of a money market seize-up, yet illiquidity persists. What more can they possibly do if we move into another acute phase?

Update 11:30 AM: Reader Scott sent this chart, showing two year US swaps, with the comments. "The concept that the Fed has stabilized the system is fantasy.....queue the Ride of the Valkyries."

Why Companies Aren't Fighting Climate Change

Consider this example: In 1997, British Petroleum decided to lower its carbon emissions below the 1990 level by 2010. It achieved the goal in 3 years rather than 13 at a cost of $20 million. Oh, and it happened to save $650 million. With that sort of calculus, you'd think that every big corporation would be on the emissions-reduction bandwagon.

While the savings for other companies may not be as dramatic, other analyses have found that investing in energy savings is attractive:

A study by the McKinsey Global Institute (MGI) found that an annual global investment of $170 billion in energy productivity through 2020 could half the global energy demand—an amount equivalent to 64 million barrels of oil per day. This investment would create energy savings with an average internal return rate of 17 percent, or $29 billion. MGI said the most cost-effective method for reducing global greenhouse gas (GHG) emissions is through energy productivity. Additionally, the report says the investment would cut CO2 emissions to about 550 parts per million—the amount needed to stabilize the gas at the safety limit set by the Intergovernmental Panel on Climate Change.

In order to achieve this, MGI said the global industry sectors need to invest about $83 billion per year, residential sectors would need to invest about $40 billion, and the transport and commercial sectors must invest $25 billion and $22 billion per year, respectively. Diana Farrell, director of MGI, said “the vast majority of global executives say fixing global warming problems can boost profits.... We’ve identified huge opportunities to reduce energy demand and carbon emissions through improved efficiency.”

So not only does the math pan out, but in addition, most corporate leaders agree that combatting climate change will improve the bottom line. So why aren't companies moving ahead aggressively?

An article by Karin S. Thorburn at VoxEU, "Why the U.S. policy for climate change is flawed," points out an ugly reality: the stock market doesn't get it. Apparently, investors do not buy the idea that investing in greater energy efficiency in an era of of $115 a barrel oil is compelling (and note that despite all the brouhaha about alternative fuels, using less energy will have a far greater impact).

How could investors be so ill informed? One possibility: socially responsible investing has gotten consistently bad press. It's generally depicted as a soft-headed way to guarantee inferior investment performance. Thus, being a skinflint about energy use, which like other types of cost-cutting is good for profits, is instead treated as naive do-gooderism and punished.

Aggressive PR might reverse this perception; Thorburn recommends regulation to combat this glaring market inefficiency.

From VoxEU:

US climate change policy relies on corporations voluntarily reducing their greenhouse gas output. But recent research shows that pledging to cut carbon is bad for business, which is why so few firms take such voluntary measures. Reducing carbon emissions will require regulation.

Climate change may prove to be the most severe environmental challenge of this century. Yet, the United States, one of the world’s largest producers of greenhouse gases, has refused to ratify the Kyoto Protocol mandating a reduction of greenhouse gas emissions. Rather than national regulation of greenhouse gas emissions, the Bush administration relies on voluntary measures to combat global warming. The success of U.S. climate change policy therefore ultimately depends on how profitable it is for companies to voluntarily reduce their carbon footprint. In other words, in order to be widely adopted, investments required to reduce greenhouse gas emissions must increase shareholder wealth and thus have a positive net present value.

Porter and van der Linde (1995) and Reinhardt (1999) argue that environmentally responsible investments can improve corporate financial performance. They propose that pollution-reducing investments create “green goodwill,” which differentiates the firm’s products and increases its market share. Such investments may also reduce production costs and the risk of future environmental liabilities, as well as give the firm a competitive advantage if subsequent regulatory actions force industry rivals to follow. In addition, Heinkel, Kraus and Zechner (2001) suggest that if investors refuse to hold the stock of polluting firms, the cost of capital may rise to the point where it is optimal for some firms to undertake environmentally responsible investments.

Do voluntary measures pay?

In joint work with Karen Fisher-Vanden, I examined the positive net present value assumption underlying the U.S. policy for climate change (Fisher-Vanden and Thorburn, 2008). Specifically, we studied the stock market’s reaction when companies joined Climate Leaders, a voluntary government-industry partnership in which firms commit to a long-term reduction of their greenhouse gas emissions. Importantly, when the firms announced to the public that they were joining Climate Leaders their stock prices dropped significantly. Controlling for general market movements, the average abnormal stock return was -0.9% over a three-day window and -1.5% over a five-day window around the announcements. For the 46 sample firms that joined Climate Leaders, the total loss in market value was $16 billion. The stock price decline was smaller for firms in carbon-intensive industries, where regulatory action is more likely (and thus partially anticipated in the stock price), and greater for high-growth firms, suggesting that the green investments crowd out growth-related capital expenditures.

Firms joining Climate Leaders conduct a careful inventory of their greenhouse gas emissions before they subsequently announce a reduction goal. The average firm in our sample set a goal to cut its total emissions of greenhouse gases by 17%. Interestingly, the stock price plummeted even further (on average -1.3%) when the greenhouse gas goal was announced, and the more aggressive the goal, the greater the price decline. The study also included 22 firms joining Ceres, a network addressing sustainability challenges whose principles are adopted by its members as an environmental mission statement. Stock returns were largely unaffected by the Ceres announcements, perhaps reflecting—in contrast with Climate Leaders—the lack of specific environmental investment commitments in Ceres. In addition, we looked at portfolios of industry competitors, but found little movement in stock prices when their rivals joined an environmental program.

Why do firms volunteer?

The negative market reaction for firms joining Climate Leaders reveals that the reduction of greenhouse gases is a negative net present value project for the company. That is, the capital expenditures required to cut the carbon footprint exceed the present value of the expected future benefits from these investments, such as lower energy costs and increased revenue associated with the green goodwill. Some may argue that the decline in stock price is simply evidence that the market is near-sighted and ignores the long-term benefits of the green investments. Notice, however, that the stock market generally values uncertain cash flows in a distant future despite large investments today: earlier work has shown that firms announcing major capital expenditure programs and investments in research and development tend to experience an increase in their stock price. Similarly, the stock market often assigns substantial value to growth companies with negative current earnings, but with potential profits in the future. In fact, only two percent of the publicly traded firms in the United States have joined the Climate Leaders program to date, supporting our observation that initiatives aimed at curbing greenhouse gas emissions largely are value decreasing.

The loss of market value implies that the decision to substantially limit greenhouse gas emissions conflicts with shareholder value maximisation and thus the fiduciary duty of corporate directors in the United States. By comparing the sample firms to their industry rivals, we identified characteristics of the firms that voluntarily joined Climate Leaders and Ceres. We found that the sample firms on average had relatively high environmental ratings and low corporate governance ratings, and were more likely to join in periods when public concerns with global warming were high (measured by the number of U.S. press articles). Overall, the evidence is consistent with the notion that management’s interest in environmentally responsible investments, possibly combined with poor shareholder oversight, drives the decision to commit corporate resources to cut the carbon footprint. This is further supported by the anecdotal evidence that two firms acquired by private investors (Norm Thompson and Polaroid) left the Climate Leaders program shortly after going private.

The need for regulation

So what does this all mean? In a nutshell, it suggests that the federal government’s reliance on voluntary measures to reduce greenhouse gas emissions will likely prove unsuccessful. The success of voluntary programs depends on their ability to achieve meaningful corporate participation. Such participation will ultimately depend on the payoff to shareholders. Our research shows that shareholder value declines when companies join Climate Leaders and pledge large cuts in their carbon footprint. Indeed, greenhouse gas emissions, like most other pollutants, seem to constitute a classic example of an externality, where the overall cost to society is not internalised by the individual corporation. In light of such market failure, federal regulation is a viable way to achieve a broad reduction of greenhouse gas emissions. It is high time for the U.S. federal government to face the facts and take real measures to seriously fight global warming.

The Rise of the Neo-Malthusians

Paul Krugman, commenting on a Wall Street Journal article that invoked, then tried to dismiss, concerns about resource scarcity, defended Malthus:

Malthus was right about the whole of human history up until his own era.

Sumerian peasants in the 30th century BC lived on the edge of subsistence; so did French peasants in the 18th century AD. Throughout history population growth had always managed to cancel out any sustained gains in the standard of living, just as Malthus said.

It was only with the industrial revolution that we finally escaped from the trap (if we did — for all we know, 35th-century historians will view the period 1800-2020 or so as a temporary aberration).

Was Malthus just unlucky? No. The same forces that made the industrial revolution possible — above all, the spirit of inquiry and rationality — also led to the birth of analytical economics. There probably couldn’t have been a Malthus until the world was on the verge of becoming non-Malthusian.

Krugman's 35th century comment indicates he thinks it's quite possible that our respite from Malthusian constraints may be nigh.

But modern economics is a product of the Industrial Revolution. It will take a major reorientation to adapt its precepts to a world where growth is constrained by resource limits and the need to manage externalities, such as greenhouse gas emissions, garbage, and pollution.

Reader pls pointed to an article in the Asia Times by Joe Costello on, among other things, the limits to growth. He had reservations about the article, as do I. It's long, rambling, somewhat unfocused (I've noticed this with Asia Times articles. They must give writers large word budgets that they flounder to fill). And he draws inferences that are inaccurate (he makes it sound as if Volcker was an active participant in bringing about the Reagan revolution. Yet Volcker was a Carter appointee, and even though Reagan gave him for a second term, he later ditched Volcker for the libertarian enthusiast Greenspan. While it is probably accurate to say that Volcker's successful monetary experiment enhanced Milton Friedman's reputation in the public's eye, Volcker is a staunch believer in regulation and no fan of "free markets" as a rationale for curbing oversight).

Nevertheless, despite the considerable shortcomings of this article, it nevertheless makes some important observations, the biggest that the main branches of economic orthodoxy regard growth as their main objective and are likely to revert to denial about resource constraints. While Costello lacks serious economic credentials, Krugman also reminds us that:

One of the defining features of the last 8 years or so has been the way ideas go from crazy stuff that only DFHs believe to stuff everyone knows, without ever going through a stage in which the holders of conventional wisdom acknowledge that they were wrong. Oh, and the people who were right are still considered DFHs; you see, they were right too soon.

As someone who worked on Jerry Brown's presidential campaign, Costello is a card-carrying DFH.

From the Asia Times:

However, we may very well be at a point of fundamental questions neither the New Deal or neo-liberalism care to ask. For in the end, New Deal and neo-liberal political economy are simply two sides of the same coin. They are a political and cultural school of thought that seeks one end, economic growth. Both ultimately depend on growth in the creation of jobs, growth in the production of goods, and growth in consumption each year.

They are a school of thought that depends on infinite resources from what every year becomes increasingly clear to the collective mind of humanity is a very finite planet. It is this fundamental contradiction that will increasingly move into the center of all debate on political economy and a question neither New Deal or neo-liberal economics has any answers....

The questioning of unlimited growth is not new to political economy, it has been around since almost the inception, beginning most famously, or as most of economic proselytizers of unlimited growth would say most infamously, with the thinking of Thomas Malthus....

Yet, Malthus became held in ill-repute nowhere more so than amongst the economic community. His idea of humanity as part of nature flew in the face of both burgeoning growth economics, the new industrial ethos which seemingly proved man's control over nature, and of course the much older philosophical and theological conceits of humanity's natural exceptionalism.....

If in fact the planet's 6 billion people were to live like the United States several other planets would need to be available, and despite all efforts to date, we are still very much Earthlings. In the last few years, as a billion or so new people have embraced the philosophy of infinite economic growth, it is increasingly clear Malthus must once again be reckoned with...

If we are to alter and reform the two centuries old patterns of industrial society, we must also completely reevaluate our understanding of economics. We can begin to do this quite easily by first rejecting the notion of economics as a science and understand that economics is at its foundation a cultural system. In order to change our industrial society, we will need to change our culture and we can begin by putting the political back into the economy.

There are several fundamental pillars in reforming political economy:
1. Ending the idea of infinite linear production and consumption in the closed system that is Earth.
2. Moving away from a fossil fuel-based energy system.
3. Corporate and government reform.

Concentrating on these three interlinking subjects will allow a comprehensive though in no way exhaustive look at evolving political economy.

The first thing that must be changed is the linear production and consumption model. We must accept the fact that we live on a finite planet, which means the doctrine of infinite growth is an eventual doctrine of disaster. The first rule we must adopt is to bend the current linear production and consumption process into a circle, which means most importantly, we must realize on a closed system like the earth there is no such thing as waste or garbage. We must look at everything we produce as recyclable and if it presently isn't, it must become so.

Secondly, we have to move people off the production and consumption hamster wheel. This is the wheel that requires people to work to produce ever more things so they can be rewarded with ever more consumption. An ethic must be developed of not wanting more, but simply wanting enough - the system as whole must embrace this ethic. People must be enabled to work less and have more time to do other things than just consume.

For breaking out of the linear production and consumption model, the robust evolution of information technologies is going to play a critical role. To this point, information technologies have simply been used to enhance the linear production and consumption model, that is to simply produce more stuff. However, the real value of information technology lies in design, that is, eventually creating more livable societies that use less stuff. Most of our economic institutions will need to be retooled so their most important element is not production, but design. We need to figure out how to design our economy to not produce the most stuff, but more elegantly produce enough. Design is measured not by quantity, but by quality.

The most important element of the modern economy that will need to be redesigned is energy. If there is one thing that can be said that separates the industrial age from all preceding it, it is the exponential rise in energy consumption....

The interesting thing about industrial society and energy is that energy has been so relatively cheap and plentiful, little thought and even less practice has been given to using it efficiently and conservatively. For example, the automobile, thousands of pounds of steel powered by the internal combustion engine can also be looked at as one of the most energy-inefficient methods to move around a 150-pound person.....

While over the course of industrial society, the cost of labor has been scrutinized extensively, in most processes, the cost of energy has been paid too little attention. The United States needs to redesign its energy economy, looking to how all its processes can become much more efficient. This includes food production, w