naked capitalism

There’s been an interesting dialogue between Streetwise Professor and Deus ex Macchiato on the matter of the practical impact of the pending Basel III rules, which will rejigger, in a pretty significant way, bank capital requirements (see here and here for details). The reason Basel III matters is that the Treasury has been touting it as the remedy for all the things that didn’t get done in the financial reform hoopla: if the banks are forced to have “enough” capital (query what “enough”) is, and better liquidity buffers, the likelihood of a financial crisis will be lower.

As an motherhood and apple pie statement, it’s hard to argue with that sort of thing, but making it operational is quite another matter. And here’s where the chat between Streetwise and Deus comes in. Per Streetwise Professor:

Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls. If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks. The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks. That’s why I am very leery of global capital regimes, a la Basel. If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global…

This is a story about relative prices. In a risk based capital regime, some risks are mispriced relative to others. Banks load up on those mispriced risks. Since all face the same distorted pricing signal, they tend to trade the same way. They held more capital than they were required to, but that provided a false sense of security because the required levels of capital did not accurately reflect the risks.

There is, in fact, dysfunction in the financial system. That dysfunction, in the first instance, is the result of the deadly combination of implicit and explicit guarantees that stoke moral hazard, and woefully inadequate and scarily expansive capital requirements that are intended to make it difficult for banks to exploit that moral hazard, but fail to do so.

Let’s examine this a bit further. It’s important to recognize that the mispricing of risk under Basel II was a significant contributor to the global financial crisis. Eurobanks, which were subject to Basel II rules as of 2006, entered the crisis with lower capital levels than their US counterparts. Moreover, many engaged in a particular form of capital arbitrage that played a direct role in stoking the credit bubble, which was holding the AAA rated tranches of CDOs and insuring them (usually in part) to further reduce the amount of capital they had to hold. So the concern is valid.

Even with the likely (in Streetwise’s view, inevitable) mispricing of risk, the impact might not be as significant as he contends if the capital levels for the underpriced risk was still high enough. In other words, I’m not certain I buy the strong form of the “crowded trades” argument, a risk based capital regimes is inherently flawed. And Streetwise effectively concedes that point:

The capital required against certain instruments (government debt being another example) was too small relative to the true risks of those instruments. So too many banks loaded up on them.

But from a practical standpoint, his concerns are valid. The unrecognized crowded trade problem only make matters worse. Even if the authorities were to come up with a sound program, the crowding in the strategies that were cheap on a relative basis would make them riskier, and hence the render the required capital levels insufficient.

Let’s face it, the notion that we are going to have adequate private sector equity in the banking system anytime soon, if ever, is a fantasy. The way that Fannie and Freddie have stepped in to become become virtually the only mortgage issuer/securitizer, with the obvious aim of propping up the housing market and bank balance sheets, is a highly visible example of the extent of back door support to undercapitalized banks. Team Obama is of course trying to divert public attention from the continuing high level of support and regulatory forbearance via its continued iMission Accomplished “Paid back the TARP” three card monte.

Richard Smith did a bit of quick and dirty math to determine what it would take to adequately capitalize the shadow banking system:

Let’s just ignore the liquidity issue for the moment, and ignore the variety of business models of the various kinds of shadow bank, and require the shadow banks to put up a not very demanding 5% capital cushion and regulate to that, somehow. Assume, for simplicity, that we want to keep all that lovely shadow banking activity going and that shadow banks’ assets are identical in size to their liabilities; that 5% capital cushion would then be 5% of $8-16Trn. That’s between $400Bn and $800Bn of capital to raise.

Or, perhaps more likely, our shadow banks take 50% losses on 15% of their loans that they never never want to do again (the CDO bonanza, etc), and then need 5% equity on the rest. That way our shadow banks would need $925-$1,850 billion in equity. Which is impressive, but fair enough: the traditional banking system has about $1.3Trn of equity, and we know the shadow banking system is the same size, or somewhat bigger, and more prone to runs. Why, pray, should it not at least be capitalized to the same level, either by new capital, or by shrinkage?

Yves here. It is politically unacceptable to make banks raise that much capital. Not only would the firms howl blood murder, but policymakers are unwilling to take the economic hit of a quick or even attenuated return to sounder practices. So we have state subsidies of various sorts like ZIRP standing in.

That further means we have a continuing moral hazard problem. Basel III can’t solve the problem because despite the officialdom’s fantasies to the contrary, they simply won’t get enough equity into the system. That might not be as terrible as it sound if the authorities were willing to admit that and were using other approaches to monitor and reduce risk, in particular, much more aggressive regulation, and far more intervention on pay practices.

In the stone ages of investment banking, when firms were partnerships, it would have been unheard of to take on a lot of moderately long-dated, risky, illiquid, bespoke, hard to value assets and fund them in short term where they’d be exposed to rollover risks. Similarly, in those days, the major players all held a lot more in capital than was required by regulators (reg cap was regarded as overly permissive but constraining in certain circumstances, so it still needed to be managed). Investment banks were cautious not only because the partners had unlimited liability (they could lose everything) but also because they most if not all of their wealth tied up in the firm and could access it only gradually after departing, as younger partners bought them out over time. That forced them to maintain modest lifestyles relative to their net worth and to be concerned about the long term viability of the franchise.

We have a massive agency problem in the financial services industry. The crisis was a textbook case of looting. The major firms are now more powerful by virtue of being bigger and fewer, and official denials to the contrary, are in a better position to loot than before. The belief that higher capital requirements can be the mainstay of solving this problem is wishful thinking.

Apologies for thin links, need to be on a very early flight.

Scientist: World’s helium being squandered UPI (hat time reader John M)

Double strike ‘killed dinosaurs‘ BBC

Good Bernanke commentary. Mr. Market wants to believe:

El-Erian: How to read Bernanke’s speech FT Alphaville

Bernanke is neutral, with dovish tinges Gavyn Davies

Really What Bernanke Said Is That He Doesn’t Have What It Takes To Fix The Economy Joe Weisenthal

Driving Me Crazy Tim Duy

Widespread Fear Freezes Housing Market Joe Nocera, New York Times

GDP revised down Jim Hamilton, Econbrowser

What Banks Can Learn from VCs Paul Kedrosky

Antidote du jour:

A question for readers: in many lines of commerce, large firms often enjoy significant cost and/or revenue advantages relative to smaller players. Over time, these industries tend to evolve to a format where many of the most successful enterprises are very large organizations. These firms typically wield considerable power relative to players smaller than they are, such as employees, suppliers, and customers, and often seek to influence governments. Moreover, many fields of enterprise have considerable barriers to entry, which further entrenches the position of powerful incumbents.

How do libertarians propose to respond to the power of large enterprises?

This post first appeared on November 16, 2007

A colleague was so kind as to send me the text of a speech given at the Graham & Dodd breakfast a few weeks ago by David Einhorn, CEO of hedge fund Greenlight Capital.

The speech has gotten play only in some personal-investment-oriented blogs like Seeking Alpha and Naked Shorts. Even though they are fine sites, it’s nevertheless a shame the speech hasn’t gotten broader interest. First is that most of the commentary focused on the general thrust of his argument but failed to pass on key bits of information that are likely to be news to most readers. The second it that there is still a considerable gap between what market participants know compared to legislators, regulators, economists and commentators. Yet somehow the industry types get a serious hearing when they reach an audience (i.e., when they are lobbying), but when people with insight but no axe to grind have something to add to the debate, too often it gets short shrift.

It was sobering for me to learn a few things from the speech. On the one hand, as someone who is not in the marketplace (and lacks access to a Bloomberg terminal), I am in the same position as a journalist: I am only as good as my sources. But on the other, some of the things that I picked up seemed fundamental, yet I haven’t seen them either in the press or the academic articles I’ve read.

Einhorn tells us that the securitization process is flawed (”securitization is a mediocre idea” is the nicest thing he had to say about it) and that the rating agency role is in need of root and branch reform. The entire speech is very much worth reading, and his comments are pointed and insightful. However, he does not fully draw out the implications of what he found.

The rating agencies’ role was even more deeply compromised that most commentators recognize. Their practices made it cheaper to issue the very sort of paper that is was most profitable for them to rate. They did it by letting the creators and sellers of structured credit products play on the popular perception and regulatory fiction that all AAAs are created equal, when in fact, the more complicated the paper was (and therefore more costly to rate) the more risk it was allowed to carry in each rating class.

Some key observations:

The credit problems we have are experiencing are not the result of subprime contagion, but of charging too little for risk-bearing. There was concern in some quarters about systemically low credit spreads, yet participants were confident liquidity would always the abundant. Einhorn believes that the complacency about risk was at least partly due to the securitization process, in which most investors looked heavily to the ratings in their evaluation process.

But just as some animals are more equal than others, so to are ratings:

Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%, while a corporate bond’s default rate is 1.8%, and a CDO’s is 2.7%. An A rated muni has the same change of default as and AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs.

This isn’t an accident. About a decade ago, Moody;s said, “No matter what types of instruments the ratings apply to, no mater where the issuer resides, and no matter what the currency or market in which the security is issued, Moody’s ratings are intended to have the same relative meaning in terms of expected credit loss.”

Without much fanfare, the rating agencies abandoned this process…..Instead, for each type of bond, they use a different rating scale with a different so-called “idealized default rates” for each rating. The idealized default rate for a municipal bond at a given rating is less than the idealized default rate for a corporate bond, which is less than the idealized default rate for an asset backed security which is less than the idealized default rate for a CDO….

Nomura Securities pointed out that hypothetically, if you took an AA+ rated asset backed security and repackaged it all by itself and called the repackaged instrument a CDO, it becomes AAA because the CDO has a higher idealized default rate than the asset backed security.

Einhorn points out that the rating agencies’ fees are correlated with their willingness to look the other way with credit losses. CDOs carry the highest fees, ABS next, and regular corporate ratings are cheaper still. But of course, the agencies will argue that the more complex structures are more labor intensive to rate and therefore warrant higher charges.

Regardless, this system, of higher idealized default rates for securitizations has the effect of promoting securitizations. And the higher idealized default rates promoted CDOs.

For a financial institution, the very fact that the loans with the same loss profile will get a higher rating in an ABS than if they sit on their balance sheet means that it is uneconomic for them to keep them on their balance sheet (note that this is independent of the traditional impetus for securitization, namely, the cost of deposit insurance). The rating agencies have stacked the deck via their rating process to make it even cheaper to securitize assets than it would be if investors knew the true exposure to loss.

Now mind you, we are NOT saying that securitization would not have happened without the rating agencies gaming the scorecard. Back in the early 1980s, when AAA still meant AAA, McKinsey was showing its banking clients charts illustrating how securtization had a significant cost advantage relative to traditional lending (message: investment banks are and will continue to eat your lunch). But the rating agencies’ actions played a significant role in the underpricing of risk, and almost certainly made the ABS and CDO markets larger than they would have been with proper risk measurement and disclosure.

A number of observers have criticized investors for being so dependent of rating agencies. Aside from regulatory requirements that mean many investors need to consider rating in their evaluation process, Einhorn gives us another reason: at least as far as structured credits were concerned, the rating agencies had far better information about the deal than end investors:

Have the rating agencies developed an expertise in analyzing these structures? Perhaps, but more pertinent, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. The underwriters give the rating agencies much more information that is contained in the prospectus. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to other market participants. This is kind of like a confessional where the priest delivers a public opinion on the extent of your virtues or sins – and your spouse has to guess what a AAA or BBB means about your fidelity.

In the recent crisis, the rating agencies say they shouldn’t be held accountable for their opinions because they are…..nothing more than journalists engaged in free speech. What would it be called if you paid a leading publication to do a story on you and you could putt it before press if it were unflattering? Funny, that is not free speech but “for-profit speech.” According to the rating agency party line, if people disagree, they are free to ignore the ratings. However, a credit rating is not an ordinary opinion. It is a “special” opinion – an insider opinion, because it is based on a different information set. I can’t replicate a rating analysis because I am not privy to the information. Therefore, I am not on an equal footing to be able to decide whether I agree or disagree with a rating agency. Since they know more than I do, the presumption has to be to agree. The rating agencies are structurally set up to have “insider opinions.” They just don’t want legal liability for having issued conflicted and flawed insider opinions.

Incidentally, this lack of information has made it harder for the market to find a clearing price of distressed pieces of structured deals. Without enough information in the market – other than a credit rating – it is hard for informed buyers and sellers to know what to do, once the credit rating comes into doubt.

There is not justification in the credit markets for having the rating agencies have access to deal structure information that is kept secret from investors. The only party that appears to benefit is the investment banks, who might have some structuring tricks they’d like to keep secret from their competitors. By contrast, there is an argument for rating agencies and analysts having access to corporate information of a strategic nature that they would be loath to reveal publicly. But equity analysts lost their Reg FD exemption and the world did not fall apart. There is far less justification for a Reg FD exemption of any kind in the debt business. Einhorn argues that the information that rating agencies possess should be made public.

A final tidbit from Einhorn:

In early September, a senior Moody’s executive….at a small private dinner….said, “Moody’s would never lower the credit ratings of a financial guarantor, because that would put the guarantors out of business.”

Live Tiger found in check-in baggage Traffic

Van-mounted body scanners coming to a street near you? Raw Story (hat tip reader John D). So this is where your tax dollars are going….

Beck rally will be a measure of ‘tea party’ strength Washington Post (hat tip reader Skippy):

Beck, who is both admired and assailed for his faith-based patriotism and his brash criticism of President Obama, plans in part to celebrate Martin Luther King Jr. as an American hero. He will speak on the anniversary of the “I Have a Dream” speech, from the spot where King delivered it.

Tea Party Rocks Primaries Matt Taibbi, Rolling Stone (hat tip reader Frank A). You need to read this.

Dodd vs. Warren shows that government is broken Andrew Leonard, Salon

Japan’s Consumer Prices Slide, Adding to Risk of Slower Growth Bloomberg

Despite recovery, the credit crunch actually gets worse Eurointelligence

An Autopsy of Fannie Mae and Freddie Mac Economix (hat tip Mark Thoma)

Fiscal Austerity and “Third World America” Simon Johnson

David Dayen’s Portrait of HAMP Failures Mike Konczal

Calls for radical rethink of derivatives body Gillian Tett, Financial Times. A generally fine piece, except she calls on ISDA to become a genuine trade body….when we only know how to do lobbying organizations masquerading as trade groups here in the US.

This Is Not a Recovery Paul Krugman, New York Times

Antidote du jour:

In case you’ve managed not to notice, the old saw, “the best government money can buy” increasingly applies to our legal system. In ECONNED, I describe briefly how a well funded “law and economics” movement which had corporate backing, including from the extreme right wing that was systematically trying to move America to the right, sought to incorporate ideas from neoclassical economics into the practice of law. It was seen as “off the wall” at the time, but has proven depressingly effective.

A more obvious effort is simply to get judges in place that will deliver the verdicts you want. A Mother Jones article, “Permission to Encroach the Bench,” (hat tip reader Francois T) discusses how already big ticket battles over state supreme court seats are likely to rocket to a new level of priciness:

For a down-ballot category that even well-intentioned voters pay little attention to, judicial races are astonishingly expensive. In 2004, $9.3 million was spent in the race for a single seat (pdf) on the Illinois Supreme Court. That’s higher than the price tag of more than half the US Senate races in the nation that year. In 2006, three candidates for chief justice in Alabama raised $8.2 million combined.

But those sums could look paltry compared to the spending likely to be unleashed in the wake of the Supreme Court’s Citizens United ruling. In all, 39 states elect judges—and with the stakes including everything from major class actions to zoning and contract cases to consumer protection, workplace, and environmental issues, corporations have always taken a major interest in those races. The US Chamber of Commerce, Forbes reported in 2003, has devoted at least $100 million to electing judges sympathetic to its agenda. “No organization has had more success in the past 10 years of judicial elections,” says James Sample, a professor at Hofstra University who studies judicial reform issues. “Its winning percentage would be the envy of any sports franchise.” Citizens United has essentially wiped out not just federal restrictions on campaign spending, but many state-level regulations as well, Sample notes, and that’s “going to increase the ability of corporations, and to a much lesser extent unions, to engage in electioneering that is basically aimed at winning particular cases.” And given the low profile of these races, it may not take that much to sway that outcome, notes Bert Brandenburg, executive director of the advocacy group Justice at Stake. “A judicial election is a better investment for anyone spending money” than, say, a congressional campaign.

Note the reference to Alabama, a state I know a wee bit about, and my local sources say the Mother Jones figures are greatly understated, and attorneys in the state who’ve turned over a few rocks put the price tag for a state supreme court seat at $12 million. I’ve had a quick look at a Supreme Court justice’s house. It is in an implausibly costly district for his income (and no, there’s no heiress wife to explain the discrepancy).

Why is Alabama such a valuable state to control? It used to be a favorite venue for class action lawyers, since juries often handed out multi-million-dollar awards. Getting business-friendly jurists in place at the highest court has meant that any verdict, no matter how egregious and damaging the violations, is cut to $1 million.

And the degree of banana republic behavior is reaching new levels. Consider: a once prominent corporate firm has been reduced to becoming primarily a foreclosure mill. However, because longevity counts in the South, and many of the firm’s senior partners still dine with judges, it has clout well in excess of its fallen standing.

On a case which is now being tried, this fading firm (we’ll call it Billem) has managed to get the case (which is being heard only by a judge) moved from the court before a decision has been rendered to a sympathetic appeal court judge. In addition, Billem is appending four other cases which that have already been decided and are past the time frame for appeal (in Alabama, you have 43 days in which to file an appeal). The rationale is that these cases present similar issues, but that still has the effect of reopening cases which under existing law are settled. For lay reader, if you miss the deadline for appeal, you can’t appeal…..except in when the right people in Alabama want it to occur.

So this isn’t merely having judges who will provide the opinions big business wants. We now have a court running roughshod over basic elements of procedure. The last bastion of defense of the individual is being gutted, to the point where even the forms of the law will be ignored if that’s what it takes to produce the outcome the big money interests need.

And to remind us why that puts us all at risk, consider this defense of the reason of the law from Roger Bolt’s screenplay about Thomas More, A Man for All Seasons:

More: Yes. What would you do? Cut a great road through the law to get at the Devil?

Roper: I`d cut down every law in England to do that.

More: Oh! (advances on Roper) And when the last law was down, and the Devil turned round on you –where would you hide, Roper, the laws all being flat? (He leaves him) This country’s planted thick with laws –man’s laws, not God’s –and if you cut them down –and you’re just the man to do it –d`you really think you could stand upright in the winds that would blow then? (Quietly) Yes, I`d give the Devil benefit of law, for my own safety`s sake.

The Jackson Hole conference starting today is expected to include a talk by Ben Bernanke on the benefits and costs of further monetary easing, which in ZIRP-land means quantitative easing. Gavyn Davies put up a good short list of arguments made against QE at the Financial Times, and most do not look terribly persuasive. One which I found interesting was:

“QE will weaken the Fed’s balance sheet, and undermine confidence in the institution.” This was a very powerful argument in Japan in the 1990s, which reduced the amount of quantitative easing which the BoJ was willing to undertake. If the Fed simply buys Treasuries, it is hard to see how this weakens the balance sheet, unless you believe that the US government could default on its debt. However, if the Fed were to buy private sector assets, like securitised debt and/or equities, then it could subsequently have to take mark-downs on these assets, and many people would see this as a problem. But the Fed probably should not be treated like a private bank, which would suffer a loss of solvency if it suffers a mark-down on its assets. The Fed does not have to mark-to-market like a private bank. And, anyway, does it ultimately matter if the Fed has a negative net worth? The answer would be yes if it undermines the public’s faith in the institution, causing people to reduce their holdings of dollars, in exchange for goods, or foreign currencies. But this is just another way of saying that there is an inflation constraint on the Fed’s ability to increase QE, which everyone would accept. So the balance sheet argument only holds as a special case of the inflation argument.

I think Davies is missing a part of the dynamic here. The intensity of the battle over Bernanke’s reappointment and the partial victory for the Audit the Fed movement are tangible signs that the Fed’s aggressive action during the crisis has led to a hard pushback from Congress. Part of it may be deserved loss of faith in an organization that utterly failed to see the crisis coming and refused to exercise any control over banks; another may be that Congress recognizes full well that the Fed was acting as an extralegal, off-balance-sheet funding vehicle for the Treasury, meaning a route for circumventing normal budgetary processes. So if the Fed were to balloon its balance sheet to, say, $5 trillion, my sense is that there would be enough concern about the scale of Fed operations, particularly if the problem is a lingering economic malaise rather than a crisis, to produce concern in some quarters and lead to Congressional prodding (recall, by contrast, that the 2009 QE was implemented when banks still were on the ropes). So the fear of political action may also be playing into how the Fed views this issue.

The problem (which many economists and analysts will readily acknowledge) is that QE is being used as a stand in for fiscal policy, and it is a not so hot second best in an economy where firepower was already deployed to spare banks pain and prop up asset values. And in the US, stimulus was not well targeted, in addition to being half-hearted.

George Magnus of UBS, in Thursday’s Financial Times, made a lesser of two evils argument in favor of QE:

Better, if necessary, to print money and be damned, rather than tighten policy and be damned. Under the former, there is always redemption by withdrawing the stimulus if circumstances warrant. Under the latter, there is only chaos.

While I am not unsympathetic toward the case for QE, I think Davis made the most potent argument at the top of his post:

“Quantitative easing was tried in 2008/09, and it did not work.” True, the Fed expanded the size of its balance sheet by about $1.5 trillion dollars in a matter of a few weeks in 2008, so QE was certainly tried. We do not know what would have happened if this had not been done, but there seems a strong chance that the banking collapse would have been worse, and the economic recession much deeper, without QE. In that sense, the policy ”worked”, but the cure does not seem to have been permanent. It is hard to isolate the real reason for this. It may be because QE is an ineffective policy tool, or it may be because not enough of it has yet been done. Take your pick.

This is narrowly true, but misses the point. When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint).

And even more important, to the extent money costs matter, the relationship between price and activity is asymetrical. Too costly funding can kill a project. But cheap money (except for scamsters) is not going to make a businessman wake up and say, “Gee, my borrowing rate has fallen 2% in the last six months. I really should go out an open an new store.” He’ll do that ONLY if money being 2% higher was a binding constraint. The prospects for his business are always a first order consideration, the cost of money second order.

So the state of demand in his market is a major consideration, and for most businesses, that’s a function of the health of the overall economy. Most businesses see lousy conditions and surveys of small businesses (which employ over half the people in the US) show them expecting their businesses to face even more difficult conditions in a year. Various bank surveys similarly show weak demand for business loans.

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Einstein defined insanity as doing the same thing over and over again and expecting different results. And to me, the most compelling reason to be against QE is that policymakers will nevertheless hope it might be effective if used again. They will therefore refrain from trying more politically difficult, but more promising course, namely, restructuring debts and using government spending to cushion the impact, with a keen focus on measures that will restore competitiveness and reduce our trade deficit.

Dolphins ‘cough’ up DNA secrets BBC

India, the Rent-a-Womb Capital of the World Slate

Irish debt downgrade raises fears of international deflation spiral Independent

Ooh, they must be bored over at Clusterstock! Look at these stories (hat tip reader John D): 15% Of Women Have Slept With Their Bosses — And 37% Of Them Got Promoted For It (obvious bad risk/return tradeoff) and CEOs Who Wash Dishes Have Better Sex (sorry, when I read the headline, I expected even more tips in the story, like “CEOs Who Dress Up Like Nursemaids Have the Best Sex of All”).

Alan Simpson: Social Security Is Like a “Milk Cow with 310 Million Tits!” CBS

Tough calls after bungee jump recovery George Magnus, Financial Times

Peaches and local investing Lambert Strether

On Doomed Rig’s Last Day, a Change of Plan Wall Street Journal

The Plunge inJuly New Home Sales Was Not Due to the Expiration of the Tax Credit Dean Baker

Valuation ranges Deus Ex Macchiato

More thoughts on what to expect from the Fed Jim Hamilton, Econbrowser

Roubini Says Q3 Growth in U.S. to Be `Well Below’ 1% Bloomberg

“Inequality and the High-End Bush Tax Cuts” Mark Thoma

Lack of skilled workers threatens recovery: Manpower Reuters (hat tip reader John D). We’ve heard this meme before. Some of it seems to be legit, some of it is employers lowballing, and some of it is due to reduced geographic mobility thanks to the housing bust.

Covert Operations Jane Mayer, New Yorker. Today’s must read. A very well researched piece on the extraordinary influence of the Koch brothers, who since the 1970s have been working assiduously to promote their business interests, both narrowly and by systematically promoting a radical libertarian makeover of the US. Also discusses how the Kochs, who have major oil and coal businesses, have been the architects and funders of a many-headed effort to sow doubts about global warming.

Antidote du jour:

Normally, I don’t report on anecdotes from my immediate circle, but a set of conversations in less than a 24 hour period suggests that even those comparatively unaffected by the crisis are bracing themselves for the possibility of sudden, large-scale, adverse changes. And that sort of gnawing worry seems to be growing in New York despite being buoyed by TARP funds and covert bank subsidies.

When out on my rounds the day before yesterday, I ran into an old McKinsey colleague, who had subsequently had impressively titled jobs in Big Firms You Heard Of before semi-retiring to manage family money. He and his very accomplished wife were big Bush donors and had been invited to both inaugurations.

He made short order of niceties and got to the point: “We need more fiscal stimulus. Obama did too little and too much of what he spent on was liberal pork. We could and need to spend a lot on infrastructure. This is looking a lot like 1936. I’m afraid it could get really ugly. And I’m particularly worried that the Republicans will win big this fall. They’ll cut even deeper, that’s the last thing we need right now.”

No I am not making this up, and yes, this is one of the last people I would have expected to express this line of thinking.

Next day, I had lunch with a two long standing, keen observers and participants in the New York scene, as in very involved in some of the city’s important institutions. Both have witnessed the shift in values over the last thirty years and the rising stratification, particularly at the top end (New York has always been plutocratic, but it formerly had a large upper middle class and a much smaller and much less isolated upper crust).

They started by commenting on my Bill Gross post, which had mentioned the appalling Steve Schwarzman contention that taxing private equity overlords more on their carried interest was like HItler invading Poland. Schwarzman is not only not retreating from his remark, he is convinced that the reason the economy is so lousy is that rich men like him are not getting their way (this is if anything an understatement of their account. Both men expect his head to be the first on a pike).

The conversation turned to whether the US was going towards revolution or fascism. One argued for the a continuation of trends underway: that the continuing weakness of the Obama Administration (and the discrediting of other members of the elite) meant there was a power vacuum. The obvious group to exploit it is the most strident, uncompromising opportunists, an area where the extreme right has a monopoly. The other, who has ben reading up on the French Revolutions. took issue with the conventional idea that a revolution is impossible in America: “In France, the trigger was that people were hungry. We are close to that point than most think.” He stressed the desensitization to violence (video games, more and more violence) plus widespread gun ownership. And he pointed to rising and underreported crime in the city, for instance, assaults of cab drivers.

He also noted that he believed that there were a lot of people (and he meant in the upper income strata) who were barely holding on, keeping up appearances, and hoping something would break their way. Some might get lucky, but most will hit the wall financially.

This was an engaging and lively conversation, but it you stepped back, the content was grim. Another thread was the decay in values, that there has been two generations of parents not setting boundaries for their children. One lives next to one of the elite private schools and likes children, but called those in his ‘hood as “monsters,” describing how a boy was beating up on his nanny and he had to intercede.

These data points don’t converge neatly, but they suggest a deep-rooted anxiety that economic and social structures are near a breaking point, and whatever comes next is not likely to be pretty.

The very minute the Paul Volcker, who proposed the sound idea that government backstopped banks not engage in proprietary trading, said that trades done on behalf of customers were meant to be excluded from this proposal, anyone familiar with trading could see he’d just deep sixed his idea.

Proprietary trading existed LONG before banks decided to create separate “prop” desks to speculate with house money. And even in the era of prop desks, in the vast majority of cases when a prop trader puts on or exits a trade, who is the end buyer? A customer.

So the measure of whether a bank is making bets in its customer dealing book isn’t the composition of its counterparties, it’s how much in the way of bets it winds up carrying (traders, just like rug merchants, can shade the prices they buy and sell at to keep from accumulating too much inventory). It would have ben possible for regulators to devise rules, such as value at risk limits, requirements that dealers hedge or otherwise “flatten” their positions beyond a certain size level within a specified time period. Even with provisions like that in place, some desks will be exposed when markets turn chaotic, but it should be far fewer, with much less loss exposure.

Instead, as the New York Times recounts, life in big bank land continues more or less as it did before, including large losses when traders make bad bets:

But for all the talk of shutting down trading desks and reassigning employees to prepare for the Volcker Rule, proprietary-style trading will probably survive, if under a different name.

This year, for example, several large insurance companies approached Goldman Sachs, looking to bet that the markets would not stay quiet. Goldman gladly took the other side of the trades, but when the markets turned choppy in May, the firm was caught short and quickly lost $250 million.

Goldman, through a spokesman, declined to comment on its losses on that investment. But in a conference call with analysts last month, the bank’s chief financial officer, David Viniar, explained: “We didn’t hedge it fast enough. Things spiked really dramatically, really fast.”

Months before that trade, though, Goldman Sachs’s research department named a bet against volatility as one its top 10 trading strategies for 2010. Goldman followed its own advice and put its own money in play by failing to adequately hedge the trade with the client who wanted to bet on volatility, which would have given Goldman a neutral position. In this way, a client-oriented trade can effectively become a proprietary bet…..

“Goldman tends to have businesses that have a customer focus with a proprietary overlay,” said one hedge fund manager and Goldman alumnus who insisted on anonymity. “That overlay can effectively allow them to make directional bets by using the customer flow to get them there.”

But Goldman is hardly unique when it comes to walking the fine line between serving clients and taking positions.

Late last year, with clients eager to bet that coal prices would rise, JPMorgan took the other side of the trade and amassed contracts on hundreds of millions of dollars on coal — enough to dominate the European market.

Initially the trade went JPMorgan’s way and yielded profits, but in April the Morgan traders were caught off guard when European coal futures abruptly started rising. In fact, the wrong-sided bets erased all of the previous gains, and by the middle of June, it had turned into one of the commodities unit’s biggest losses — nearly $130 million.