Media Rorschach Test: Divergent Readings on the Saudis' Wee Production Increase

The interpretations of the implications of the Riyadh-Washington pas de deux over oil production increases were surprisingly disparate, a seeming Rorschach test of sentiment about the US, Bush, and the Middle East.

The papers that see themselves as US opinion leaders, namely the New York Times and the Wall Street Journal, stressed how little the White House had secured. Was this mismanagment of expectations by Team Bush, undue hope on the part of the public at large, or simply a reflection of prevailing distaste with the lame duck president?

No matter how you look at this, there is less here than meets the eye. 300,000 barrels won't have much impact on oil prices; the most important issue for Bush is that he be seen to be Doing Something. Unfortunately for him, Goldman's bullish forecasts have sway; the announcement by the kingdom took only a bit more than a buck off the per-barrel price.

Yet foreign and even some domestic outlets noted a concession had been made. From the Financial Times, in "Saudis to boost oil output after US pressure":

Saudi Arabia said on Friday that it was increasing its oil production to its highest level in two years, bowing to intense US pressure after the price surged to a fresh record of almost $128 a barrel.

The announcement of a boost to output by about 300,000 barrels a day came after a plea by George W. Bush, US president, to King Abdullah of Saudi Arabia in Riyadh....

Saudi Arabia said on Friday that it was increasing its oil production to its highest level in two years, bowing to intense US pressure after the price surged to a fresh record of almost $128 a barrel.

The announcement of a boost to output by about 300,000 barrels a day came after a plea by George W. Bush, US president, to King Abdullah of Saudi Arabia in Riyadh.

The Saudis did engage in a wee bit of revenge:

However, Riyadh pointedly waited until Mr Bush had left the meeting before it made the announcement – leaving US officials in the embarrassing position of having already briefed reporters not to expect any movement from the Saudis.

Bloomberg reached broadly similar conclusions, citing industry sources:

``It's just a token increase but it shows that the Saudis realize just how important it is for the president to not come back empty handed,'' said Peter Beutel, president of Cameron Hanover Inc. in New Canaan, Connecticut. ``This is about a lot more than oil. The special relationship between the countries is at stake.''....

In another sign of cooperation, Saudi Aramco, the kingdom's state-run oil company, and U.S.-based ConocoPhillips said they will build and own a 400,000 barrel-a-day refinery in Yanbu on the Saudi Red Sea Coast, to be completed by 2013.

The Telegraph argued that the production increase was not granted to Bush (the Saudis said they made the decision May 10, allegedly to accommodate customers, primarily in the US); the Times of London gave a mixed reading, stressing that the Saudis would pump more only if demand warranted it.

By contrast, the US coverage was decidedly unkind. From the Journal:

The Saudi king rebuffed President Bush's request for higher oil production, in the latest sign of how U.S. leaders are struggling to combat soaring energy costs that have become a major election-year issue...

The Saudis' cool response Friday to the volley of American pleas and threats underscores that the U.S., which relies on imports for about 60% of its 20-million-barrel-a-day oil habit, has no near-term prospect of managing prices down. But even as the administration pressed its request for more Saudi supplies, U.S. officials conceded the current level of Saudi production isn't the prime factor driving today's oil spike.

And the Times:

Mr. Bush’s visit here was, in many respects, a reprise of a trip he made to the king’s ranch in January, when he asked for an increase in production and was rebuffed publicly by the oil minister and privately by the king. This time, the Saudis again resisted Mr. Bush, while offering at least the appearance of a concession.

Yet for the most part, there was perilous discussion of the underlying difficulties (for instance, the Journal made it sound as if the differences were rooted in conflicting interests regarding petroleum). The Times in passing acknowledged political tensions:

Mr. Hadley told reporters recently that “the Iraq war was a stress” on the relationship. Jon Alterman, a Mideast expert at the Center for Strategic and International Studies, said Saudi confidence in the United States has been “extremely shaken,” over the war as well as what Saudis perceive as Mr. Bush’s lackluster effort on behalf of the rights of Palestinians.

“They’ll be polite,” Mr. Alterman said, “but they’re not really going to put themselves out to help this president.”

Remarkably, it took the Guardian to point out the move that almost guaranteed a cool reception from the Arab kingdom: Bush came straight from celebrations of the 60th birthday celebrations of Israel's independence. If I were the Saudis, I would have told him to come at a more suitable time. The symbolism couldn't have been worse. From the Guardian:

Bush's speech in the Knesset on Thursday lavished praise on Israel and excoriated its enemies - Hamas, Hizbullah in Lebanon, as well as Iran and Syria. But he barely mentioned the Palestinians, who were that same day marking the "nakba" (catastrophe) they suffered as the Jewish state won its independence in May 1948.

It will have confirmed many Arabs in their conviction that the US is irredeemably biased in favour of Israel.

And there was a collective failure to mention another possible strategem of the wily Saudis posited by Lehman: if they can increase production after the US election, they will to gain greater influence. From Shariah Finance Watch:

A key assumption, however, is that the Saudis will increase production after the election to curry favor with the new president and try to influence policy in the Middle East. While Saudi Arabia guards its oil production and reserves as state secrets, the nation has recently announced three long-awaited oilfields have begun production. Lehman estimates those will add 1.3 million barrels a day of capacity, compared with expected global demand growth of 900,000 barrels a day.

If the Saudis open the spigots, in other words, crude prices would drop, just in time for the desert nation to gain influence over whoever takes residence in the White House.

Far-fetched?

“There’s a history of output increases, not exactly coinciding with the election but a few months afterwards,” says [Lehman analyst James] Crandell.

What Has Happened to Gillian Tett?

A year ago, I found Gillian Tett, then the Financial Times' capital markets editor, to be the single most useful financial reporter by a considerable margin. She gave insights into areas that were important but badly neglected elsewhere, such as CDOs, credit default swaps, SIVs, all well before they entered the mainstream lexicon.

She was promoted. While she may add value behind the scenes, her stories this year are a shadow of her former work. And that's being polite.

Consider her offering du jour, "How talking can help cut the risk of a lemming fall." Here's the set-up:

Imagine for a moment that you are a banker, who stumbles across a juicy new instrument called the "lemming" product that your sales team could sell to retail clients - for a fat profit......even though it has been rubber-stamped by your compliance department....investors will suffer big losses if stock markets fall more than 30 per cent.

....over 70 per cent of the audience [in a Securities and Investments Institute conference] voted to block the lemming deal in an anonymous poll, taken after the participants had discussed the issue with neighbours.

But then the organisers presented a chart which highlighted a more sobering point: when the SII has done these tests before, it has typically found that the proportion of bankers who block risky trades falls dramatically when participants do not discuss the issue with their neighbour first - even if they vote anonymously.

Tett uses this example to conclude that what investment banks need isn't better incentives, but (to use that horrid American term) more dialoguing:

....bankers should be forced to talk about their business with a wide pool of colleagues, including those outside their immediate silo, rather than just their bosses alone.

Rubbish. A conference is such an artificial setting that to generalize its findings to the day-to-day operations of a company is fantasy. People want to look good before their peers, and in a weird bit of self-deception, once someone takes a position publicly, they typically find it difficult to recant privately. And here, the tradeoff has been framed in uncharacteristically black and white terms: big profits versus big downside to clients in relatively low-odds situations. Would the response had been different if the question has included: "the odds of the market falling 30% in the next X year is Y"? Yes. Survey results are HIGHLY influenced by the wording of the question. So just imagine how susceptible real world situations are to subtle and shifting pressures.

Take the lemming. The response of a manager/department head in the real world no doubt will also be shaped by:

How tough standard disclosure language would be

What leadership in the lemming might do for league table rankings

How close your team is to being on track for its targets for the year

Whether your boss is satisfied with you these days

Whether your firm has had a major compliance/litigation problem in the last two years

Whether you sell to retail clients directly (ie, you own them) or primarily via other firms' salesforces

Whether other firms are selling lemmings actively. This is probably the biggest single consideration. There is far less perceived risk if others are already in the pool

Tett also argues that Goldman, an example of better practice, engages in just this sort of debate:

Institutions such as Goldman Sachs, for example, try to ensure that different business silos have ways of watching what each other does. They also invest heavily in creating a holistic risk management culture: Goldman Sachs' risk systems, for example, are run by Gerry Corrigan, the former New York Federal Reserve president, who makes a virtue out of sticking his nose into as many dark corners as possible - and trying to encourage companywide debate.

Tett has the causality backwards. Goldman still carries the legacy (now weakened since it went public and is dominated by the trading side) of being extraordinarily risk averse and image conscious. The firm when it was a partnership went to unusual lengths to make sure that even very junior staff understood the finer points of legal and practical liability. This was pragmatism; the partners regarded it as a cheap form of insurance.

The firm in the 1980s was also cautious about delegating decision-making authority to client facing staff that other firms delegated routinely (such as not letting investment bankers quote indicative prices for financings) and about putting capital at risk (it was late to book interest rate swaps). When its practices became visibly uncompetitive, it generally came up with a solution, or at least a finesse. Goldman is an inwardly-focused firm that takes few mid-career hires, so its culture is reasonably intact. The structure is a product of the culture, not vice versa.

Something this misleading from a formerly keen observer is surprising and disheartening. She needs to get back out and mix it up with her source more often.

Media, Congress Waking Up to Freddie and Fannie Default Risk

It's amazing how a problem isn't a problem until it's presented as one on television or a respected print outlet. Never mind the fact that the cognoscenti have been worried about the possibility that the two big mortgage guarantors, Fannie Mae and Freddie Mac, were too thinly capitalized relative to their massive balance sheets. Never mind that well respected economists have told the Fed it should be worried to its face, as James Hamilton did at the Jackson Hole conference last August. Never mind that Fannie and Freddie spreads rose sharply at the end of January, the market's protest against Congressional plans to make the two government sponsored enterprises the rescuer of stressed homeowners, and led to creative footwork by the Fed to combat the caution toward Fannie and Freddie's offerings (namely, the TSLF).

On the one hand, it's high time that the great unwashed public is finally being told that the GSEs might be a wee bit precarious, and expanding their balance sheets too far could set in motion a very nasty chain reaction.

But on the other, there is still a failure to grasp certain not so pretty realities. The first is that there are certain things that America cannot have, that are simply beyond our reach. We cannot prop up a $20 trillion housing market. It's simply too big. No one seems willing to fess up to that, and (even if you accept that a salvage operation is desirable) that choices will have to be made among who is spared and who isn't. A lot of the proposals implicitly engage in triage, or at least set priorities, but the PR (for the most part) is that these measures can and will save homeowners on a mass basis. That just isn't happening.

A second problem is that this "save the homeowner" talk runs the risk of digging us into a deeper hole. The US already has one of the most, if not the most, heavily subsidized housing markets in the world. Now the midst of a crisis is probably not exactly the best time to rein in the support programs. However, the public is being done a great disservice in not being told how our policies have led so much of US investment to go into housing, a sector that does not help US competitiveness. Even if it is unrealistic to remove the props anytime soon, how much we are subsidizing housing and whether it produces social benefits that it is alleged to ought to be discussed rather than assumed. (Oh, but wait, I've just recommended a full employment act for lobbyists and PR agencies representing homebuilders, banks, and brokers. Ain't democracy in America grand?)

Today in the New York Times is a good piece, "Doubts Raised on Big Backers of Mortgages," which put the finances of Fannie and Freddie in the spotlight.

It's when I read statements like this from otherwise intelligent people (and yes, Barney Frank is intelligent) that I get worried:

“I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess,” said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. “Otherwise, why should they exist?”

Um, my understanding is that the FHA, and not Fannie and Freddie, was designed to help low income families secure housing. Indeed, the reason we got in this mess was that the private sector decided to improve on FHA loans by making them more user friendly, ie, by dispensing with nuisance items like making the borrower he was good for the payments. And it isn't obvious to me why Freddie and Fannie should be made to take on risky mortgages to save bail out hapless investors and foolhardy creditors.

If you must go the intervention route, I'd first prefer figuring out how to get/induce/force servicers to do more mods (see next post for more discussion), second the Dean Baker's "own to rent" proposal, or lastly, using a new entity (Alan Blinder proposed a revival of the 1930s Home Owners Loan Corporation) to avoid tainting Fannie's and Freddie's paper and make the cost and scale of the operation explicit.

Other key bits from the New York Time article:

And as Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.

But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion — the capital that their regulator requires them to hold — underpins a colossal $5 trillion in debt and other financial commitments....

The companies are sitting on as much as $19 billion in additional losses that they have not yet fully acknowledged, analysts say. If either company stumbled, the mortgage business could lose its only lubricant, potentially causing the housing market to plummet and the credit markets to freeze up completely.

And if Fannie or Freddie fail, taxpayers would probably have to bail them out at a staggering cost....

Bush administration officials, the Federal Reserve and lawmakers all believe that the companies’ financial safety cushion is far too thin and have pleaded with them to raise more capital from investors.

Freddie and Fannie, which are enjoying new growth and profits, have largely resisted those pleas, people briefed on the talks say, because selling new shares could dilute the holdings of existing shareholders and drive down their stock prices. Though executives have promised to raise money this year, they refuse to specify how much and when.

Let me interject. That ugly little problem, of management refusing to issue more stock and rushing out eagerly to book new business, is pouring gas on a fire. It's also clear evidence that this quasi-public structure is untenable. The GSEs are clearly to big to fail, and need to be nationalized ASAP.

However, the article notes that the only plan to forestall the likely socialization of risk is to criticize Fannie and Freddie. No joke. Indeed, this very article may be part of that plan.

Back to the Times:

....Though the companies’ main regulator, James B. Lockhart III, director of the Office of Federal Housing Enterprise Oversight, has voiced strong confidence in the companies, a high-ranking member of his staff said some officials had begun considering the worst.

“It’s not irrational to be thinking about a bailout,” said that person, who requested anonymity, fearing dismissal....

But now that the government depends on Fannie and Freddie to keep markets humming, the companies are making demands of their own — namely, repealing some of the limits created after the scandals and even some established by law.

Last year, in return for buying billions of dollars of subprime mortgages to help stabilize the market, executives won the right to expand their investment portfolios. In March, the companies agreed to raise more capital within the year. In exchange, they received an additional $200 billion in purchasing power.

Last month, the companies promised to pump money into the more expensive reaches of the housing market. In return, Congress temporarily raised the cap on the size of the mortgages they can buy to almost $730,000 from $417,000...

Each time Congress or regulators have given the companies new room for growth, their stock prices have risen. But so far the companies have balked at raising more capital....

As worrisome as the need for new capital, some analysts say, are the companies’ books.

A report released earlier this month by Mr. Lockhart, the regulator, noted that although Freddie and Fannie had a combined $19.9 billion of “unrealized losses” on mortgage-related investments, neither company had reduced its earnings to reflect those declines. That is because they judged the losses to be temporary — in essence wagering that the mortgage market would recover before those assets were sold. Such a wager is permitted by the rules but difficult for outsiders to analyze.

If the monolines can take that position, why not the GSEs? And of course, banks and securities firms have their Level 3 assets. Back to the Times:

....Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss.

Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure. But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.

A version of those events began in November, when Freddie Mac’s capital fell below congressionally mandated levels. The company stemmed the decline by selling $6 billion in preferred stock. But it might not manage that again if there is another unexpected loss, analysts say.

Quelle Surprise! National Association of Realtors Says Many Housing Markets Doing Well

A MarketWatch story "Home prices aren't tanking everywhere," has the all the earmarks of being a National Association of Realtors plant. Note that it's even told from the perspective of supposedly well-meaning (as opposed to commission-motivated) brokers trying to educate clients that the press is wrong, things really aren't that bad.

Here's the gist of its bullish message:

The housing problems largely aren't national but regional in nature, said Susan Wachter, a real estate professor at the University of Pennsylvania's Wharton School.

"The interesting thing is that there are parts of the country where housing prices are doing fine, thank you," she said. In fact, only five states are in what she would consider a housing recession: California, Arizona, Nevada, Florida and Michigan.

In the fourth quarter of 2007, 73 out of 150 metropolitan areas showed an increase in the median existing single-family home price compared with the same quarter in 2006, according to statistics from the national Realtors group.

Now why is that factoid, that average prices are rising, utterly misleading? Well, consider the nature of the crisis we are in. A lot of people overextended themselves (per Tanta's "We are all subprime now") but it's the most marginal borrowers that have been hit the hardest. And in most cases, they aren't buying the biggest ticket houses.

So if you have a lot of low priced sales disappear, the average price goes up, even if average prices among the more costly houses falls.

Further confirmation that the article is hogwash: the average price figure was the ONLY metric cited to support the assertion that housing is doing just fine in a lot of markets. You'd expect them to be able to marshal other indicators of market strength, such as declining inventories or shrinking average time on the market. But those indicators were notably absent.

Now that isn't to say that there aren't pockets of strength in the US. No doubt there are, most likely due to local incomes holding up well and a lack of overbuilding. But to imply that nearly half the markets in the US are doing better than last year is patently ridiculous. Housing, even in markets that did not run up like the boom areas, still rose to levels considerably out of line with incomes and rental prices. A reversion is inevitable.

And some of the areas the article highlights as being strong are not terribly populous states:

Utah -- where home prices rose 9.27% in the fourth quarter of 2007 compared with the fourth quarter of 2006 -- was the state with the highest appreciation rate, according to the Office of Federal Housing Enterprise Oversight. Utah was followed by Wyoming, where prices rose 8.27% over the year, North Dakota, where prices rose 7.87%, and Montana, where prices rose 6.90%.

And for the one market I can verify directly, Manhattan, the article is utter rubbish:

Manhattan, however, tends to be a real-estate juggernaut all its own.

The average price of a Manhattan apartment was up 47% in the first quarter, compared with the first quarter of 2007, according to Brown Harris Stevens, a provider of real-estate services in the area. The boost was largely due to an increase in high-end sales that occurred at two luxury condo developments.

But the median price of a Manhattan apartment, which is less impacted by high-end activity, also rose 13% over the year, according to the firm.

One driver of the market: A rising demand for three- and four-bedroom units in Manhattan, said Jim Gricar, executive vice president of Brown Harris Stevens. More families are opting to live in the city as opposed to seeking larger homes in the suburbs, as was common in the 1980s and early 1990s, he said.

One of those "two luxury condo developments" was guaranteed to be the Plaza, which is a special situation.

For at least the last two months, if not longer, the Sunday New York Times real estate section has said loud and clear that the market is softening. And given brokers' propensity to always say now is the time to buy, the fact that they are 'fessing up that things are bad says they are REALLY bad. I see many blocks with more than one townhouse for sale, a clear sign of stress at the top end (townhouses became popular as more families wanted to stay in the city, particularly among the Wall Street set that would be quite affluent by anyone's standards save that of the highly restrictive boards of tony Park and Fifth Avenue co-operatives).

I simply went to the most recent Sunday section and found this example, "Take My Condo, Please":

They've offered buyers swimming pools, stretch limousines, movie theaters and automated parking garages. Lately, they’re even covering closing costs.

But the condominium developers at “Luxury Living” in SoHo, a recent sales event sponsored by The New York Observer that combined elements of a trade show and a Tupperware party, used a cheaper and lower-tech gimmick to hawk their products: candy.

Safety-orange M&M’s filled a glass bowl at the booth for 45 John in the financial district. Gumballs, in rainbow hues, sat ready to be dispensed for 80 Metropolitan, in Williamsburg, Brooklyn. Not to be outdone, the Harrison on the Upper West Side offered both a dish of foil-wrapped bonbons and a masseuse, who sympathetically kneaded stressed-out backs.

Brokers, perhaps mindful of first-quarter reports showing that sales volumes have slipped, lined up for back rubs.

“I needed this because I just started my job,” said Tony DiPietro, 39, of University Heights in the Bronx, who has been a sales agent for Mara & Company for one month. “But even if the market’s turning, people will always be looking for housing.”

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.”

Paulson's Cosmetic, Cynical Financial Regulation "Reform"

Why is it that the media feels compelled to take pronouncements from government officials more or less at face value? By now, they ought to know that if someone from the Bush Administration is moving his lips, odds are it's a lie.

Today's object lesson is the so-called financial services regulatory reform plan announced by Treasury Secretary Hank Paulson. Both the Journal and Times treat his proposals as significant. Their headlines, respectively: "Sweeping Changes in Paulson Plan," and "Treasury’s Plan Would Give Fed Wide New Power."

There is less here than meets the eye, and what is here is guaranteed not to be implemented during the remaining months of the Bush presidency. And that of course is precisely the point of this exercise. Appear to be doing something and dump the mess in the lap of your successor.

To the details. Remember where we are: we've had years of misguided confidence that investment banks could be left to their own devices, that the wonders of the originate-and-distribute model meant Things Were Different This Time. Specifically, the powers that be believed that risks were so widely spread and diversified that the financial system was now much more resistant to systemic shocks. We've seen what a crock that idea was.

So although no one has come up with a detailed reform plan, it's clear that the old model is badly tarnished. Since we have demonstrated that losses from investment banking risk-taking will be socialized, curbs need to be put on them. Otherwise, the very presence of a put to the government will guarantee untoward speculation and poor allocation of capital. In addition, continued taxpayer funded rescues of institutions with egregiously well-paid staff would eventually result in bankers' heads on pikes.

A number of ideas have been proposed: tougher capital requirements; restrictions on the use of off-balance sheet entities; driving more trading on to exchanges; limiting the risk-taking of institutions that are big enough to be systemically important (say allowing them to risk only a certain portion of capital in hard-to-value, volatile, or illiquid products); pro-cyclical capital charges; addressing poor incentives; improving transparency and disclosure.

But would any of the measures proposed by Paulson have prevented our crisis-in-motion? No.

What Paulson offered up instead what a plan for some consolidation of financial services industry regulatory oversight. This isn't useless; it would help prevent regulatory/supervisory arbitrage and allow for more consistent implementation of any new regulation. But to pretend that bureaucratic consolidation is tantamount to reform is dishonest. But the New York Times parrots the Administration's story line:

The proposal is part of a sweeping blueprint to overhaul the nation’s hodgepodge of financial regulatory agencies, which many experts say failed to recognize rampant excesses in mortgage lending until after they set off what is now the worst financial calamity in decades.

In reality, the biggest single culprit was a lack of willingness of major regulators, in particular the Fed, to intervene in a securitization process that, as long as it beefed up housing prices, was seen to be virtuous. A secondary factor was that the Federal government, largely through favorable court rulings, has for the most part stripped states of the power to regulate financial services firms. Yet many states have been far more aggressively pro-consumer than the Feds; usury laws, now gutted, existed only at the state level, as did the tougher versions of predatory lending laws. Ironically, had the states been more in the driver's seat (which is a less rather than more consolidated regulatory approach), the mortgage crisis might have been severely blunted (it might not have been attractive to design and market the more aggressive subprime products if they would have been permissible only in certain states). But the Federal government has long had a regulatory bias that favors industry profits over consumer protection.

Yes, as we'll detail, Paulson did add a couple of bells and whistles that were a slight nod to the need to reform. But some had already been served up (and we had deemed them wanting); one is severely misguided.

To the guts of the Paulson program. From the Journal:

Mr. Paulson's plan will include merging some agencies, such as the Securities and Exchange Commission with the Commodity Futures Trading Commission, while broadening the authority of others, such as the Federal Reserve, which appears to be a winner under the proposal. Mr. Paulson is expected to recommend that the central bank play a greater role as a "market stability regulator," with broader authority over all financial market participants.

Mr. Paulson is also expected to call for the Office of Thrift Supervision, which regulates federal thrifts, to be phased out within two years and merged with the Office of the Comptroller of the Currency, which regulates national banks. One reason is that there is very little difference these days between federal thrifts and national banks.....

In addition to some of the short- and medium-term changes, Treasury officials have also designed what they believe to be an "optimal structure" of financial oversight. It would create a single class for federally insured banks and thrifts, rather than the multiple versions that now exist. It would also create a single class of federally regulated insurance companies and a federal financial-services provider for other types of financial institutions.

A market stability regulator, which would likely be the Fed, would have broad powers over all three types of companies. A new regulator, called the Prudential Financial Regulatory Agency, would oversee the financial regulation of the insurance and federally insured banks. Another regulator, the Business Regulatory Agency, would oversee business conduct at all the companies.

Note also that the SEC would be merged with the Commodity Futures Trading Commission.

"Market stability regulator" is a dangerous bit of Newspeak. This is code for the fact that the Fed's role as chief bailout agency will be formalized. And when Japanese regulators there spoke about promoting market stability, that meant protecting industry incumbents, usually by somehow limiting competition and therefore improving profits.

And this program sounds as if it is replacing a hodgepodge now fractured by type of institution (thrifts vs. national banks vs. securities firms) with a smaller number of regulators that will be fragmented functionally. The idea of the Business Regulatory Agency is utter hogwash. How do you oversee business conduct separate and apart from supervisor audits? This agency is bound to be toothless, which is probably the point. And if I read this correctly, we will have the new Prudential Financial Regulatory Agency and the Fed (n the cases of banks with significant trading operations)regulating the same institution, which can lead to either overlapping mandates (which generates conflicts) or supervisory gaps.

Now to the elements that involve some bona fide regulation. Again from the Journal:

A key part of the blueprint is aimed at fixing lapses in mortgage oversight. Mr. Paulson plans to call for the creation of a new entity, called the Mortgage Origination Commission, according to an outline of the Treasury Department's plan, which was first reported by the New York Times. This new entity would create licensing standards for state mortgage companies. This commission, which would include representatives from the Fed and other agencies, would scrutinize the way states oversee mortgage origination.

Also related to mortgages, Mr. Paulson is expected to call for federal laws to be "clarified and enhanced," resolving any jurisdictional issues that exist between state or federal supervisors. Many of the problems in the housing market stemmed from loans offered by state-licensed companies. Federal regulators, too, were slow to create safeguards that could have banned some of these practices.

We had noted before that the merit of mortgage licensing idea depended not on the licensing standards itself (do you really think making brokers take courses and sit an exam is going to lead to better behavior?) but on the standards for conduct, monitoring procedures, and enforcement. Paulson hasn't mentioned any of those. Similarly, it isn't clear how deeply the federal authoriites can get into interfering with, um, overseeing the states on mortgage origination. Since deeds are recorded locally, and contracts are a state law matter, Washington's influence may be limited.

In keeping with notion that the Fed is underwriting the financial system, the Paulson plan gives lip service to the idea the the central bank should have enhanced regulatory powers. However, the proposals are remarkably vague. From the executive summary:

First, the current temporary liquidity provisioning process during those rare circumstances when market stability is threatened should be enhanced to ensure that: the process is calibrated and transparent; appropriate conditions are attached to lending; and information flows to the Federal Reserve through on-site examination or other means as determined by the Federal Reserve are adequate. Key to this information flow is a focus on liquidity and funding issues. Second, the PWG should consider broader regulatory issues associated with providing discount window access to non-depository institutions.

This says the Fed should be able to send inspectors into an institution once it has started propping it up. That is tantamount to shutting the barn gate after the horse is in the next county. The Fed should be supervising any institution that it might have to bail out, period. And the idea that the Fed can effectively examine an organization that it hasn't previously overseen is utter bullshit. Do you think the Fed has any ability to monitor Bear?

Despite its overly generous warm-up, the New York Times does point out the many shortcomings of this plan:

While the plan could expose Wall Street investment banks and hedge funds to greater scrutiny, it carefully avoids a call for tighter regulation.

The plan would not rein in practices that have been linked to the housing and mortgage crisis, like packaging risky subprime mortgages into securities carrying the highest ratings.

The plan would give the Fed some authority over Wall Street firms, but only when an investment bank’s practices threatened the entire financial system.

And the plan does not recommend tighter rules over the vast and largely unregulated markets for risk sharing and hedging, like credit default swaps, which are supposed to insure lenders against loss but became a speculative instrument themselves and gave many institutions a false sense of security.

Congress would have to approve almost every element of the proposal....Mr. Paulson’s proposal is likely to provoke bruising turf battles in Congress among agencies and rival industry groups that benefit from the current regulations.

And the real kicker:

The bulk of the proposal, however, was developed before soaring mortgage defaults set off a much broader credit crisis, and most of the proposals are geared to streamlining regulation.

In other words, this isn't even rearranging the deck chairs on the Titanic; it's keeping the ship on full throttle with a only slight change in course.

Bloomberg Pronounces Hope for Subprimes Based on Single Deal

An article by John Berry at Bloomberg, "Fed Actions Defuse Subprime ARM Rate Reset Bomb," is extraordinarily misleading, claiming that a Fed paper based on a single pool of MBS issued by New Century in 2006 shows that subprimes will work out much better than conventional wisdom says.

Let' s start with Berry:

Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level.

Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007.

The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level....

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much.

Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been....

A new report, ``Understanding the Securitization of Subprime Mortgage Credit,'' by economists Adam B. Ashcraft and Til Schuermann of the New York Federal Reserve Bank, published this month, provides a wealth of detail about subprime mortgages. Much of its information is based on a pool of such mortgage-backed securities issued by New Century Financial in June 2006.

All but 12 percent of the loans in the pool were ARMs, either the so-called 2/28 or 3/27 variety. That is, they carried a fixed-initial rate for two or three years, respectively, so the former will first reset in June.

The average initial rate for the loans was 8.64 percent, set when the six-month Libor was 5.31 percent, according to the report. It was a teaser rate in the sense that once resets began, the interest rate would be based on Libor plus a spread of 6.22 percentage points.

Now the interesting thing is that the authors of the paper stress that they investigated only one pool used to illustrate how subprimes work and to try to understand how the product turned out to work so badly. The abstract and executive summary make no reference to the economics of subprimes. The abstract:

In this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise. We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time. Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century Financial during 2006

Fed economists no doubt would know better than to use on one pool of MBS issued by one issuer in one month for an economic when there are vastly more comprehensive data sources that are designed for precisely that sort of analysis. And a quick look at one suggests that Berry's conclusions are quite a stretch.

The American CoreLogic databases as of March 2007 contained 38 million mortgages. Their extraordinarily detailed analysis of 8.4 million ARMS originated between 2004 and 2006 showed only 9.1 % with initial interest rates of 8.5% or higher (note that the paper claims an average of 8.64%)

There were more mortgages ate 2% and below (1,1 million) than above 8.5% (770 thousand). Without throwing in the intermediate levels, it's obvious that the weighted average is well below 8.64% (the level in the New Century pool, which gave Berry the notion that there wouldn't be much reset shock). Similarly, a March 2007 (admittedly now dated) paper by Chris Cagan deemed ARMs with initial rates of 6.5% or higher as not-very-vulnerable to reset shock.

ARMs with low introductory rates were never intended to reset; the assumption was that the would refinance. And recent pools are running at unheard-of rates before reset, with monthly default rates of 3.5%, which equates to a 34.8% cumulative default rate over three years. Thus the performance of later subprimes is horrendous independent of the issue of resets.

Finally, while Libor was a popular index for setting the reset rate, it's far from the only benchmark. Others include the 11th District Cost of Funds rate, the Prime rate, the Monthly Treasury Average rate, the Constant Maturity Treasury rate. And some of these have not been affected by the Fed's cuts:



Note that while prime has fallen, its level is not much below what it was in 2005 and 2006, which were the heaviest years for origination of dubious subprimes (while the 2007 vintage is worse in terms of quality, the volume issues was lower than in the two preceding years):

Bear: Did the Fed and Treasury Push Too Hard?

Andrew Ross Sorkin in the New York Times provides some important background on how the Bear deal wound up being retraded today. But he does his readers and the greater public a huge disservice by telling the story so as to flatter Wall Street.

According to Sorkin, the $2 price for Bear was the Fed's and Treasury's idea; JP Morgan was prepared to pay more, but they nixed the idea, saying they did not like the "optics" of the deal. The implication is that the officials overstepped their bounds. That is a pretty outrageous spin when the government is putting up taxpayer money.

Had it been an option, the Fed should have nationalized Bear. It was going to declare bankruptcy Monday if there was no deal; its shareholders would have been wiped out. Why am I so confident of this view? If bondholders, as rumored, were buying shares to make sure the JPM deal went through (and thus would take losses on their stock purchases when the deal closed), that meant that they thought their bonds were worth well under 100 cents on the dollar in a bankruptcy. Shareholders are subordinate to bondholders, so equity owners would have gotten zilch.

I can think of a host of reasons, however, why the Fed did not go the nationalization route, the biggest being that it lacked clear authority (it couldn't declare Bear to be insolvent, as it could a member bank). And letting Bear fail (and having acsounts frozen) was what the Fed was trying to avoid, so letting it fail and then seizing control (even assuming it could do that) was never an option. No doubt, the central bank also did not want to assume administrative control of an entity that it had never regulated (ie, its supervisors had never kicked its tires) that dealt actively in markets in which the Fed has little expertise. Even in an orderly liquidation scenario, that it a lot to take on.

Sorkin nevertheless argues that the Fed did Bear a dirty because:

.....the night that Bear signed the original bid, the Fed opened what’s known as the discount window to companies like Goldman Sachs and Lehman Brothers — oh, yes, and to Bear, too. Except that the Fed didn’t tell Bear that it planned to open the window when it was signing its deal with JPMorgan.

This verges on being revisionist history. First and most important, the discount window was opened to keep the panic about Bear from spreading to other firms, most notably Lehman. It almost certainly would not have happened then if Bear was not on the verge of imploding. Remember, a mere week and a day ago, there was pervasive fear that the wheels were about to come off the financial system, particularly if counterparties started getting leery of dealing with Lehman.

Moreover, usage of the new discount window the first week was light due to worries about stigma. If Bear had gone and used it aggressively, it may well have reinforced rather than allayed fears about the trading firm's health. If other firms continued to refuse to deal with Bear, its collapse was assured. There was a very real possibility that even if Bear had remained independent and used the window, its bankruptcy merely would have been delayed a day or two. And it would have been well nigh impossible to put together a three party takeover deal between the close of business in New York and market opening in Asia on a weekday.

But the most appalling aspect of Sorkin's account: he acts as if Bear had the right to be informed of the Fed's plans. Sorkin seems to have forgotten the golden rule: he who has the gold makes the rules. The Fed had every right to be calling the shots. They were taking the biggest risk in this transaction. The notion that a firm about to fail is entitled to be treated as a being on an equal footing with its rescuers is absurd. And the fact that Sorkin (and presumably others on Wall Street) sympathize with this view says the industry badly needs to be leashed and collared.

Finally, a series of posts at Dealbreaker suggest that JPM knew full well that it was guaranteeing Bear's trades (the supposed mistake in the contract):

As we pointed out this morning, we don’t think it was an oversight. On the conference call on the Sunday night the deal was announced there was a lot of discussion of the guarantee. Some of it was confusing, as much of what happens on public conference calls is often confusing. But it seems pretty clear that JP Morgan fully understood that it’s guarantee would cover Bear liabilities even if the deal was rejected.

After the jump, we present an excerpt from the transcript of the Sunday night conference call. In the excerpt, Steve Black, the co-head of JP Morgan’s investment banking division, is asked by an analyst about the guarantee. He clearly says that it will cover Bear liabilities already entered into and those entered into prior to closing or rejection, but not those entered into after the rejection.

Sorkin also makes clear that Dimon was unhappy paying so little for Bear and was concerned about a revolt among those employees he wanted to keep. That then raises the question of whether the supposed fits thrown by Dimon over the trading guarantees really were a bad case of buyer's regret. After all, at a price of $2, JPM was paying more than a billion less than than it eventually offered. Was that exposure really so awful that the economic value of getting out of it was worth a billion plus?

It thus seems more plausible that the alleged contract defects gave Dimon the excuse to pay the price he wanted to pay to keep peace in the family. And I will go further: knowing a bit about one of the attorneys involved (Rodgin Cohen of Sullivan & Cromwell, who represented Bear), I consider it quite possible that the lawyers contrived to have glitches in the deal to allow it to be reopened. (On a deal I was involved in, Cohen pulled a huge ruse with the Fed that my client to this day is unaware of, according to Gene Ludwig, who was later my attorney). Their loyalties are to the Street, not the Fed or the public at large.

Even the Times' news reporting (a story by Lanodn Thomas and Eric Dash) falls for the Wall Street party line:

Mr. Dimon’s about-face illustrates the deep complexity and political sensitivity of a deal with participants who reached into the highest corners of Washington, from the Treasury to the Federal Reserve System. It also underscores the extent to which JPMorgan and government officials underestimated the wave of anger and opposition that would flow from irate Bear employees and shareholders who saw the original $236 million that JPMorgan agreed to pay just a week earlier as far too cheap....

And finally, the low-ball offer cast Mr. Dimon as an unscrupulous negotiator in the eyes of envious rivals, who felt no compunction in raiding Bear for its talent, with many employees only too happy to leave. The new terms, he hopes, will show him to be a more pragmatic deal maker, willing to seek compromise to save a deal that for the time being at least, brought a jolt of confidence to Wall Street.

Bear was going to fail as of Monday. Bye bye equity and many if not most jobs. How hard is this to understand? I thought anyone who was remotely financially literate understood what bankruptcy means. The employees should be grateful to get anything. But no, the media slavishly accepts their sense of entitlement.

So I don't buy Sorkin's theory that the Fed overreached. In fact, I'm deeply offended that he is presenting this idea at all. It's part of the conspiracy to foist the losses of a reckless securities industry onto the public at large.

Update 1:40 AM: A post by Steve Davidoff at the New York Times' Dealbook argues that the revised deal could be more susceptible to being upended by the Delaware courts. While most Bear shareholders have reportedly thrown in the towel, billionaire Joe Lewis has the funds and motivation to keep fighting.

Mirable Dictu! A Good Column by Ben Stein!

I nearly fell off my chair.

Ben Stein's column this week, "What McCain Could Do About Taxes," is sensible and vastly more tightly written and argued than his previous work. No free association or gratuitous name-dropping, no leaps of logic, no wishful thinking.

More shocking, not only does he take issue with the Republican party line, he comes out on the same page as Dean Baker.

I wondered if he had gotten a ghost writer.

He tells McCain to forget about tax cuts, they burden future generations and leave us indebted to foreigners, and that tax increases need to target the rich.

Reasoning like that shouldn't be cause for celebration, save that the Republicans have become hooked on faith-based economics. While one robin does not make a spring, Stein's piece may be a hopeful sign that reality is finally starting to sink in among GOP loyalists.

I found nothing objectionable on a first pass, which (given my critical eye) is a noteworthy accomplishment.

This is the guts of his article:

Let’s start with the obvious. Almost everyone dislikes taxes. No sane person enjoys writing out a big check to Uncle Sam when he could spend that money or bank it for retirement. By the same token, almost everyone likes the phrase “tax cuts” for the same reason.

The problem, and it’s a killer, is that over the years we have obligated ourselves as a nation to spend truly staggering sums. These sums are growing rapidly. They consist mostly of entitlements, like Social Security and Medicare; fixed obligations like interest on the national debt, pensions for federal and military employees and various subsidies that have already been enacted; and morally mandatory expenses like those for national security.

All politicians campaign on the promise to cut federal spending by identifying hitherto unfound waste, fraud and corruption. None of them ever do so in a meaningful way. Total federal spending has not once fallen noticeably since 1954, no matter the party or the promises of the incoming chief executive,

That is the first thing you need to know. The next thing is that the Republican Party (my party and yours) has for the last 30 years or so been operating under a demonstrably false and misleading premise: that tax cuts pay for themselves by generating so much economic growth that they replace the sums lost by tax cutting.

This would be a lovely thing if true, and the best of all ideas, the “something for nothing” idea. In fact, tax cuts lower federal revenue and generate federal deficits. It is also true that they do stimulate the economy and after a long period of years, federal tax receipts go back to where they were before the tax cuts.

For example, when President Bush enacted his tax cuts in the early 2000s, income tax receipts fell dramatically. It took almost six years for them to reach the level they had been in the last year of the Clinton administration, while G.D.P. in that period rose by roughly 30 percent. In the eight years Ronald Reagan was president (and I love and worship him), tax receipts did not fall anywhere near as much, but they rose more slowly, on a percentage basis, than they did in any other comparable eight-year period after World War II.

In other words, tax cuts do not pay for themselves, at least not on any basis I can see. Certainly, they are not worthless. They make taxpayers feel good and they generate growth. But basically, they shift the tax burden from us to our progeny and add immense amounts of interest expense to the federal budget. At this point, taxpayers shell out about $1 billion a day just for that item.

Moreover, immense federal deficits in modern life are financed largely by foreign buyers of our debt. This means that the American taxpayer must work a good chunk of the year to send money to China, Japan, the petro-states and other buyers of United States debt. In effect, we become their peons.

By flooding the world with debt, we in effect beg foreigners to take our dollars, and this leads to a lower value of the dollar and a higher cost of imports, including oil. If you feel pain filling up the tank, you can partly thank those tax cuts. If you feel the sting of inflation, you can partly thank the supply siders. Deficits matter....

You can propose still more tax cuts, create still more deficits and add to the debt, and say to yourself, like Louis XV, “Après moi, le déluge.”

Or, you can raise taxes. But whom to tax? The poor are, well, poor. The middle class is struggling to pay for its middle-class life. That leaves the rich. It would be lovely if we did not have to tax them. Many have worked hard for their money. Many have created useful businesses. Many of them are fine people.

But as Willie Sutton said when asked why he robbed banks, “Because that’s where the money is.” By definition, the truly rich have a lot more money than they need. If they don’t, then they are not rich by my standards. The first step toward putting our house in order, once we are past the seemingly looming recession, is much higher taxes on the truly rich and serious enforcement to prevent offshore tax evasion.

To put it even more starkly, the government — which is us — needs the money to keep old people alive, to pay for their dialysis, to build fighter jets and to pay our troops and pay interest on the debt. We can get it by indenturing our children, selling ourselves into peonage to foreigners, making ourselves a colony again, generating inflation — or we can have some integrity and levy taxes equal to what we spend.

Now some will protest that when we are entering a recession is not exactly a propitious time to raise taxes. Fair enough. But the general drift of Stein's argument is a badly needed counterbalance to those who think the US can run up a tab to be paid by overseas is a game we can keep up forever.

Our foreign debt suppliers are already starting to wise up. They used to be content to buy Treasuries, which is the least costly way for us to compensate them. Put on your business hat: any startup prefers to fund itself with debt, preferably cheap debt, like friends and family. But more costly debt is preferable to giving up equity.

But now foreign governments, with massive foreign exchange reserves, are looking to invest overseas and are moving out of debt into equity related investments. That has the effect of increasing our cost of funding.

So even if we as a nation aren't able to discipline ourselves, our friendly money sources will.

Rating Agency Conflicts in Munis Coming Under Fire

In "States and Cities Start Rebelling on Bond Ratings," the New York Times attempts to make the case that municipalities can lead a revolt against Wall Street:

Does Wall Street underrate Main Street?

A growing number of states and cities say yes. If they are right, billions of taxpayers’ dollars — money that could be used to build schools, pave roads and repair bridges — are being siphoned off in the financial markets, where the recent tumult has driven up borrowing costs for many communities.....

States and cities have begun to fight back, saying they can no longer afford the status quo given the slackening economy and recent market turmoil.

It's a bit late to come to that realization. The horse hasn't just left the barn, it's in another county by now. As Bloomberg tells us in "Auction Supply `Tsunami' Foreshadows Deeper Municipal Losses," issuers of auction rate securities, already hosed by market failures and the resulting spike-up in rates, are going to take a second beating when they try to secure longer-term funding due to a massive supply/demand imbalance:

U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities....The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989....

``It's a supply tsunami,'' said Robert Fuller, principal of Capital Markets Management LLC in Hopewell, New Jersey, a financial adviser to municipalities. ``All of that is going to be redone and it's going to be redone fast,'' he said of auction-rate bonds.

Now the New York Times piece, on page one, is no doubt intended for a broad audience, so it explains (without giving comparative default rates, which would have been useful), that rating agencies grade muni bonds more harshly than corporates:

At every rating, municipal bonds default less often than similarly rated corporate bonds, according to Moody’s. In fact, since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings. Furthermore, when municipalities do default, investors usually receive some — or even all — of their money back, unlike in most corporate bankruptcies..... Moody’s estimates that more than half of the market would be rated triple A or double A using the corporate scale. Triple-A securities are considered nearly as safe as Treasury bonds issued by the federal government.

However, the piece notes rather blandly the central conflict of interest: that rating agencies have good reason to have established and perpetuated this double standard. When less than AAA municipalities go to buy bond insurance, they are paid again to issue the second rating.

Despite noting this large economic incentive, the Times makes no attempt to obtain or develop estimates of what these second ratings might be worth in financial terms to the rating agencies. One has to assume that these second ratings are highly profitable; there's just about no effort involved in rubber-stamping a bond insurer policy.

While journalists can't be as pointed as commentators, the lack of critical thinking, as exhibited in failure to question the pablum fed the author, is striking. Consider this section:

Moreover, some bond specialists caution that this is the wrong time to rerate municipal bonds. The slowing economy and faltering housing market are squeezing state and city tax revenue. At the same time, public pension liabilities keep rising. Facing budget shortfalls, states like California, New Jersey and Arizona are cutting services.

And pray tell, who assumed that the municipalities should pay for new ratings? All that these hapless issuers (and allied state attorney generals) are asking for is for their self-serving grading scales to be recalibrated. They can do that using their existing data. The notion that they'd extract another fee for this is preposterous.

And the rating agencies are resorting to bald-face lies to defend their practices:

Ratings firms, bond insurance companies and some bond investors defend the separate ratings scales, arguing that it allows investors to make distinctions among various debt and, ultimately, set appropriate interest rates. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.

Gail Sussman, the Moody’s executive in charge of public finance ratings, likened the firm’s dual ratings scale to a ruler that measures in inches on one side and centimeters on the other.

“The distance between point A and point B is the same” whether it is measured in inches of centimeters, Ms. Sussman said.

Well, of course the rating agencies and bond insurers defend the system; it's a meal ticket. And some investors might like it because it creates market inefficiencies.

But contrary to their sudden protestations otherwise, ratings were always supposed to mean the same thing, in terms of default risk, not matter what was being rated. That was the rating agencies' own position on the matter. From Joshua Rosner and Joseph. Mason's "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions":

Credit rating agencies (CRAs) have long argued that the ratings scales they employed were consistent across assets and markets. Not long ago Moody’s stated “The need for a unified rating system is also reflected in the growing importance of modern portfolio management techniques, which require consistent quantitative inputs across a wide range of financial instruments, and the increased use of specific rating thresholds in financial market regulation, which are applied uniformly without regard to the bond market sector.” In a similar pronouncement in 2001 Standard & Poor’s stated their “approach, in both policy and practice, is intended to provide a consistent framework for risk assessment that builds reasonable ratings consistency within and across sectors and geographies”.

However, the willingness of ratings agencies to lie in public should come as no surprise. Moody's, in testimony before the Senate Banking Committee last September, maintained that it played not role in structuring or designing structured securities. They dare make statements like that despite the fact that numerous industry textbooks, as well as documents at the SEC, describe the process of creating structured finance instruments, and frequently describe, in some detail, the active participation of the rating agencies. If this practice is so well known that it shows up in textbooks, it would be trivial to get industry participants to confirm it.

But of course, the rating agencies have a huge incentive to try to snooker anyone who can't be bothered to dig deeper. Admitting to their well-known role in structured finance transactions could open them to liability by virtue of being an underwriter (now they are suit-proof by virtue of being able to hide successfully behind the First Amendment). So in keeping with their fierce attention to their bottom line, they'll also defend their municipal bond sham as long as they can get away with it.