is the securitization crisis driven by non

8/14/2019 Is the Securitization Crisis Driven by Non

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Is the Securitization Crisis Driven by Non-Linear Systemic Processes?

Posted: 12 May 2008 07:00 AM CDT

Reader Richard Kline, who provides regular, sophisticated comments, was

keen to continue the discussion provoked by a post last wee, " Hoisted From

Comments: Greater Liquidity Produces Instability ." An anonymous reader

offered a complex systems theory view of our modern financial system. The

opening paragraphs:Perhaps a lesson to be learned here is that liquidity acts as an efficient

conductor of risk. It doesn't make risk go away, but moves it more quickly

from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do

if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex

system is promiscuity of information (i.e., feedback loops but in a more

generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing

its non-linear behavior is to divide it up into little boxes and use them to

compartmentalize information so signals cannot easily propagate quickly

across the entire system.

I hope I am not oversimplifying what either the anonymous reader or Richard

intend to convey, but the non-linear issue is not trivial. Processes that are

described by non-linear equations are unpredictable. That is why, per above,

inducing or enabling non-linear behavior is Not A Good Idea.

Worse, non-linear math is really hard, so while lots of mere mortals can model

linear processes, it takes high powered skills to deal in non-linear modeling.And you therefore get a second problem: due to computational convenience,

most practitioners will try to describe a system using linear models, and if it
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works well enough in most cases, it gets a go. To illustrate: pretty much every

mainstream financial model (Black Scholes, for instance) assumes continuous

markets, which simplifies the math. This, for instance, is the origin of the

classic fat tails problem. Pretty much everyone knows that models that use a

normal distribution underestimate tail risk (the odds of outliers, which in thiscase is dramatic price rises or falls). Yet the flawed models are still consulted

out of convenience (note I am not saying other models aren't used, but the

reliance on models known to have fundamental shortcomings is considerable).

Richard has provided a through, thoughtful exploration out of some of theissues. After a general discussion, he sets forth five questions and works

through the first one. on innovation (note the discussion ranges far beyond

the financial markets). Recall that one of the defenses of our current financialmess is that the products were innovative and hasty regulation will curtain

other useful advances (this argument is that the products weren't the

problem, it was the practitioners, or in popular terms, "guns don't kill people,

people kill people"). But as Richard illustrates, that level of discussion is

simplistic; there are ways to parse the problem that can lead to better

thinking about possible remedies.

His ideas on issues 2-5 will come in later posts in this series.

Your comments very much appreciated. I've edited his piece slightly to make

it a bit less formal.

Now to Richard Kline;

To what extent have nonlinear processes promoted the Securitization Bubble,

precipitated its collapse, or prolonged the resulting instabilities in the financial

system? I'll keep the discussion non-technical, i.e. non-mathematical. While I

have an informed opinion, I dont pretend to expertise, and hope to elicit

further comment and debate.

While there is evidence for most of my contentions, it isnt conclusive;. I raise

ideas more than offer conclusions. Some general, but valuable, further

reading is suggested for those interested. Comment by those with technical

background in nonlinear complex systems, especially economic systems, is


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welcome---but Im not holding my breath. Though nonlinear dynamics in

financial markets received no little initial research ten years ago and more,

many of the specialists involved have since been hired into the hedge fund

industry where their work has presumably become proprietary. Not only do we

not know what they are doing, we dont even know what they know now;there has been little recent publication of consequence.

To delve into this issue, then, let us first briefly consider financial markets as

systemic phenomena. Given their inherent complexity and diversity of inputs,

modern financial markets are inherently complex systems with numerousnonlinear phenomena embedded within their actions, that is phenomena

whose transformations are not smooth, not continuous, or both. Such

overlapping dynamical phase spaces appear less complex than they arebecause salient stable equilibria within them are defined by firm, cohesive,

and above all observable parameters such as priced units of exchange,

transaction terms, regulatory limits, and the like. Such firm parameters do

typically though not invariably have the virtue of precluding overtly chaotic

behaviors in their respective financial event-spaces, and to a degree in the

larger interaction systems which contain them. Indeed, while complex

systems will often self organize with emergent properties developing within

them in consequence, the intervention of human participants in these markets

tends to limit or swiftly capture observable systemic properties---or at leastthat is the idea.

Since these defined and manipulated parameters are of lower dimension than

the market processes to which they map, they give the illusion to the

observer that markets themselves are more solid and of lower dimension than

is really the case, like skin on hot chocolate. This illusion is compounded by

the fact that the very large volume of quantitative data regarding finance and

markets, including trend analyses beloved by academically trained

economists, are presented in linear analytic terms; ants crawling on that skin,

if you will. Such linear models tell something regarding what dwells below,but less then we often lead ourselves to believe.

Bear in mind, though, that such linear models only map to the nonlinear

trajectories and higher dimensions of the underlying event-spaces, if with fair


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reliability, rather than fully describe them. These are fuzzy, noisy spaces in

that they largely describe human behavior which is intrinsically inexact,

information which can be imperfect and/or corrupt(ed), and rule-parameters

which are not always followed and which do not capture all relevant

processes. Phase spaces and their properties are best described as geometricstructures with a time dimension which describe relationships whereas our

analyses in a modern educated context are overdefined by linear

mathematical methods which abstract fixed values. The present conceptual

mismatch of methods to phenomena further leads to an insufficient cognitive

engagement with systemic and nonlinear processes on their own terms, ineconomic behavior and elsewhere:

Our tools are yet poorly matched to the natural phenomena we wish tounderstand. I will pose it as a truism that processes which appear disjointed or

broadly nonlinear do so when they are viewed from perspectives which are or

lower dimensionality than are the structures observed; Flatland views of

Squareland trajectories. Tensor analysis may prove sufficient to effectively

analyze some complex processes; perhaps. Since most of us cannot execute it

competently, nor are the guidelines clear by which to operationalize available

data into tensor matrices, we will have to sharpen our complex reasoning to

make heuristic judgments better suited to the data-events instead. This

exercise is valuable in and of itself. It is even more true in consideringcomplex systems than otherwise that as you define your questions you

describe the parameter space of your possible answers. So, lets build some

better questions.

From that position, here are five questions recently and variously posed which

I find personally interesting:

Does innovation require untrammeled information flow across social/

economic event spaces?

Is the crisis in securitized debt the result of a black swan event?

Was the creation of the Securitization Bubble the result of nonlinear processes

in the financial markets?


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yes. Innovative design does not necessarily flourish in noisy environments

maximally in flux. There, relationships can be hard to grasp, and innovations

may soon be suboptimal in ever changing contexts; indeed, conservative but

stable designs may better reward success. In brief, innovative design occurs

best in the enriched niche, not in the middle of a crossroads.

Innovation diffusion, by contrast, occurs best where information and

adaptation are minimally constrained across a context. Consider the adoption

of mobile phones in Europe or Korea, where a single technical standard was

publicly designated, adoption of mobiles was rapid and deep, and use-drivendevelopment burgeoned. In contrast in the US, competing technical

standards and incompatible service provider networks slowed adoption, and

have left services fragmented. Diffusion is a process which implies pointautonomous use of what is adopted or put to use. In contrast, propagation is

more nearly a spread whose nodes remained linked.

Consider Linux an example of diffusion and Windows an example of

propagation. Linux point sources can transform or adapt independently, while

Windows point sources are under heavy systemic pressures (incompatibility

drift) to transform in relation to nodal (i.e. Redmond) based changes. It isnt

commonly understood that many innovative designs are effected well before

they diffuse (or are propagated), perhaps because salient fads can diffusewith great rapidity in modern societies. A typical example is the Internet,

which was functionally extant well before software refinements turned it into a

mass medium, a medium whose greater scales drove product and

organizational developments thereafter. The adoption trajectories of

innovations most typically are logistic functions in form, but with longer low

adoption under-the-radar initial tails then considered, even much longer.

Whether relatively rapid diffusion is a social version is debatable, but it is

certainly an economic gain if only for implementation investment.

There are two points to making this distinction between innovative design andinnovation diffusion (or propagation). First, the two processes can be

facilitated or inhibited separately. For example, a society with low barriers to

diffusion may still be the one to capitalize upon innovations, regardless of

source, because they scale the markets and formalize product parameters.


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Second, large profits come to those investing in innovations which diffuse due

to market scale-ups, while huge profits come to those investing in innovations

which propagate since they remain substantially intermediated in subsequent

capital flows. The arguments one typically hears for lowering barriers to

innovation diffusion and damn the consequences are from those hoping thattheir innovations or the industries tied to them will get the market scale-up

opportunities. Pro-adoptionists, to give them a name, typically have a stake

in the outcome so their perspective is not disinterested (presuming that

anyone elses could be, either). To get innovative designs we need enriched

niches whether or not we have low barriers to innovation adoption. We canhave rapid adoption without being particularly innovative. Societies can, in

fact, deliberately choose whether or not to have rapid adoption.

Moreover and more importantly societies can deliberately choose which

innovations to rapidly adopt (within limits); consider China in the latter regard

of selective adoption. Choices about which innovations to permit rapid

adoption are choices about who will get very rich, however. Much of the

shouting about innovation is, at its base, concerned with the last proposition.

Further reading:

Nebojsa Nakicenovic and Arnulf Grbler. 1991. Diffusion of Technologies and Social Behavior .

Jacob Getzels and Mihalyi Csikszentmihaliy. 1976. The Creative Vision .

[Respectively the best texts on technological innovation and the creative

process I have ever

found. Of course they are the least known.]

"The global slump of 2008-09 has begun as poison spreads"

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Uber-bear Ambrose Evans-Pritchard waxes apolyptic this week, after finding

that Standard & Poors issued a report that was even more pessimistic than heis.

From the Telegraph : The avalanche of bankruptcies has begun. Six US companies of substance

have defaulted on bonds over the past fortnight, against 17 for the whole of

last year.

As a "non-believer" in the instant rebound story, I am not easily shocked by

gloomy reports. But the latest note by Standard & Poor's - The Bust After The

Boom - gave me a fright....

As the Fed's latest loan survey makes clear, lenders have dropped the

guillotine. With the usual delay, the poison is spreading from banks to the real

world.

Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the

rate of past downturns. "Companies are heading into this recession with a

much more toxic mix. Their margin for error is razor-thin," she said.

Two-thirds have a "speculative" rating, compared to 50pc before the dotcombust, and 40pc in the early 1990s. The culprit is debt. "They ramped it up in

the last 18 months of the credit boom. A lot of deals were funded that shouldnot have been funded," she said.

Some 174 US companies are trading at "distress levels". Spreads on their

bonds have rocketed above 1,000 basis points. This does not cover the

carnage among smaller firms outside the rating universe.

The California city of Vallejo (117,000 inhabitants) has just made history by

opting for Chapter 9 bankruptcy, the result of tax erosion from a 26pc fall in

local house prices. Half Moon Bay may be next.

"This is the tip of the iceberg: everybody is going to line up for Chapter 9 inCalifornia," said John Moorlach, Orange County board chief.
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US consumers are juggling plastic to put off their day of reckoning. The Fedsurvey said credit card debt had jumped 6.7pc in the first quarter to $957bn,

or $6,000 per working American, despite usury rates near 20pc.

"My guess is that many Americans continue to run up massive credit card

debt because they have little intention of paying it off," said Peter Schiff at

Euro Pacific Capital. Quite.

Thankfully, the Fed's monetary blitz has averted a depression. Emergency

lending under the "unusual and exigent circumstances" clause of the Fed Act -

the nuclear Article 13 (3), unused since the 1930s - has put a floor under the

banking system.

There will be no "reset Armaggedon" as rates vault on honey-trap mortgages.

Drastic Fed cuts - to 2pc from 5.25pc in September - have conjured away that

disaster, at least....

Despite the rescue, US house prices are likely to fall 25pc from peak to trough

(Lehman Brothers, Goldman Sachs). We are barely half done, yet 10m-12m

households are in negative equity already.

The bears at Socit Gnrale are going into Siberian hibernation, issuing an

"Ice Age" alert. They have slashed exposure to global equities to a minimum30pc for the first time ever.

Their weighting of super-safe "AAA" government bonds has been raised to a

maximum 50pc. This is a bet on gruelling "Japanese" deflation. The bank

expects equities to fall by 50pc to 75pc.

"Nowhere and nothing will be immune. We are on the cusp of an equity

meltdown that will slash and shred portfolios," said Albert Edward, SG's global

strategist.

"We see a global recession unfolding. Liquidity will drain away and crush thetwin emerging market and commodity bubbles. The recent hope that 'the


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worst might be over' is truly staggering. Profits are disintegrating," he said.

Today's "bear rally" may live on into June. Don't count on it. Global bourses

are no longer rising hand-in-hand with oil in exuberant celebration of liquidity

relief (US, UK, and Canadian rate cuts).

Crude ceased to be a friend of equities when it reached around $110 a barrel.

At last week's close of $126, it became an outright threat. The Bush rescue

package - $600 in rebate cheques per household - has been rendered null and

void by the latest spike. The average US home is now spending over 8pc of

income on energy or fuel.

OPEC is playing with fire by refusing to pump more oil to offset rebel attacksin Nigeria. The cartel's output drop of 350,000 barrels a day in April is a

hostile act at this point.

But there again, why should Middle Eastern states help America as long as the

White House keeps filling the US petroleum reserve to prepare for war with

Iran? Bush is playing with fire, too.

The oil spike will burn itself out. China has hit the buffers. With inflation at

8.5pc, it risks political turmoil. Moreover, it has repeated Japan's mistakes inthe 1980s, building too many factories shipping too many goods at slender

margins into a crumbling export market.

Lehman Brothers' Sun Mingchun says China will tip over in the second half of

this year. "With so much latent overcapacity, an export-led slowdown could

trigger a chain reaction which, in the worst case, could threaten the stability

of [its] financial and economic system," he said.

Britain, Europe, Japan, and China will go down before America comes back up.

This is turning into a synchronised bust, after all. The Global Slump of 2008-09

is under way.
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Bottom Testing in Mortgage Land Posted: 12 May 2008 02:38 AM CDT

The Financial Times has a long analysis, " Value to Unlock ," on how various

financial players are starting to pick and choose among distressed mortgage

assets. This may prove to be premature (recall how Wall Street firms eagerlybought subprime brokers through January 2007) and the housing market itself

appears unlikely to hit its floor before 2010, but even at this stage, there may

be pockets that are so cheap that the downside is (or appears) modest.

Note this seems to be a theme du jour: Calculated Risk also saw signs of

buying in some distressed markets , and too is cautious about reaching

conclusions.

The set up is that the Mortgage Bankers Association, a sober and sparsely

attended affair this year, is galvanized by the report that a BlackRock fund will

buy $15 billion of UBS's subprime debt for 75% of face (UBS is a minorityinvestor in the fund; query whether there was more than meets the eye here).

The piece comments on various players buying servicers allegedly to gain

expertise. Maybe I am talking to the wrong people, and Tanta et al will correct

me, but my sources tell me servicers are factories, and don't have skills that

are relevant to evaluating mortgage pools. Remember, the credit decision was

made long before the securitized mortgage got in the hands of the servicer

(and in the recent environment, calling them "credit decisions" is generous.

More accurate might be "handing out cash to anyone who had a pulse andcould fill out a form"). I'm a little perplexed that this factoid, while narrowlyaccurate, keeps being bandied about uncritically.

From the Financial Times:

Policymakers, bankers and investors all want more buyers like BlackRock to
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emerge for mortgage securities and other risky assets, to provide a tipping

point that ends the credit crisis. Yet thus far there has been only patchyevidence that this healing wave of purchases is under way.

Certainly, the market for corporate debt has shown some positive signs. The$23bn buy-out of Wrigley by Mars, agreed two weeks ago, involved more than

$10bn of debt - although less than $6bn of that debt came from investors,

with the rest provided by Warren Buffet's Berkshire Hathaway.

The debt capital markets, which last year made possible deals that were twice

that size, still have a long way to go before they recover fully.....Banks are so

desperate to rid their balance sheets of these loans that they are offering

their best clients sizeable discounts and lots of leverage to sweeten thesales....

Investor fear of buying distressed assets too soon and catching the "falling

knife" is even more intense in the mortgage market, where premature buyers

have been badly burnt by plummeting asset prices...

Nevertheless, BlackRock's deal with UBS represents one of the more

significant examples of a small but growing number of contrarian bets on

distressed mortgage assets by opportunistic buyers. Goldman Sachs, TPG andother investment banks, private equity firms and hedge funds have also

started looking to buy portfolios of mortgages - in some cases reversingbearish bets made last year.

Indeed, in the past 10 months more than 80 funds have begun raising money

to buy bad mortgage debt on the cheap, including Marathon Asset

Management, GSC Group, Pimco and Fortress Investment Group. Goldman is

trying to deploy around $4.5bn to invest in mortgage assets...

Placing values on distressed mortgage assets remain an enormous problem

for both buyers and sellers, in part because it is hard to predict the full extent

of the continuing slide in US home prices and the accompanying level of

mortgage defaults and foreclosures.


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Part of the difficulty is that faith has been lost in the measures of probable

losses on which lenders used to rely, such as credit ratings and historical data.For pools of subprime mortgages, guides such as loan-to-value ratios, used to

compare the size of a loan against the value of the property on which it is

secured, have proved unreliable.

Mark Fleming, director of economics at First American CoreLogic, a research

provider, says that while reported loan-to-value ratios for many subprime

mortgage pools had been around 100 per cent, the existence of unreported

"piggyback" loans meant that in some instances the ratio could be as high as

160 per cent.

"The problem is that while market-based pricing is not necessarilycommensurate with the true risk, it's still hard to measure the mismatch

between pricing models, rational pricing opinions and prices driven by fear,"

says Mr Fleming.

The valuation problem is worse for more complex instruments, for which there

are still no buyers, particularly if these fall under fair-value accounting rules

that require securities to be "marked to market" - priced on the books at no

more than what is achievable. Susanna Kondraki, vice-president at Risk Span,

an advisory firm, says one client spent $250,000 on valuation services for a$1bn portfolio of collateralised debt obligations backed by mortgages, only to

discover that the portfolio had to be valued at zero.

James Fratangelo, head of whole loans sales and acquisition at Bayview

Financial, says snags like this are why many parts of the mortgage market are

yet to establish clearing prices. "There is plenty of liquidity for distressed

assets but there is still a huge gap between where buyers want to buy and

where sellers want to sell," he adds - with the gulf between bids and offers

remaining as wide as 20 cents on the dollar for many assets.

Robert Gaither, head of the secondary marketing group for mortgage

securities at Bank of America, illustrated this problem at last week's

conference. He described receiving bids for a portfolio of so-called "Alt-A"mortgages, between prime and subprime, that the bank had marked down to


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91 cents on the dollar. After a series of bids from prospective buyers at 50

cents, he finally received one at 86.5 cents. Yet the bank's pricing model saidthe mortgages should be priced in the mid-90s.

The bank decided to hold on to the portfolio, even though it was forced bymark-to-market accounting rules to write down the mortgages to match that

86.5 cent bid.

Many European banks are also refusing to sell at prices that they consider to

be artificially depressed....

She says European banks' belief that such asset prices have fallen too far has

been bolstered by a recent Bank of England report suggesting that triple-Atranches in particular were mispriced......

Still, there are signs - including UBS's sale of loans to BlackRock - that some

higher quality assets are beginning to move...Traders say the scale of buying

generally remains small, however. In the European markets, buyers are

placing orders of just 20m (16m, $31m), far below the 500m orders that

were normal before the crisis broke.

Many funds say they remain constrained in the volume of deals they can doby the sheer difficulty of raising finance. Others fear this means there is too

little capacity to absorb the volume of distressed assets in the market.

"What worries some people is that you have seen a few people fill up but it's

not clear whether there will be more buyers after that - it could just be one or

two groups that are ready to buy," says one London-based hedge fund official.

"The market is so thin and prices are so volatile that if they stop buying, we

could go back down again."....

One of the biggest problems facing prospective buyers of distressed mortgage

assets is that US house prices continue to fall and the flood of late mortgage

payments and foreclosures shows few signs of abating. Unless the rising tide

of losses in the housing market can be stemmed, establishing a floor underasset values may be difficult, writes Saskia Scholtes.


15/23

Mark Kiesel, a portfolio manager at Pimco, the big US bond investor, says: "Wemay need housing prices to bottom for this entire process to trough and for

most markets to rebound."

Links 5/12/08


Is divorce bad for the parents? PhysOrg

British Gas fights Accenture over billing Times Online . A world class IT mess.

Shipping rates near record levels Financial Times

The case for invading Myanmar Asia Times, Mirable dictu. The Asia Times,

which is is pretty unsparing in taking the US to task, is calling for a US forayinto Mynanmar. This would be a "humanitarian intervention" but I wonder

what the subtext is. Does this mean they don't trust the locals (China, India. Thailand etc.) to do in with UN coordination and blessing?

When to have a go Willem Buiter

Capital market deals raise $20bn FT Alphaville

Oil Nonbubble , Paul Krugman, New York Times. Krugman argues (as he has on

his blog) that the lack of inventory buildup means that there is no oil bubble.

The problem I have with that argument is we cannot be certain of thesupposed lack of inventory increases. The New York Times, in a recent story

on the runup in agricultural commodity prices, discussed how some farmers

who cannot sell to elevator companies and are frustrated with the ways the

options and futures markets are misbehaving are doing deals outside the

exchanges, directly with sponsors of commodity funds such as AIG. AIG, which
http://feeds.feedburner.com/~r/NakedCapitalism/~3/288514416/links-51208.htmlhttp://www.physorg.com/news129727971.htmlhttp://business.timesonline.co.uk/tol/business/industry_sectors/utilities/article3912583.ecehttp://www.ft.com/cms/s/0/c517799e-1f85-11dd-9216-000077b07658.htmlhttp://www.atimes.com/atimes/Southeast_Asia/JE10Ae01.htmlhttp://blogs.ft.com/maverecon/2008/05/when-to-have-a-go/#more-238http://ftalphaville.ft.com/blog/2008/05/12/12936/capital-market-deals-raise-20bn/http://www.nytimes.com/2008/05/12/opinion/12krugman.html?hphttp://www.nakedcapitalism.com/2008/04/commodity-volatility-creates-problems.htmlhttp://feeds.feedburner.com/~f/NakedCapitalism?a=02M4YHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=vuTXWHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=E0nWsHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=GXBiSHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=yw99IHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=FFK1mhhttp://feeds.feedburner.com/~f/NakedCapitalism?a=uODMjhhttp://feeds.feedburner.com/~f/NakedCapitalism?a=EegqVHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=4wlylHhttp://feeds.feedburner.com/~a/NakedCapitalism?a=xeG4tfhttp://feeds.feedburner.com/~r/NakedCapitalism/~3/288514416/links-51208.htmlhttp://www.physorg.com/news129727971.htmlhttp://business.timesonline.co.uk/tol/business/industry_sectors/utilities/article3912583.ecehttp://www.ft.com/cms/s/0/c517799e-1f85-11dd-9216-000077b07658.htmlhttp://www.atimes.com/atimes/Southeast_Asia/JE10Ae01.htmlhttp://blogs.ft.com/maverecon/2008/05/when-to-have-a-go/#more-238http://ftalphaville.ft.com/blog/2008/05/12/12936/capital-market-deals-raise-20bn/http://www.nytimes.com/2008/05/12/opinion/12krugman.html?hphttp://www.nakedcapitalism.com/2008/04/commodity-volatility-creates-problems.html


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runs commodity index funds, buys the commodity, the farmer stores it for a

fee, and the farmer buys it back later at a pre-set price. Again, does theinventory held with the farmer by a commodity index fund get recorded

anywhere? And note further (if the author got it right): commodity funds are

not supposed to buy commodities. But AIG, the fund manager, apparently did.If this is somehow to AIG's advantage (certain) it's a no-brainer that Goldman,

which manages about 60% of the GCSI funds, is doing similar moves on a

greater scale. And if private deals of the sort depicted in the article aren't

recorded, we could indeed have more inventory that is widely recognized.

(And remember, even if inventories are actually growing, bubbles can go a

very long time before they burst).

Bottom line: more deals are being done OTC, and physical trades related tothem may not be fully captured. Anyone with knowledge is encouraged to

comment.

NAR President-Elect Brays About Banks Bank Lawyer's Blog. Amusing.

Two Posts Everyone Needs to Read Angry Bear

Antidote du jour:
http://www.banklawyersblog.com/3_bank_lawyers/2008/05/nar-president-e.htmlhttp://angrybear.blogspot.com/2008/05/two-posts-everyone-needs-to-read.htmlhttp://www.banklawyersblog.com/3_bank_lawyers/2008/05/nar-president-e.htmlhttp://angrybear.blogspot.com/2008/05/two-posts-everyone-needs-to-read.html


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Waldman: Halt the Fed's Mission Creep


Steve Waldman has a typically top notch post at Interfluidity," Let's not write

the Fed a blank check ," in which he dissects the implications of the Fed's

request to Congress to pay interest on bank reserves.

Waldman explains the technical workings and the pros, and gets to the real

issue. This represents a change from a fractional reserve banking system to a

so-called channel or corridor system . Fixed reserves become incidental and

might be dispensed with, since the Fed would manage interbank rates directlyby setting what amounts to a bid and offered price (a bit simplified, see

Waldman for details).

Now the Fed did not just wake up and decide in a fit of housekeeping to adopt

this practice, which has been road tested by other central banks. The

problem, as has been clear from the when this idea first surfaced, is that its

main objective is to allow the Fed to circumvent its balance sheet constraints

in salvaging the financial system. The method open to it now, of simply
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issuing liabilities so it could take on more dodgy assets, is tantamount to

printing money and inflationary.

Aside: you thought the credit crisis was over? This proposal says the Fed is

afraid it isn't. Per Waldman, the Fed has already used $475 billion of balancesheet capacity and has another $300 billion to go. As he points out, the

amount already loaned to Wall Street equates to $1500 per person in the US;

use of the additional $300 billion would bring it to $2500. Don't kid yourself; if

these loans go bad, they come out of the public purse. The Fed wants

approval for a mechanism that allows it to go even higher.

The Fed's mission creep is yet another sorry Greenspan era development.

Earlier central banks understood their mission: to provide a stable price of money, preserve the soundness of the banking system, and promote full

employment. Greenspan took an unprecedented interest in the stock market,

which has never been any central bank's responsibility (a May 8, 2000 Wall

Street Journal cover story discussed this at some length, although predictably

not in disapproving terms). Even worse, Greenspan's predilections seemed a

prescription for moral hazard: minimal regulation and a "let a thousand

flowers bloom" approach to new products, no matter how geared, combined

with aggressively backstopping the industry at any whiff of trouble.

Much has been written about the Greenspan put; less has been said about his

Fed's other moves that extended the Fed's purview without any formalapproval. The biggest, the one that set the stage for the Fed's current

expansive view of its role, was the bailout of LTCM. Although the Fed did not

broker the deal, it did review LTCM's books before calling 24 firms, most of

which it did not regulate, to meet at its offices. While that intervention has in

retrospect been presented as a success, it wasn't clear then, and cannot be

determined now, whether a LTCM failure would have been a systemic event.

However, at the time, it was quite controversial, precisely because the Fed

was extending its reach to areas that were not part of its charter.

The problem, as Richard Sylla points out in the Palgrave Dictionary of Money

and Finance, is that.....the Fed was a compromise between two central banking traditions in


19/23

America. Each was tried for extensive periods and then rejected. The first was

the tradition of the corporate central bank, chartered by the State but ownedwholly or in great part by private investors...After the corporate central bank

was rejected, the US flirted for seven decades with a second central banking

tradition, namely having the the government's fiscal authority, the US Treasury Department, serve also as the central bank.....The Federal Reserve

Act rejected the earlier traditions of monetary policy controlled by bankers or

the Treasury, but it gave each of these interests a voice in central bank policy

formation.

Fast forward 95 years, and we are coming to the limits of this model. Not only

have private interests managed to co-opt the central bank, as opposed to

have a voice in monetary policy, but they have the Federal governmentapparently ready and willing to give the industry an unlimited, unconditional

guarantee. Retail deposit insurance is capped; why should professional

investors, shareholders (who unless they work for Bear, know to diversify their

holdings) and incumbents, who created this mess, get a far more generous

deal?

Remarkably, and sadly, Congress had the chance to rein in the Fed during its

hearings on the Bear rescue. Indeed, I thought that was the point of that

exercise. But having given the Fed a free pass, there is zero possibility thatthe legislature will leash and collar the Fed as Waldman recommends below.

From Waldman:

As long as the Fed is conducting ordinary monetary policy, switching to a

channel system offers modest benefits at a modest cost to taxpayers. But the

Fed's monetary policy has not been ordinary at all lately. In fact, it's been

quite extraordinary....and it is in the context....that we must consider the

change.

The core of the Fed's new exuberance is a willingness to enter into asset

swaps with banks.... In doing so, the Fed puts taxpayer funds at risk. If a bank

that has borrowed from the Fed runs into trouble, the Fed would face an

unappetizing choice: Orchestrate a bail-out, or permit a failure and acceptcollateral of questionable value instead of repayment. Either way, taxpayers


20/23

are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will

soon have dwindled to $300B, give or take. The difference, about $475B,

represents an investment by the central bank in risky assets of the USfinancial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more

than $1500 from every man, woman, and child in the United States, and

invested that money on our behalf in Wall Street banks that private financiers

were afraid to touch. For bearing all this risk, if things work out well, taxpayers

will earn about what they would have earned investing in safe government

bonds. If things don't work out well, the scale of the losses is hard to predict. The Fed will claim to have done "due diligence" on its loans, to have valued

collateral conservatively, and will point to strength of bank guarantees and

the enormous diversity of collateral assets to convince us that its actions are

safe and prudent. But rating agencies made the same claims about AAA CDO

tranches, and turned out to have been mistaken. Correlations often tend

towards one when asset values fall sharply. Central bankers struggling to

manage day-to-day crises in financial markets might cut corners when trying

to value complex securities. They might find it convenient to err on the side of

optimism, as the ratings agencies did, albeit for very different reasons. Andeven if the Fed is cautious and sober-minded, are we sure that central bankers

can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it

would have invested more than $2500 for every man, woman, and child in

America. Public investment in the financial sector would have exceeded the

direct costs to date of the Iraq War by a wide margin. Would that that be

enough? If not, how much more? Just how large a risk should taxpayers

endure on behalf of companies that arguably deserve to fail, to prevent

"collateral damage"? Have we considered other approaches to containing

damage, approaches that shift costs and risks towards those who benefited

from bad practices, rather onto the shoulders of taxpayers and nominal-dollar

wage earners? Does this sort of policy choice belong within the purview of anindependent central bank?....


21/23

I don't love the decisions that were made, but decisions did have to be made,and there weren't very good options. But now we have a moment to reflect. If

the credit crisis flares hot and bright again, how much more citizen wealth

should be put at risk before other policy options are considered? That's not arhetorical question: We need to choose a number, a figure in dollars. My

answer would be something north of zero, but not more than the roughly

$300B stock of Treasuries that remains on the Fed's balance sheet....

.....suppose Congress gives the Fed the authority to pay interest on reserves.

Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for

troubled assets..... Since interest rates can be held to any level by adjusting

the "corridor", the Fed would retain the flexibility to respond to inflation. Atthe same time, it would be able print cash in any amount that it pleases "to

infinity and beyond!" in order to fund asset swaps (or outright purchases)

at taxpayers' risk. This strikes me as a delegation of Congressional authority

that would not only be undesirable, but arguably unconstitutional......

I think that Congress should grant the Fed's request, but it should

simultaneously impose constraints on the composition of the Fed's balance

sheet that cannot be violated without express legislative consent. This will be

a complicated exercise, unfortunately. Besides government debt, centralbanks quite ordinarily hold precious metals and foreign exchange, and

limitations on non-Treasury assets will have to take this into account. Plus,restrictions would have to be written carefully to apply to off-balance sheet

arrangements such as TSLF, and contingent liabilities like the insidious

reverse MBS swap proposal. Finally, Congress must consider restrictions on

the Fed's ability to enter into derivative positions, whether directly or

indirectly via special purpose entities, including how the bank's existing

derivative book should be managed and whether the bank should or should

not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be

permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary


22/23

monetary policy, exchanging government debt for cash and vice-versa. But if

the central bank wants to put ever greater quantities of public money at risk,it will have to accept a lot more public supervision. If the prospect of intrusive

oversight is too much for the Fed, then, as James Hamilton hints, perhaps the

roles of central bank and macroeconomic superhero should be moved toseparate boxes on the organizational chart. If we are not careful, the next

bank requiring a taxpayer bailout may be the Federal Reserve system itself.

Downtown LA Package for Sale at 35 Cent on the Dollar

Posted: 11 May 2008 08:42 PM CDT

Bloomberg reports that the company that is the biggest property owner in

downtown LA, with concentrated holdngs in the Little Tokyo section of LosAngeles is trading at a deep discount to book value minus borrowings. The

reason? The company may not be able to refinance debt coming due.

Now one may legitimately take book value with a handful of salt, and my dim

recollection of LA is that Little Tokyo is adjacent to rather than in the businessdistrict. Another factor is that this stock probably trades by appointment:

market cap of $142 million, with 45% held by the CEO. Nevertheless, this is

yet another manifestation of the credit crunch.

From Bloomberg :

A package of Los Angeles real estate on sale for 35 cents on the dollar isattracting investors to the depressed shares of Meruelo Maddux Properties

Inc., the biggest private landowner in the city's four-square-mile downtown.

The stock has plummeted 85 percent since an initial public offering 15 months

ago as the global credit crisis threatens to disrupt refinancing of $200 million

in mortgage debt coming due in the next 12 months, as well as completion of

the city's tallest downtown residential tower.
http://feeds.feedburner.com/~r/NakedCapitalism/~3/288296320/downtown-la-parcel-for-sale-at-35-cent.htmlhttp://www.bloomberg.com/apps/news?pid=20601087&sid=amTX0Zbyzuhw&refer=homehttp://feeds.feedburner.com/~f/NakedCapitalism?a=0JdYGHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=hO5iyHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=zlcg2Hhttp://feeds.feedburner.com/~f/NakedCapitalism?a=wmJDsHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=h2casHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=Jj4uQhhttp://feeds.feedburner.com/~f/NakedCapitalism?a=QqpU3hhttp://feeds.feedburner.com/~f/NakedCapitalism?a=Qj2vdHhttp://feeds.feedburner.com/~f/NakedCapitalism?a=HQexOHhttp://feeds.feedburner.com/~a/NakedCapitalism?a=QVkCNfhttp://feeds.feedburner.com/~r/NakedCapitalism/~3/288296320/downtown-la-parcel-for-sale-at-35-cent.htmlhttp://www.bloomberg.com/apps/news?pid=20601087&sid=amTX0Zbyzuhw&refer=home


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Meruelo Maddux owns or controls 80 acres including the Little Tokyo Shopping

Center, home of the country's largest Japanese supermarket, as well aswarehouses and buildings used in Tom Cruise's action film ``Mission

Impossible III.''

``It sure looks like a cheap way to play the downtown L.A. market,'' said Mike

McGarr, a portfolio manager at $2.4 billion Becker Capital Management in

Portland, Oregon, which has added shares this year and owns 1.55 million.

``You're not hanging your hat on a few properties. You've got about 50

properties in various states of development or redevelopment.''....

Loan payments and maintenance consume $500,000 a month more than the

company takes in, eroding the developer's $13.5 million in cash.

is the securitization crisis driven by non

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