kingaj12

Dear Fed: The Problem is Solvency, Not Liquidity

Seems to me that liquidity crisis comes first and is dealt with, then the solvency crisis unwinds.

What does this article say? What is a "solvency" policy?

What if World Governments Had Washed Their Hands of the Financial Crisis?

Following Soros' well made points on radical fallibility, we must assume that it is highly unlikely that we have got all of the most important things right. The things we can't know (closed systems) are likely to be the source of the next trouble.

The best we can do is to insist on more transparency into the most strategic parts of the economy. It would be good to know that someone is watching balance sheets of systemically important institutions, for example, so that all the liquidity generated by new taxpayer debt doesn't just go into building the next unproductive bubble (USD carry trade anyone?).

Wouldn't it be nice to know that of all our precious new debt some of it was funding something important -- like new energy sources?

Don’t Blame Free Markets for the Crisis: They Never Existed

Seems like you don't need the Fed -- until you really need someone to create a lot of liquidity in a hurry.

Ponzi investors need to pay for that liquidity backstop. Insurance premiums or haircuts related to the systemic cost of defaulting on their hugely leveraged bets might do the trick.

Financial Reform: The Moment Has Passed but the Need Is Clear

There is a Committee to Establish the National Institute for Finance -- a group in industry and academia proposing to fund a concrete effort to develop infrastructure and research programs concerning systemic risk. At the very least we might get something going that has the potential to gain some insight into our bubble economy.

Check out the NIF at www.ce-nif.org/. It has a petition you can consider signing.

Judge's Message to Rating Agencies: Free Speech Not Freedom to Defraud

Very good article and comments, especially Chap08 and MikeOz. Thank you.

Reform of ratings agencies is the main piece of business needed to restore financial health and to allow the central bankers to draw down government issued liquidity. An effective reform will probably require changing the notion of a "rating".

Transparency is the key issue. A ratings service that enables investors to run their own internal models against the underlying assets would go a long way to restoring confidence in asset-backed paper. The technology to do this is all based on Monte Carlo simulation of cash flows from an underlying factor model. As I understand it, these models and their assumptions are part of the material reviewed by a CRA to justify the ratings application.

How to make this transparent to investors? Well, the models and assumption are captured in computer programs that are run against a database of assets, the results of which are part of the submission to the CRA. Computer programs have interfaces that enable users to change their input assumptions (for example: HPA, interest rate trends, etc). If these computer programs are required to have standardized interfaces, then investors could substitute their own models for those reviewed by the CRA - without needing access to the details of each and every asset in the portfolio.

Extending this thought a bit further: CRAs in effect rate the qualities of a computer model that is seeded with assumptions and is run against a database of privileged information. There are many models out there in the financial world. Some models perform better than others in certain environments. If the interfaces are standardized, then investors could subscribe to multiple model providers. Ratings services could track and rate "model" performance!

So how could we get started on this? I think the key requirements are 1) standardization of the inputs of the cash flow generation modules, and 2) the right of any investor to substitute their own model for those examined by the CRA.

Will the Efficient Markets Hypothesis Survive This Crisis?

EMH is more of a slogan than a principle. It needs to be replaced by a much more careful analysis of how information flows in markets.

Goldman's Success: Put Down Those Pitchforks

Goldman moved themselves up on the risk spectrum and are reaping the benefits. The point is that these profits depended on the US Treasury to finance a huge systemic rescue.

The profits of the surviving banks are a direct result of the liquidity written by the US Treasury and Fed. That liquidity had to be injected because of the bad bets on the US housing market. If regulators had required banks to take haircuts in proportion to the systemic risk they were taking, then there would not have been any profits on shorting the bubble.

Its our fault. If we don't charge for systemic risk, then surviving banks will look successful and pay themselves big bonuses.

It looks like capitalism, but it's not. It depends on the socialization of credit.

What Were Subprime Loans Modeled On?

The Fed has a great analysis on securitization of subprime.

www.newyorkfed.org/res...

The basic point is that the subprime ARMs were so punitive that that owner was forced to refinance in 24 or 36 months at the option of the issuer. The issuer (of course) counted on the refi to turn a risky mortgage into hard cash.

You don't need to invoke CRA abuse to follow their argument. So long as investors believed that home prices would not fall, then subprime was an amazingly good deal for the issuers.

Systemic Risk Is Unmanageable

The bottom-line question appears to be what to do during the inflationary build-up that preceeds (or triggers) a deflationary crisis. According to Minsky, the financial sector inevitably transitions from conservative lending (when liquidity is plentiful), to speculative activity (when liquidity is scarce and and risk-taking is well-rewarded), and finally to outright Ponzi schemes like subprime securitization.

We need to make all this financial scheming pay in advance for the liquidity that these schemes depend on. The reserve banking system has in effect sold a "put" option on the equity of the financial sector: a systemic bank rescue restores the balance sheets of the financial system so it can be viewed as the payout of a put option on bank equity. The marginal change to the cost of hedging this put option can be attributed to changes in bank positions, and some percentage of this change can be charged back to the banks in the form of a systemic risk haircut, or some such device.

Even if one got the calculation wrong (a reasonable assumption!) systemic risk haircuts would supply a counter-cyclical pressure on leveraged financial risk-taking. Moreover such attributions can be scaled based on a reasonable view of the fundamentals. Financial institutions taking large leveraged positions in crowded markets are making use of a social good (liquidity). Liquidity is not free. If they paid for it up front then maybe, just maybe, their behavior would change.

A Socratic Dialogue: Fearing the Collapse of U.S. Treasury Bond Prices

The key point (not really well put by the author) is that the only source of liquidity creation since mid-2008 has been US Treasury borrowing.

Liquidity creation = creating assets that folks willingly hold in place of cash.

When the rest of the world starts creating liquid instruments that folks want to hold in place of cash, then you might see effects from oversupply of US Treasuries.

The Mystery Behind the Parabolic Yield Curve

Time for a bankcor, anyone?

en.wikipedia.org/wiki/...

Anna Schwartz: The Fed's Performance 'Has Been Disappointing'

I apologize for my flame above. Thomas Gordon's comment above was more appropriate.

Anna Schwartz: The Fed's Performance 'Has Been Disappointing'

I have to say, with all due respect, that Anna Schwarz's observations on Bear Stearns and Lehman were much shallower than I would have expected given her reputation. This might lead one to reflect that, since she and Friedman were the academic inspiration for much of how the Fed operates monetary policy, it is perhaps hardly a surprise that we find ourselves in this kind of dilemma today.

Monetarism offers no guidance about systemic risk. Their argument that bailouts encourage bad behavior is inconsistent. Under the typical monetarist assumptions (EMH, etc) such risk-taking ought to have been curbed by investors fleeing their paper long before it became systemically important.

It is easy to construct a case that the attractiveness of monetarism to the political classes was the argument that unemployment was the fault of the unemployed and unionized labor rather than a symptom of an unstable economy.

Now that we have experienced two huge bubbles (internet and subprime) with no "external shocks", all under relatively conservative monetary policy, it is hard to deny that there is something about the financial system that monetarists do not understand.

What worries me and angers me the most is that it is quite likely that there is a lot that monetarists don't understand, and so the few policy levers admitted by this bankrupt economic theory are simply inadequate to finish the job.

The Coming Economic Collapse, Part 1

This article and discussion is very good -- they can be essentially placed into destabilizing forces described by Minsky. See "Stabilizing an Unstable Economy".

The first force is inequality of incomes. The advanced economies are creating labor force that is paid from corporate profits (think managers, Madison Ave, Wall Street, R&D) and government transfer payments that bid for consumption goods without (at least in the short run) actually contributing to their manufacture.

This induces inflationary pressures on consumption goods in excess of the productivity gains of that sector. Hence the decline in real wages going to that sector, even as the services sector (R&D, advertising, managers) tends to see large wage gains.

Outsourcing production to China/India doesn't change this picture, it just alters the location. Minsky's recommendations were to limit transfer payments along with barriers to entry in labor markets, and to control wage growth in the managerial classes.

The second Minsky force described in this article essentially discusses where we are in the process dealing with yet another inflationary bubble. To combat deflation, we know that we must retain the capability to lend and provide liquidity to the lenders. This is a lesson we have learned real well.

The government paper currently being created is highly liquid and can be used as collateral to finance business loans. Much better collateral IMHO than the RMBS paper that was being used for similar purposes a little while ago. This process will work. There is no reason to doubt this.

The question going forward is how to deal with the inevitable inflationary pressures. All that government paper is just going to be rocket fuel for the next bubble.

Some basic controls on leverage are necessary. Why should we be complacent while banks and hedge funds leverage out 100:1 to create fortunes for themselves? They rely on the services of the Reserve Banks and the Treasury to provide the systemic liquidity that underlies the prospect of delivering such fortunes. When that liquidity is gone, they are essentially asking taxpayers to foot the bill.

Systemic liquidity is a service to speculative investors. If they are so hot, then they should pay for this service. Some kind of liquidity insurance should be demanded of folks who rely on liquidity to unwind huge positions. Currently they get it for free -- from us.

Greenspan's Got a Capital Idea

Do you think that Greenspan just got burned when one of his bubble creations infected a major industry?

It seems that up till the early 2000's he had been running a closet Keynesian policy for the benefit of Wall Street. So long as the ramifications were contained to financial assets who would care?