In trying to find a common thread from each of the political spectrum’s, I have to conclude that Ben Bernanke [Fed] and Henry Paulson [Treasury] do not have enough credibility remaining to get the rescue plan they are seeking.

Perspective from the Left – Paul Krugmanof the NY Times has a four-step view of the financial crisis:

1. Bursting of the housing bubble
2. Financial Institutions with too little capital
3. Financial Institutions unable or unwilling to lend
4. Financial Institutions trying to pay down their debt by selling assets, which has led to a downward spiraling of prices, known as the ‘paradox of deleveraging.’

He refers to the Paulson package as ‘trash for cash.’ He emphasizes that the same people who have been telling us that things were under control, now tell us the sky is falling and we have to act now. Specifically he notes:

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

Perspective from the Center – Robert Samuelson of Newsweek emphasizes how much of a confidence game this all is and how financial institutions have lost it. He lays out how this all developed:

• Housing bubble burst resulting in big losses in $1.3 trillion market for subprime mortgages.
• The losses should have been manageable to the economy since US stocks and bonds totaled $50 trillion in 2007, however no one knew the real value of the losses, so the confidence crisis spreads.

The Fed has done 3 things to prevent eroding confidence from becoming panic:

1. Cut interest rates on Fed Funds – from 5.25% to 2%
2. Act as lender of last resort through new ‘lending facilities’ = $300 billion to date
3. Prevent bankruptcies – Bear Stearns, Fannie Mae & Freddie Mac, and now AIG.

Each of these steps have lost their hoped for effects as new developments emphasized that the crisis was not manageable, i.e. loss of confidence in Bernanke and Paulson. We can’t even have an idea how much this will all cost. He summarizes:

Objections to Paulson’s proposal abound. It would rescue some financial institutions from bad decisions. Some investors doubtlessly bought subprime securities at huge discounts and would reap massive profits by reselling to the government. That might trigger an angry public backlash. The program would be huge (“hundreds of billions,” says Paulson) and could burden future taxpayers. To which Paulson has one powerful retort: It’s better than continued turmoil and possible panic. But that presumes success and begs an unsettling question: if this fails, what — if anything — could the government do next?

Perspective from the Right – The WSJ Editorial page mission is to not allow the perception to take hold that this crisis is primarily attributable to deregulation and greed. First they have a little fun:

Once upon a time, in the land that FDR built, there was the rule of “regulation” and all was right on Wall and Main Streets. Wise 27-year-old bank examiners looked down upon the banks and saw that they were sound. America’s Hobbits lived happily in homes financed by 30-year-mortgages that never left their local banker’s balance sheet, and nary a crisis did we have.Then, lo, came the evil Reagan marching from Mordor with his horde of Orcs, short for “market fundamentalists.” Reagan’s apprentice, Gramm of Texas and later of McCain, unleashed the scourge of “deregulation,” and thus were “greed,” short-selling, securitization, McMansions, liar loans and other horrors loosed upon the world of men.

Then the WSJ Editorial page gets down to business and tell you who failed to do what:

• Federal Reserve – Original sin of this crisis was Alan Greenspan’s easy money from 2003 to 2005.
• Fannie Mae & Freddie Mac – Created by government, they — like Obama insider Jim Johnson — abused the subprime market to meet Congressional demands to finance affordable housing and increase their own bonuses. Their investors [mainly mainland China] correctly assumed that the investment was without risk, given their political mandate.
• Credit-rating oligopoly – A few credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong. Assets officially deemed rock-solid by the government’s favored risk experts have lately been recognized as nothing of the kind.
• Banking regulators – The great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed’s regulators blessed, or overlooked, Citigroup’s off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.
• Community Reinvestment Act – This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

All articles referenced are copied in full at end of post.

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WSJ Editorial – 9/22 – A Mortgage Fable

Once upon a time, in the land that FDR built, there was the rule of “regulation” and all was right on Wall and Main Streets. Wise 27-year-old bank examiners looked down upon the banks and saw that they were sound. America’s Hobbits lived happily in homes financed by 30-year-mortgages that never left their local banker’s balance sheet, and nary a crisis did we have.

Then, lo, came the evil Reagan marching from Mordor with his horde of Orcs, short for “market fundamentalists.” Reagan’s apprentice, Gramm of Texas and later of McCain, unleashed the scourge of “deregulation,” and thus were “greed,” short-selling, securitization, McMansions, liar loans and other horrors loosed upon the world of men.

Now, however, comes Obama of Illinois, Schumer of New York and others in the fellowship of the Beltway to slay the Orcs and restore the rule of the regulator. So once more will the Hobbits be able to sleep peacefully in the shire.

With apologies to Tolkien, or at least Peter Jackson, something like this tale is now being sold to the American people to explain the financial panic of the past year. It is truly a fable from start to finish. Yet we are likely to hear some version of it often in the coming months as the barons of Congress try to absolve themselves of any responsibility for the housing and mortgage meltdowns.

Yes, greed is ever with us, at least until Washington transforms human nature. The wizards of Wall Street and London became ever more inventive in finding ways to sell mortgages and finance housing. Some of those peddling subprime loans were crooks, as were some of the borrowers who lied about their incomes. This is what happens in a credit bubble that becomes a societal mania.

But Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania. Let us take the roll of political cause and financial effect:

– The Federal Reserve. The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.

Fed Chairmen Alan Greenspan and Ben Bernanke prefer to blame “a global savings glut” that began when the Cold War ended. But Communism was dead for more than a decade before the housing mania took off. The savings glut was in large part a creation of the Fed, which flooded the world with too many dollars that often found their way back into housing markets in the U.S., the U.K. and elsewhere.

– Fannie Mae and Freddie Mac. Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.

These are the firms that bought the increasingly questionable mortgages originated by Angelo Mozilo’s Countrywide and others. Even as the bubble was popping, they dived into pools of subprime and Alt-A (“liar”) loans to meet Congressional demand to finance “affordable” housing. And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.

Fan and Fred’s patrons on Capitol Hill didn’t care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing. Even after taxpayers have had to pick up a bailout tab that may grow as large as $200 billion, House Financial Services Chairman Barney Frank still won’t back a reduction in their mortgage portfolios.

– A credit-rating oligopoly. Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government’s favored risk experts have lately been recognized as nothing of the kind.

When debt instruments are downgraded, banks must then recognize a paper loss on these assets. In a bitter irony, the losses cause the same credit raters whose judgments allowed the banks to hold these dodgy assets to then lower their ratings on the banks, requiring the banks to raise more money, and pay more to raise it. The major government-anointed credit raters — S&P, Moody’s and Fitch — were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn’t begin to take effect until 2007, too late to stop the mania.

– Banking regulators. In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed’s regulators blessed, or overlooked, Citigroup’s off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.

The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history. Of course the SEC’s task was only to protect the investor assets at the broker-dealers, not the holding companies themselves, which everyone thought were not too big to fail. Now we know differently (see Bear Stearns below).

Meanwhile, the least regulated firms — hedge funds and private-equity companies — have had the fewest problems, or have folded up their mistakes with the least amount of trauma. All of this reaffirms the historical truth that regulators almost always discover financial excesses only after the fact.

– The Bear Stearns rescue. In retrospect, the Fed-Treasury intervention only delayed a necessary day of reckoning for Wall Street. While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.

Morgan Stanley, Lehman and Goldman Sachs all concluded that they could ride out the panic without changing their business models or reducing their leverage. John Thain at Merrill Lynch was the only CEO willing to sell his bad mortgage paper — at 22 cents on the dollar. Treasury and the Fed should have followed the Bear trauma with more than additional liquidity. Once they were on the taxpayer dime, the banks needed a thorough scrubbing that might have avoided last week’s stampede.

– The Community Reinvestment Act. This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

Robert Litan, an economist at the Brookings Institution, told the Washington Post this year that banks “had to show they were making a conscious effort to make loans to subprime borrowers.” The much-maligned Phil Gramm fought to limit these CRA requirements in the 1990s, albeit to little effect and much political jeering.

We could cite other Washington policies, including the political agitation for “mark-to-market” accounting that has forced firms to record losses after ratings downgrades even if the assets haven’t been sold. But these are some of the main lowlights.

Our point here isn’t to absolve Wall Street or pretend there weren’t private excesses. But the investment mistakes would surely have been less extreme, and ultimately their damage more containable, if not for the enormous political support and subsidy for mortgage credit. Beware politicians who peddle fables that cast themselves as the heroes.
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September 22, 2008
The Great Confidence Game
By Robert Samuelson

WASHINGTON — It’s doubtful that former Princeton University economist Ben Bernanke and ex-Goldman Sachs CEO Hank Paulson imagined what awaited them when they took charge of the Fed and the Treasury in 2006. Since then, they have put their agencies on a wartime footing, trying to avert the financial equivalent of an army’s collapse. As in war, there have been repeated surprises. As in war, the responses have involved much improvisation — for instance, the $85 billion rescue of American International Group (AIG). But last week their hastily built defenses seemed threatened, and so Paulson proposed a radical solution of having the government buy vast amounts of distressed debt to shore up the financial system.

It’s all about confidence, stupid. Every financial system depends on trust. People have to believe that the institutions they deal with will perform as expected. We are in a crisis because financial managers — the people who run banks, investment banks, hedge funds — have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is a financial panic. Paulson aims to avoid that.

As is well-known, the crisis began with losses in the $1.3 trillion market for “subprime” mortgages, many of which were “securitized” — bundled into bonds and sold to investors. With all U.S. stocks and bonds worth about $50 trillion in 2007, the losses should have been manageable. They weren’t, because no one knew how large the losses might become or which institutions held the suspect subprime securities. Moreover, many financial institutions were thinly capitalized. They depended on borrowed funds; losses could wipe out their modest capital. So the crisis spread.

Since August 2007, the Fed has done three things to prevent eroding confidence from becoming panic. The first was standard: cut interest rates. By April, the overnight fed funds rate had fallen from 5.25 percent to the present 2 percent. The aim was to promote lending and prop up the economy. By contrast, the second and third responses broke new ground.

If banks still avoided routine short-term loans — fearing unknown risks — then the Fed would act aggressively as the lender of last resort. Bernanke created several new “lending facilities” that allowed commercial banks and investment banks to borrow from the Fed. They received cash and safe U.S. Treasury securities in return for sending “securitized” mortgages and other bonds to the Fed. In this manner, the Fed has lent more than $300 billion.

Next, the Fed and the Treasury prevented bankruptcies that might otherwise have occurred. With the Fed’s backing, the investment bank of Bear Stearns was merged into JP Morgan Chase. Fannie Mae and Freddie Mac, the mortgage giants, were taken over by the government; their subprime losses had also depleted their meager capital. And now AIG, the nation’s largest insurance company, has been rescued.

How much all this will cost taxpayers is unclear. It could be many billions — or nothing. For example, the Fed is charging AIG a hefty interest rate and expects to be repaid from the sales of the firm’s businesses. But turning the Fed into a massive lending agency supporting specific firms and types of credit was a dramatic shift from its role of regulating interest rates and credit conditions. The official justification: Companies that lent to and traded with the salvaged firms wouldn’t suffer further losses.

Unfortunately, these confidence-building exercises slowly lost their effect. As today’s surprise followed yesterday’s, it became less convincing that Paulson and Bernanke could control the crisis. Practical problems also loomed. The Fed has financed its lending program by reducing its massive holdings of U.S. Treasury securities. It could not do this indefinitely without exhausting all its present Treasuries. A danger: The Fed might then resort to old-fashioned — and potentially inflationary — money creation.

Against that backdrop, Paulson suggested something resembling the Resolution Trust Corp. of the savings and loan crisis. This new entity would buy subprime mortgage securities to stabilize the financial system. But hard questions remain. Which securities would be eligible? Just subprime? Suppose a weaker economy creates new classes of bad debt — say credit card securities? What price would the government pay? Would government hold them to maturity or sell? What about U.S. securities held by foreigners?

Objections to Paulson’s proposal abound. It would rescue some financial institutions from bad decisions. Some investors doubtlessly bought subprime securities at huge discounts and would reap massive profits by reselling to the government. That might trigger an angry public backlash. The program would be huge (“hundreds of billions,” says Paulson) and could burden future taxpayers. To which Paulson has one powerful retort: It’s better than continued turmoil and possible panic. But that presumes success and begs an unsettling question: if this fails, what — if anything — could the government do next?

Copyright 2008, Washington Post Writers Group
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NY Times
September 22, 2008
Op-Ed Columnist
Cash for Trash
By PAUL KRUGMAN

Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system “cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.
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