The Fall of AIG

The Washington Post has a three part series on the downfall of AIG, and the role of the Financial Products Group. This is a story of how a subsidiary that was started making hedged transactions in derivatives expanded into credit default swaps. The idea was to leverage AIG's AAA credit rating and provide insurance against what seemed extremely low risks. As AIG's credit rating fell the cost of supporting the swaps increased as counterparties demanded more collateral. And the group's model did not adequately forecast the risks inherent in CDO's built from sub-prime lending.

It is an important story. What we see is that a business that started out limited expanded beyond its original horizons. As the business morhped risks increased in ways that were not recognized.

Justin Fox has some interesting comments on the series.

The Weekend Investment Banking Died

The Wall Street Journal has an article recounting the weekend that Lehman failed, Merrill was sold, and Goldman, Sachs and Morgan Stanley became commercial banks. Inside Wall Street stuff.

Felix Salmon has some good commentary about the implications of this story.

Predatory Lending and Bailouts

Tyler Cowan argues in today's NYT that we would be in better shape today if the Fed had not arranged the bail-in of Long Term Capital Management in 1998. He argues that:

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

We should remember though that the investors in LTCM essentially were wiped out. So much for moral hazard. Cowan's argument, however, is that we were better prepared in 1998 to absorb such a crisis since we had a budget surplus and the economy as a whole was much better. But could the FED really imagine that we would have 8 years of disastrous fiscal policy that we have experienced in the 21st century?

Moreover, it is not clear that this would have dealt with the fundamental psychosis that fueled the real estate bubble. The history of WAMU, described here, is really chilling. The bank was so intent on making loans it used photos as substitutes for documents:

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

The article also describes WAMU's policy of paying real estate brokers to bring loans to WAMU. What is important about this episode is the policy of not even bothering with risk. Earning fees now when the bubble was expanding was the sole concern of the bank. I suppose one can argue that if LTCM had failed we would not have seen widespread securitization of loans, and the whole ideology that the market could police itself would have never crystallized. So sure, failure would have prevented this crisis, but at what cost.

A better scenario would have been a proper response to LTCM. This would have involved more attention to the problems of leverage and more vigorous regulation. And what would have happened to regulators who allowed LTCM to fail in 1998? They would have been vilified for causing a crisis (what happens to any policymaker who tried to stop a Ponzi scheme).

Perhaps the only benefit might have been the ruin of Bob Rubin's reputation, and this might have helped Citigroup marginally.

Chinese Predatory Lenders

This article in the New York Times examines how Chinese savings fueled the US bubble. In accord with Bernanke's Global Savings Glut theory it argues that excessive savings in the rest of the world is the source of our deficits and there is nothing we could have done about it, except pressure China to revalue the reminbi.

The essential parallel is with subprime lending. The Chinese were the predatory lenders and Americans were the ill-informed borrowers. It is a hard story to maintain. The fact that China saved excessively and lent to the US did not mean that we had to use these flows to finance a housing bubble. We could just as easily have used it for investment not consumption, or for building roads in the US instead of in Iraq. The fault for what we did with Chinese savings lies with us. If we had used low-cost finance effectively we would be better off now. The fact that we used it poorly is just a reflection of how short-sided our leaders were and how foolish investors were to believe that a bubble can go on forever.

Bonuses

I have noted before that Wall Street incentives promoted risk taking because the bonuses are earned before the losses are realized. This article in the NYTimes uses the experience of Merrill Lynch to illustrate the problem. There is a very nice graphic there as well.

Excess Returns

Investors often report performance that beats the market. Successful investors are treated as superstars who prove that markets are not really efficient. While such cases are possible there are often other explanations. Today, the superstar investor Bernard Madoff was arrested for essentially running a Ponzi scheme, as reported in the here and here. Madoff reported very high, and very stable, returns for a very long time, and rich people invested in his funds. Now he reports that he paid the returns out of new investments, a classic Ponzi scheme.

Just the other day we learned that William Miller, "the era's greatest mutual-fund manager" has seen all of his superior returns wiped away in the last year. According to this article in the WSJ:

A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.

What these, and many other cases illustrate, is that one cannot tell from observing a string of good years (or of merely reports in the Madoff case) that excess returns are really being earned. This is another case of excess risk masquerading as high "alpha." The problem for investors is that reports of past performance are no guide to future risks, as the disclosure statements always repeat, and as most investors usually ignore.

An important economic point is that prior to the crash the superstar investor is treated as a true Master of the Universe. And those who question this based on efficient markets reasoning are treated as ostrich-like academics, or worse. The investors on a hot streak earn more than those who are more cautious, so over time the latter get replaced. The market is filled with superstar investors and those who aspire to be them. They are encouraged by their management contracts to take on excessive risk and are rewarded. The big problem is that the losses tend to be more broadly felt. They get socialized.

Bubbles

Virginia Postrel has an article in the Atlantic on experimental results concerning bubbles. Even though the participants in the experiments can easily determine the fundamental value of the assets they are trading bubbles and crashes still appear. What seems to happen is that traders are not sure if others realize that there is a bubble and try to profit before the crash.

Although she does not mention it, these results are not surprising given the work by Abreu and Brunnermaier on bubbles and crashes. In their work

The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period.

The key point is then is that even if I know a stock is overvalued I may still participate in the bubble if I do not realize that you are similarly aware of it. After all, if I short the stock and am by myself I may lose big time, while if I ride for a while I may profit till enough short sellers are ready to attack. So the sequence of learning is essential.

It is just this phenomenon that the experimenters seem to be pointing at. But Brunnermaier has already shown that similar phenomena were at play in previous bubbles, looking at the trading strategies of informed traders.

But there is another problem regarding bubbles that is worth discussing. That is the bias in the benefits. Think of the housing bubble. While it is taking place who is losing? Certainly those priced out of the markets, but who else? Everybody else is gaining, whether they are construction workers, bankers, financiers, governments dependent on tax payments...Now what happens if the bubble bursts? Everybody who was riding the bubble now suffers.

Suppose that the bubble was burst by the actions of a concerned policymaker. Would this policymaker be applauded? Seems unlikely. Everyone who suffers would blame the messenger. Certainly, everybody hates short sellers -- the only difference being the latter try to profit from their information. But still, if a bubble collapses it is hard to believe that the policymaker would be anything but blamed.

If this is correct, then there is a bias in favor of bubbles. Cheering on the asset price increases the politicians can say how we have a new economy. The old rules do not apply, and look at the prosperity we have brought. The gloomy official who tries to prick the bubble will be pilloried.

Flight to Safety

Treasury bills are now trading at the lowest rates in history. This article in Bloomberg news has the details:

The Treasury sold $27 billion of three-month bills yesterday at a discount rate of 0.005 percent, the lowest since it starting auctioning the securities in 1929. The U.S. also sold $30 billion of four-week bills today at zero percent for the first time since it began selling the debt in 2001.

Essentially, the government is being lent money at zero cost. This, at the same time that the government is bailing out banks and the budget deficit is approaching $1trillion. One would expect a risk premium for lending to this government. But instead the flight to safety is causing interest rates to the minimum barrier of zero. This is truly a new kind of crisis.

Fannie and Freddie Knew the Risks

This article in the Washington Post reveals emails that show analysts at Fannie Mae and Freddie Mac knew of the risk associated with subprime and Alt A loans, but that top officials refused to get out of this market. Fear of being irrelevant in the mortgage market drove their decision apparently.

The chief credit officer of Fannie Mae

warned that securities backed by these loans might not be as safe as they seemed. Fannie reported them as carrying the top grade given by credit-rating agencies, AAA, but Marzol cast doubt on that. "Although we invest almost exclusively in AAA rated securities, there is concern that rating agencies may not be properly assessing the risk in these securities," he wrote.

Despite these concerns, Fannie continued to push into this new market. A business presentation in 2005 expressed concern that unless it didn't, Fannie could be relegated to a "niche" player in the industry. Mudd later reported in a presentation that Fannie moved into this market "to maintain relevance" with big customers who wanted to do more business with Fannie, including Countrywide, Lehman Brothers, IndyMac and Washington Mutual.

This certainly does not mean that Fannie and Freddie caused the crisis, but it shows the extent to which they played along, and joined the party at the worst possible time.

Joining the Club

The financial crisis is causing some countries to reconsider their opposition to adopting the euro. As this article notes, even Denmark, which twice rejected membership in referendums are now considering a third try. The experience of currency crises in Iceland, Hungary and Poland are causing governments in those countries to try to push towards the euro. What good is monetary sovereignty when you have to go the IMF for emergency funds to save your currency?

As one Polish economist noted: “'When there’s a threat, find God,’ goes the proverb in Poland,” said Rafal Antczak, an economist at Warsaw University. “And that is what has happened.” Substitute the euro for God.

Beware what you say

Perhaps I should be more careful about what I say about the financial crisis. In Latvia, economist Dmitrijs Smirnovs was arrested for "for bad-mouthing the stability of Latvia's banks and the national currency, the lat. Investigators suspect him of spreading 'untruthful information,'" according to this article in the Wall Street Journal. In October Smirnovs "took part in a discussion organized by a small local newspaper, Ventas Balss. Predicting serious trouble ahead for Latvia, he said: "'All I can advise is this: First, don't keep money in banks. Second, don't keep money in lats.'"

The problem, of course, was the Smirnovs was correct:

After insisting its banking sector was healthy, Latvia last month took over the largest locally owned bank, Parex, to save it from collapse. After denying it needed aid from the International Monetary Fund, the government is now in talks with the IMF.

Finance Ministry officials acknowledge that secret police won't save the country from economic crises. But they do believe Security Police vigilance makes the public think twice before spreading uninformed gossip about banks.

"It is a form of deterrence," says Martins Bicevskis, Finance Ministry state secretary.

Arresting people for spreading rumors, or the truth, about the economy is an old Soviet practice. The Latvian officials are afraid of the effect of rumors on speculative flows of capital. But it is not clear that such policies are anything but counterproductive. The less information people have about the economy the more subject they are to rumors and fears.

Back to Keynes II

Greg Mankiw seems to agree with me about the current relevance of Keynes. So does Tyler Cowan. He is creating a discussion of the General Theory at Marginal Revolution.

Morgan Stanley and Short Selling

This article in the Wall Street Journal reports on short selling regarding Morgan Stanley in September. Recall that CEO John Mack attacked short sellers for what happened to the stock price, and was instrumental in getting the SEC to initiate the short selling ban. The interesting tidbit in the article is that hedge fund clients of Morgan Stanley reacted by pulling their funds out as revenge:

But within days, more than three-quarters of Morgan Stanley's roughly 1,100 hedge-fund clients had put in requests to pull some or all of their assets from the firm, according to a person familiar with the operation. Even though most kept some money at the firm, Morgan Stanley couldn't process all the withdrawal requests at once, adding to market fear.

As Felix Salmon argues the notion of a bear raid on Morgan Stanley does not hold water. The cost of insuring against Morgan Stanley default increased because investors needed to hedge, not because of a bear raid. Two months later the cost of insurance is down but the stock is still in the doldrums. As Salmon notes:

Even now, after yesterday's massive rally and a further uptick this morning, Morgan Stanley stock is trading at less than $15 a share. Clearly the stock price is not being driven down by manipulative speculators taking advantage of an illiquid CDS market to sour sentiment.

What I wonder about is how much the loss of business caused by the attack on short sellers cost Morgan Stanley.

Back to Keynes

It is hard right now not to think about the economics of John Maynard Keynes. We appear to be in an environment where the lessons of the General Theory are once again relevant.

Given the developments in macroeconomics in the last 25 years it is a bit hard to type those words. Yet is surely seems to ring true today. After all, our current economic crisis is not the result of some external shock -- indeed, the boom continued while oil prices sky-rocketed. The crisis is related not to external events but to the unraveling of a bubble. In essence, it is essentially a failure of coordination. As investors fear for the future they rush for security. T-bill rates fall to near zero, lending to the private sector decreases dramatically, and income and employment start to spiral downwards. That is why so many now call for a severe dose of fiscal stimulus (see, for example, this article by Paul Krugman).

As my colleague Neil Wallace mentioned to me today, what is striking about our current situation is that unlike, say, Katrina -- which had serious, real destructive effects for both capital and labor but had little impact on the overall economy -- our current dilemma seems to stem directly from fear and expectations. Fear of the future has had very serious real effects. "Animal spirits," or the lack thereof, is the important factor. Investment is on strike right now and we seem to be in a liquidity trap where credit expansion is ineffective at combating the slump.

The return to the economics of Keynes at this moment makes me think about the "corridor hypothesis" that my former teacher Axel Leijonhufvud proposed. He argued that in normal times the market system works well to bring us back to equilibrium. Within the corridor of stability it is like a thermostat -- a negative feedback device. The problems that Keynes wrote about occur when we are outside the corridor. Then we cannot rely on the market to automatically restore equilibrium. That is where the economics of Keynes is relevant. Unfortunately, for us, we now appear to be in that situation.

I suppose that during a long period of stability it is not surprising that we ignore the lessons about effective demand failures. The lessons seem archaic. Now the same lessons seem very relevant. Good fortune allowed us to ignore the economics of Keynes for a while. Perhaps the consequence of assuming that those lessons were no longer applicable is the reason that we recklessly created an environment that caused us to leave the corridor.

Citigroup's Descent

The failure to adequately manage risk is the theme of this article in the NYTimes. One of the highlights concerns Citigroup's analysis of the risk of its mortgage holdings:

...when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Another amazing item is that Citigroup mainly relied on ratings agencies rather than its own risk managers to assess the risks from assets like CDO's. One might understand this if Citi was just selling the assets to gullible investors (which it did), but it held huge slices itself, and it is the losses on the assets it retains that have caused such large losses.

It is amazing to read how a company could lose $220 billion in market value in just two years. As Brad DeLong emphasizes, however, the losses in market value dwarf the announced losses on CDO's and other real estate loans. DeLong's argument is that the risk premium on holding Citi equity has risen as the crisis worsened. After all, the probability that the government will dilute the shares in a takeover has increased dramatically. He takes the rise in the risk premium as the major factor causing the value of Citi's shares to decline so dramatically.

DeLong's analysis is based on the observation that banks are institutions that trade on reputation and trust. The borrow short and lend long. Hence, they are always on the edge in a financial crisis. The risks bank take that are sensible in normal times appear insane in rough times.

Rescue package soon to follow.

Zimbabwe Hyperinflation

According to calculations from Professor Steven Hanke, the annual inflation rate in Zimbabwe has reached 89.7 sextillion percent (89,700,000,000,000,000,000,000%). On the bright side, it is only about 79.6 billion percent per month. If you go to this site you can see a table that shows its massive acceleration.

Frightening Picture of the Day

Frightening picture of the day. This is the corporate cost of borrowing in real terms, from Paul Krugman. Inflation expectations are taken from the difference between 20 year Treasury bonds and 20 year TIPs. You can really see the sharpening of the crisis. A key part of this is the decline in inflation expectations.



A related piece of information is that the spread between high yield bonds and Treasuries rose to 18.6% on Wednesday. The spread was only about 8% in August.

Agency

I've said before that the key problem that led to the crisis was agency. Incentives for financial decision makers encouraged risk taking. An article in today's Wall Street Journal provides some evidence, in the form of earnings of top executives in finance and home-building over the last five years. A key finding:

Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak.

Of course such earning filtered all the way through the financial system. Bonuses and earnings were high at investment banks because the risk taking led to high current earnings, and because insufficient attention was paid to the associated risks that the decisions that produced those earnings implied.

The key point is that these people were obviously not stupid, and the crisis is not due to stupidity, but rather to a system that rewards current performance without attention to risk. To paraphrase James Carville, "it was the incentive system stupid."

Origin of the Subprime Mess

Michael Lewis, of Liar's Poker fame, has an article that discusses the origins of the subprime crisis. As usual with him, it is very readable. The most important parts are the discussion of synthetic CDO's, though I am not sure that discussion is as clear as the rest of the article. But it is worth reading.

Saving the Taxpayers II

Regarding my previous post on the corporate raider plan to save GM I should make two points. First, I need to amend my argument to make GM bankrupt without a government bailout. This is easy: I need to suppose that the market currently factors in some amount of bailout with an expected value greater than $1.8 billion. Then the current value of cash flows is less than the value of all its liabilities. The government is still better off buying and selling the company if it can receive enough to offset some of the claims it will face in the event of bankruptcy. I will show this later.

The key point to make is that for the government the legacy costs are sunk. It is going to have to pay them in the event of bankruptcy. So any net revenue it gets lowers the taxpayer burden relative to bankruptcy. This is not true for the private corporate raider. To the private corporate raider the legacy costs are like a tax. But the government can internalize this tax. The private raider cannot.

Saving the Taxpayer from GM bailout

It seems likely that the government is going to devote taxpayer funds to a bailout of GM. It seems to me, however, that acting as a corporate raider the government can do a lot better for the taxpayer, and for other stakeholders as well. This seems bizarre, but I think it is correct. Here goes.

A Bailout for the Taxpayers: Government as a Corporate Raider

We hear that GM is likely to go bankrupt if the government does not offer a bailout. It is losing $2 billion a month, and by the end of the year its cash reserves will fall below feasible operation. We also hear that GM's problems are the result of legacy costs. These costs are a fixed cost that GM cannot unilaterally cut, and these prevent GM from investing in R&D and new models. Hence, it puts GM at a competitive disadvantage relative to other auto companies.

Let us suppose that this is true. It seems that the government, by acting as a corporate raider, could make everyone better off – surely compared with a bailout. The simple way to think of this is that GM is a company with two divisions. One produces autos and earns revenue. The other produces health and pension benefits but sells nothing. The combined value of this company is now valued at about $3 per share, which gives a current market valuation of GM at $1.8 billion. Let us suppose that legacy costs are $20 billion, and for simplicity assume that this is GM's only debt. Then the present value of cash flows must equal debt plus equity, so the present value of cash flows is $21.8 billion.

Now suppose the government purchased all the shares of GM at the current price (ignore for now the problems of making a tender). The government owns all of GM. Now it creates two companies, by splitting the two divisions. It then sells the auto division to the private sector. What would this company be worth? If the cash flows of the company were unchanged it would be worth $21.8 billion. With these proceeds the government could fund the entire legacy costs, since this is just the difference between what GM sold the auto company for and what it paid for the whole company.

But GM claims that its legacy costs are hurting its competitiveness. If this theory is correct then the expected value of GM auto cash flows would be higher if the company was relieved of the legacy costs. Hence, the government ought to get even more than $21.8 billion. If the theory is correct, splitting up the company this way ought to produce value. And remember, the legacy costs are now fully covered (perhaps they should not be, but that is a different question).

Notice that the current value of GM may be higher than it is really worth. The market may have factored in the expectation of a bailout. Perhaps, the present value of the bailout is worth $1.8 billion. Even if this is true, the government would make money on this raid as long as the expectation of future cash flows rises by more than $1.8 billion when the auto division is relieved of these costs.

How does this compare with bankruptcy? If the government does not bail out GM the company will still be restructured. But in that case the government will be stuck with the legacy costs, which will be turned over to the PBGC. The retirees will be worse off because the PBGC will pay perhaps 40 cents on the dollar of obligations (I am not sure that 40% is the right number, but you get the idea). More important, however, the government is worse off. Why? Because when GM emerges from bankruptcy the government will owe 40% of the legacy costs but have no revenue to fund this (there is future tax revenue, but they get that under the corporate raider plan too). The current shareholders are worse off because under the corporate raider plan they at least get $1.8 billion.

If this deal is so good why doesn't a private investor do it? Notice that if a private investor made a tender for GM its price would rise, lowering the gain of the deal. Presumably the government can purchase all the shares outright without having to accede to SEC regulations on tenders. Moreover, the private investor would have to be large enough to be able to fund the legacy costs until the new company is re-sold. Without this the unions would not accept the deal. In fact, it would probably be illegal for the private raider to split the company into these two divisions without putting up a guarantee for the legacy costs. But the US government could do this easily.

It seems like everybody wins. Surely, it is better than a bailout that allows GM to continue to operate with the legacy costs for more months, hoping the auto market will turn around. The only reason why this would not work would be if GM's argument that its operations are hampered by legacy costs is not really true.

It could be that GM's losses are sufficient to drive the company bankrupt even without the legacy costs. In that case the government would be out the full $20 billion for the legacy costs and receive nothing for the auto company, or perhaps some smaller amount, say $5 billion (which means the market is currently valuing the potential bailout at $16.8 billion = $21.8 billion - $5 billion, which is hard to believe given that the probability it takes place is less than certain). Then the government will be out $17 billion. Presumably in that case it can restructure the legacy costs, recognizing that if the company had gone bankrupt, which it certainly would in this case, the government would inherit the legacy costs anyway.

Let us suppose that if the government inherits the legacy costs it has to pay 40%. So if the company goes bankrupt the government is out $8 billion. Then even if the auto-GM is only worth $5 billion (as in the previous paragraph) as long as the government settles the legacy costs for less than $11 billion, the government is better off, and certainly the retirees are better off.

So far I did not consider corporate debt, aside from the legacy costs, but it is not hard to include this in the analysis. Suppose that there is $10 billion of corporate debt. Then GM's cash flows would be worth $31.8 billion ($1.8B + $20B legacy +$10B in corporate debt). If GM's theory is correct, then nothing is changed in the analysis. Absent the debt the company can be sold for $31.8 billion, which is enough to fund the legacy costs and the debt.

The interesting case is when GM's theory is incorrect, when the company is worth less than its current debt plus equity. To continue with the previous example, suppose the government can sell it for only $5 billion, so it is left with $3 billion after the purchase price. This now has to cover $27 billion in debt (corporate plus legacy). Using the 40% rule the government must reserve $8 billion for the retirees. The question then is how much of the $3 billion goes to the corporate debt holders and how much to the legacy costs. If the government pays 20 cents on the dollar to the debt holders, it can still pay $8.5 billion to the retirees, who are better off than under bankruptcy. Is 20 cents on the dollar fair? The government sold assets for $5 billion that had $27 billion in debt. Surely under bankruptcy proceedings the debt holders would have done even worse.

And what about the taxpayers? Even in this case they are better off. The government saves half a billion in this most pessimistic scenario compared with bankruptcy. And if GM is really worth something the government and the other stakeholders share in the gain. Alternatively, under a bailout the government is out the subsidy plus the same legacy costs if it is unsuccessful. And if GM still labors under the legacy costs there is no improvement in its operations. So the corporate raider solution is the best way to protect the taxpayer.

More Fannie Losses

Fannie Mae reported quarterly losses (also here) of $29 billion for the third quarter. This is a huge amount of losses, greater than all of Fannie's profits from 2002 to 2006 -- the height of the boom in housing. This suggests that we have not yet reached the bottom of the housing boom.

It is also instructive of the unintended consequences of government policy. Apparently, Fannie is having great trouble refinancing its bonds. The reason is that as a GSE Fannie has only an implicit government guarantee. But banks now have much more explicit government guarantees, indeed many are partially government owned now. So the costs of borrowing for Fannie (and Freddie) are much higher. This will make it harder for Fannie and Freddie to extend lending which the government wishes they would.

Porsche Financial Engineering

As a Porsche owner I am convinced of the quality of Porsche's engineering. But now we have more details about Porsche's financial engineering. Apparently, Porsche was able to engineer a short squeeze on VW shares as it moved to become the majority owner of the firm. The squeeze briefly made VW the most valuable company on earth, and it made Porsche, already the most profitable of auto companies a huge return.

Surprising Country Risk Ratings

Merrill Lynch analysts have decided to go back to country risk analysis the old-fashioned way, by looking at indicators of macroeconomic and financial stability (see this article). Specifically, the look at indicators such as: the current account financing gap, FX reserves/short-term external debt ratio, exports to-GDP ratio, private credit-to-GDP ratio, private credit growth, loans-to deposits ratio and banks capital-to-assets ratio.

Using these indicators they obtain the following country risk rankings which are a bit surprising.


Now I am not yet ready to move my assets to Nigeria. It is important to note that a country might do well on some of these rankings by having a horribly underdeveloped financial system. This would certainly lower private credit growth for example. And primary exporters will do well since they have high foreign exchange earnings. Still the rankings are interesting. They indicate that those countries that were the go-go countries in the boom are much more risky now.

Financial Engineering

What role did financial engineering -- complex quantitative financial models -- play in the financial crisis? This article in the New York Times discusses this issue. The article notes:

“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”

Math, statistics and computer modeling, it seems, also fell short in calibrating the lending risk on individual mortgage loans. In recent years, the securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.

An important point, noted by Andrew Lo is that while academic economists were receptive to his warnings of the risks associated with financial innovation Wall Street was not. The reason is that Wall Street had little incentive to listen as long as profits were high. He points out that we have fire safety regulations even though buildings have little risk of burning down, and financial regulation is needed for the same reason.

Gary Gorton and AIG models

Gary Gorton, Professor of Finance at Yale, has written one of the best articles on the panic of 2007. The essential point is that:

The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages...When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks.

It turns out that Gorton was also responsible for producing the risk models that AIG was using to value credit default swaps. This article explains his role and how the models failed to account for the key risks that led to AIG's downfall. As the article notes:

Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

Felix Salmon also links to the article and has a good discussion. He notes:

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let's say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you're happy, and making money. But let's say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

The answer of depends on how many such bonds you hold, and what your counterparties think. And AIG got into trouble when it could not come up with sufficient collateral to meet the demands.

How we got into this mess

How did a Wisconsin school board, a German bank located in Dublin, and the New York Subway system get caught in the financial crisis? The New York Times has the first in a series on this here.

The saga is interesting, but the story is familiar. "Financial experts" convince boards that complex financial products will lower their borrowing costs and increase their returns. The risks in the products are not adequately considered. An event occurs which reveals the true risks.

Despite the familiarity it is an interesting story.

Shiller on Failure to Forecast the Crisis

Robert Shiller argues that economists distaste of behavioral finance is the reason why warnings about the crisis were ignored. Shiller was one of the few economists who warned about the housing boom, so his experience is worth considering. I still think, however, as I discussed in a previous post, that it was the lack of belief in market efficiency that got us into this mess.

Behavioral Finance and the Crisis

David Brooks argues that the current financial crisis will be a coming out party for behavioral economics. His starting point is Greenspan's recent confession:

As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

But this misses a key point. The major players were rational. They made money because they received bonuses based on returns that hid risk. The problem was agency not irrationality. What Greenspan apparently missed is the fact that the managers of corporations do not have interests that coincide with the shareholders. The separation of ownership and control is an old issue in economics. We know that when agency problems arise incentives are need to get the agent to act in the interests of the principal, here the shareholder. To get agents to pursue profits incentive contracts give them shares. But the downside risk is zero -- you cannot indenture as a slave a manager who loses big money. Hence, the manager has big incentives for risk taking. This is what happened.

Now one can argue that the boards of directors or very top managers should have watched risk more closely. But they were booking large profits and large bonuses. Had they believed that markets were efficient they might have wondered how they were earning such large returns -- where are the associated risks that allow this. But instead they assumed markets were inefficient and assumed they had hired wizards. Notice that this is exactly the opposite of the view that Brooks is expressing.

This is not to say that behavioral finance may not have good insights about issues related to the financial crisis (and finance in general, here is a survey), but certainly not in the way argued by Brooks and most commentators today.

New Bretton Woods?

Sebastian Mallaby discusses the possibility of a new Bretton Woods agreement. He points out that it will be important how China reacts to the situation:

Today it is the rising power that pursues mercantilist policies via its exchange rate. China's leadership, which sits atop an astonishing $2 trillion in foreign-currency savings, could trade a promise to help recapitalize Western finance for an expanded role within the IMF. But China may simply not be interested. The future of the global monetary system depends on whether China aspires to play the role of Roosevelt -- or whether it prefers to be a modern Churchill.

But I wonder about another problem. The Bretton Woods agreement had the benefit of having the century's greatest economist, John Maynard Keynes, essentially running the show. He led the British delegation. There are plenty of good economists today, but any new agreement is going to be led by Presidents and Prime Ministers. Who will be the Keynes of the new agreement?

Flight to Safety

The unwinding of the carry trade and the flight to safety is causing the yen and dollar to appreciate. This is what is spreading the crisis to many emerging markets.

I gave a talk on the financial crisis this week and I noted that this crisis was unlike typical ones in one big way. When most countries experience a financial crisis currency flows out and the biggest problem is to defend the currency. The IMF then comes in and pushes lower government spending to create confidence in the future of the economy. But our crisis has caused the dollar to appreciate as the whole world demands the safety of the dollar. Hence, our government is increasing spending. We have created a new type of financial crisis. That is the risk when it comes from the financial center.

Are Banks Lending?

Joe Nocera argues in the NYTimes today that many banks are using their recapitalization to buy other banks rather than make loans. While he decries this tendency, it still represents some consolidation of the financial sector. That should make it healthier. I think that lending will be down because of fear of recession and tightening credit standards. After making so many bad loans, banks are going to look tougher at credit standards. That seems like a rational response to what has happened. It will make the recession more severe.

What this really points to is that now the recession is not due to lack of liquidity but to fear of lower earnings. The impact of the financial crisis has already been felt. Genie cannot get back in the bottle.

Recession May be Bad

Officials at the Treasury and the Federal Reserve are expecting a serious recession, according to this article in the Financial Times. One quote captures the feeling, that from former Fed Vice Chair, Alan Blinder:

“It looks to me like the economy has fallen off a cliff...The game is now about making sure this recession is less deep and less long than the 1982 recession.”

One difficulty in forecasting how deep this will be is the fact that the crisis is international. Another, is to understand how US households will respond to the cut in their wealth. Will savings rise in reaction? We have depended for a decade on households consumption based on the growth in asset prices. Now that households cannot rely on this, what will happen to consumption?

Causes of the Financial Crisis

Tyler Cowan discusses the causes of the financial crisis in the New York Times. His one paragraph summary is that:

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

New wealth matters because it led to the savings glut and a fall in real interest rates. The money had to go somewhere. The problem is where the financial system channeled those savings.

It is important to also recognize that when a boom takes place those who are betting on the bubble continuing are making large gains. They tend to shout down then naysayers at that point. That is why it is hard to implement any policy to pop the bubble. Given this is unlikely to ever change, one would hope we can at least implement policies that reduce systemic risks. But that is also easier said than done.

What's Next

Joe Nocera discusses some proposals to deal with the housing problem, which is, after all, the core problem of the financial crisis. Until we deal with this problem in some way the crisis is likely to get worse, not better.

The Crisis is Spreading

The crisis is now spreading to other economies (see this article), like Iceland, that relied heavily on borrowing at low interest rates to support their debt. Now repayment is very difficult.

Following the virtual seizing up of the Icelandic economy, countries such as Hungary, Argentina and Pakistan look vulnerable as they struggle to pay their bills. These countries took on large amounts of debt in the good times, when credit was cheap, and are now running out of money to pay them off because banks and investors refuse to lend to them.

This is the contagion. But while the crisis causes a recession in the US, the cost to emerging economies may be much greater.

Arrow on the Crisis

It is always important to listen to Kenneth Arrow on any topic. Here he talks about the financial crisis. Important passage:

the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Keynesian Recession Coming

It looks like we are in for a real Keynesian recession. The liquidity crisis seems to have led to a stop to bank lending, so we are approaching a liquidity trap. Demand is now falling, witness the drop in retail sales announced today which shook the markets, and this is a sign that the recession is already underway. If monetary policy is ineffective due to bank's unwillingness to lend, we are in the almost classic "Keynesian type" recession of old textbooks.

The relevance of Keynes to our current experience was highlighted by Robert Skidelsky in this column. He is perhaps correct when he writes that

To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

But I think he overstates his case considerably when he argues that " mainstream theory has no explanation of why things have gone so horribly wrong." In particular, he expresses the view that is prevalent now that economists focus on efficient markets blinded them to

Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models.

This is factually incorrect. We have models of bubbles and herd behavior. But more important it ignores the point that much of the problems we have now are the result of ignoring market efficiency. When investors believed they could earn extra return for no extra risk they were not basing their behavior on efficiency. The carry trade is an example of profiting from the absence of efficiency. The problems we now face are that markets caught up. The excess returns they were earning were just a compensation for the losses that are now incurred. If savers and investors had assumed that they could not earn extra return for no extra risk they would have been in index funds not CDO's. They would not have been fooled by ratings from ratings agencies.

Economists' Views on the Recapitalization

The Wall Street Journal collected some opinions of academic economists on the recapitalization plan. One item of dispute seems to be whether it is better for the government to claim preferred or common shares. The former means more security for taxpayers and no voting rights. But it also could induce more risk taking on the part of banks close to the brink. Preferred shareholders get paid first, so for the common shareholders who are close to being wiped out more risk may be better.

TED Spread

The TED spread, the difference between the rate at which banks borrow from each other, LIBOR, and the rate on Treasury Bills is a key indicator for the problems in the interbank market. Perhaps as a result of the European moves towards a bank rescue plan the TED spread fell 1.4% today. But it is still very high. You can see from the chart below that the TED spread is still much higher than in the summer. But at least today is some positive news.

Crisis Resolution

Momentum is building towards some type of bank recapitalization. A group of economists has published a set of essays describing how some resolution might take place. The essays are here. What is evident is that a broad group of academic economists see that some type of recapitalization is the way to go.

Europe Agrees to a Bailout Plan

European governments announced an agreement on a bailout plan. Here is an article that describes the agreement. The plan includes recapitalization of banks and a guarantee of interbank lending. It is clear that markets were worried about the lack of a plan, and this announcement may be good news Monday morning. Of course we will want to see more details in how this works. It seems that the details of many plans are rarely as good as the announcements. In particular, as Floyd Norris notes, "they left it up to each nation’s government to provide details of how its own banking system would be protected."

The plan asserts that it will “support systemically important financial institutions and prevent their failure.” But it is not clear which institutions will qualify as such. More important, this may not free up interbank lending if one of the banks is clearly not "systemically important."

But this action still seems to be a good step.

Plan B

Luigi Zingales offers an interesting alternative bailout plan. His plan focuses on ways to recapitalize the banking sector and to deal with the mortgage crisis. His Plan B idea is to stop the piecemeal reaction to developments in the financial crisis and implement a comprehensive plan.

Here is the core idea regarding the bank part of the bailout:

The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equityhodlers wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

I wonder if policymakers in the US are ready for such a comprehensive solution. Certainly Congress did not display the attention nor energy with regard to Plan A. Perhaps the deepening of the crisis would help, but prior to the election I think we are going to have to rely on the discretionary power of Bernanke and Paulson.

We had better hope right now that some effort towards bank capitalization appears early this week.

End of the Carry Trade

The carry trade is a bet where you borrow at low interest rates and lend at high rates. Typically, you borrow in Japan and invest in Australia. Your bet is that the interest differentials are not signaling that the Yen will strengthen relative to the weaker currency. For long periods you make small gains. Iceland seemed to be operating as a huge carry trade hedge fund.

It seems now, however, that the carry trade may be ending. The Yen is strengthening in the wake of the crisis. Notice that the carry trade is a bet that markets are not efficient -- that interest parity will not hold. For long periods of time it seems that one can make money going against this. But eventually the reckoning occurs. The problem with such bets is that when they unravel it is a very hard landing.

The carry trade was very profitable for years prior to the Asian crisis. But it unwound quickly and caused large losses when the Yen did appreciate. I wonder if the current unwinding will spread the pain now.

Not to Worry?

Casey Mulligan has an op-ed in the New York Times telling us not to worry about the financial crisis. His basic argument is:

The non-financial sectors of our economy will not suffer much from even a prolonged banking crisis, because the general economic importance of banks has been highly exaggerated.

Mulligan argues that the return to capital in the non-financial sector is still high. But it was also high prior to the Great Depression (I am not arguing we are going to have one, but...). It is hard to believe, however, that the drying up of credit will not hurt the rest of the economy. State governments, for example, are coming under great difficulties, and this is before taxes start to fall from reduced spending.

In the fall of 1929 America's leading economist, Irving Fisher, argued that "Stock prices have reached what looks like a permanently high plateau." When the Depression did arise he contributed an important explanation of debt deflation. Perhaps, Mulligan will be our next Irving Fisher.

Compared to Mulligan's article, this piece by Laurence Kotlikoff and Perry Mehrling is tame. They argue that the financial crisis brings offsetting gains as asset prices fall. Focusing on financial losses alone, overstates the problem. But financial bubbles lead to misallocation of capital. Capital has been wasted and will have to be written off. These are real losses. Of course, some people will be able to purchase homes at cheaper prices, but the losses will impact on further investment. They are probably correct that Paulson and Bernanke will not make the mistakes that translated the credit crisis of the early 1930's into the Great Depression. But when an economy deleverages from the levels we have seen, the economy is going to suffer.

Greenspan's legacy

The New York Times has this article on Greenspan's legacy. The focus is on the failure to regulate derivatives. I have to admit that at the time I was on the side of Greenspan, and Rubin and Summers. Like most economists, I just assumed that a government agency headed by a lawyer could not understand the role of a complex financial contract.

Hubris is no substitute for analysis I guess.

Short Sales Ban Ends Tomorrow

The ban on short sales ends tomorrow. Will stocks collapse? Probably not, perhaps the reason why stocks tanked Tuesday was in anticipation of the lifting of the ban. After all, if prices are expected to fall tomorrow nobody will hold them today.

Another interesting date to watch is October 10 (in an earlier post I got the date wrong, October 23 is the date that WAMU bondholders will have their auction. Lehman's auction is in a couple of days, but this just strengthens the point I am making). That is the day that the auction will take place to settle the credit default swaps relating to the Lehman bankruptcy. The amount that is owed in this case could be $400 billion. Fear over how this will play out is just another factor in the general uncertainty over the economy.

Finally, the Fed's announcement that it will purchase commercial paper must reveal that policymakers understand that the credit crisis is really bad. Otherwise they would not have taken this important step. This must have been another shock that hurt markets, but it is good that the Central Bank will take action in this case.

Crisis Goes Global

The financial crisis has gone global (see also here). Emerging markets were hit especially hard, the Morgan Stanley Emerging Market Index fell 11 percent, its larges daily fall since 1987. Russia and Brazil experienced large losses in their stock markets, where trading was suspended. This reflects the global demand for safety. Consequently, funds are leaving emerging markets for safe havens. You can see this by looking at what has happened to the dollar price of the euro. The financial crisis has ironically caused a large appreciation in the dollar.


This is perhaps even more apparent when one looks at an emerging economy currency, such as Brazil.



Notice that this dollar rally reflects a flight to safety. It is not a long-term rise in confidence in the US economy. Indeed, one must suspect that in the longer term the dollar must depreciate to offset the current account deficit, and as a reaction to the increase in liquidity injected into the economy.

Given how thin some emerging markets are, especially Russia, the flight to safety causes very large shocks to domestic stock markets. I will return to the Russian case in a later post because this raises the question of what the shock signals about Russia versus the world economy right now.

Martingales and the Financial Crisis

This article compares the developments on Wall Street to placing a martingale bet. In the martingale game you bet, say, $100 on a coin flip, and keep doubling down if you lose. The game seems to offer certain gain for no risk. If you lose on the first flip you bet $200 on the next, if it comes heads you are up $100 ($200 minus the $100 you lost on the first flip). Just hang around till you get a heads. Seems a sure thing. The problem, of course, is that it is always possible that you get a run of tails that could wipe you out before you win. This is the "law of gambler's ruin."

What is interesting about the game is that you have a high probability of winning a relatively small amount, and a small probability of losing a huge amount. Notice that as long as you don't have the cataclysmic event you are earning positive profits with seemingly no risk. You are a financial genius. You are imitated by other financial geniuses. You get a large bonus for your invention of a strategy that produces such high risk-adjusted returns.

Only you haven't really earned super risk-adjusted returns. You just have not yet experienced the run that produces the big losses. After all, a run of say 10 tails in a row is not all that likely with a fair coin. In the meantime you are the Lord of Wall Street and a Master of the Universe. You probably are playing this game with a lot of leverage too. So when you do crash, you can take others down with you.

Why do smart Wall Street types play this game? There are various explanations, but one obvious one is that while you earn the good returns you are accumulating bonuses that you do not lose when the crash occurs. The incentive schemes of hedge funds and financial institutions in general encourage risk taking. Given that they do it should not be surprising that financial managers take excessive risks.

Financial Crisis Impact on the Rest of the World

Our financial crisis is even causing concern in countries that have been rather critical of the US, especially in Latin America. See this article, for example, which notes:

Whipsawing global markets are already having a ripple effect across Latin America. As nervous investors pulled money out of emerging markets, Brazil’s currency, the real, plunged 16 percent against the dollar last month, resulting in hundreds of millions of dollars in losses at large food and eucalyptus-pulp exporters that placed bad bets on the direction of the real.

The crisis has had a big impact on Russia. The stock market has been closed on two separate days, an investment bank sold a large stake (50% minus 1 share) to an oligarch, and the government has been pumping money to support markets. The reason is that indebted banks have faced margin calls, especially as foreign investors flee to security in the worldwide crisis. What is important to remember is that Russia still has more than $570 billion in foreign reserves. This shows just how linked international markets are.

The Bailout Plan

Economists are divided on the current version of the Treasury's bailout plan. Nobody really likes it, but some believe it is necessary while others argue that it is worse than doing nothing. Here are two good examples, one of each.

Jeff Frankel explains why the current version of the plan ought to be supported. John Cochrane argues to the contrary that this plan is akin to blowing up the dam to prevent boats from sinking.

I think that the current bill is no panacea. But I think that the odds of Congress producing a better bill in the near term are close to zero. So the question is whether this bill is better than nothing. The answer depends partly on how close we are now to a credit meltdown (this article suggests that things are getting worse, as does this one). I think we are close. But as John Cochrane points out this is not sufficient. We have to ask whether this plan will work. John argues that the core of the plan requires "magic" to be successful, as it will not inject sufficient capital into the banking system. Ithink that the essence of the plan is for the government to act as a giant arbitrager (Uncle Sam is bigger even than Warren Buffet) and can purchase underpriced assets that have depreciated due to deleveraging. This can provide some support to the banking system till we can implement some additional reforms.

The big problem is that this is hardly the end of the process of shakeout in the financial sector. It is barely a start.

AIG's demise

This article describes how AIG collapsed (and the huge potential liability that Goldman Sachs may have had if the government had not stepped in). The interesting point is that the AIG London office seems to have thought they were selling out of the money put options that would never be exercised, so they could post income. But of course this opens you up to unlimited losses if the options are exercised. It is a capital decimation strategy.

Ratings Agencies

Bloomberg has a two-part series on the role of the ratings agencies in the financial crisis. Here is part one. And here is part two.

Kayshap and Diamond on Bailouts and Lehman Brothers

Anil Kayshap and Douglas Diamond had a very good guess post at Freakonomics on the rationale behind the bailouts of Fannie and Freddie and AIG, and the decision to let Lehman collapse.

Cash for Trash

Paul Krugman does not like the bailout plan in current form. Neither does Naked Capitalism.

Update: A new bailout plan that is being circulated by Chris Dodd, Chairman of the Senate Banking Committee may be a bit better than the original. Taxpayers get equity in exchange for accepting toxic debt.

Too much to report on

Too many developments to report on regarding the financial crisis. As I try to catch up here are some good links.

Joe Nocera has a good column on why Paulson's plan may be a failed Hail Mary Pass.
Luis Zingales has a very good note on the problems with the new RTC plan.

Both of the articles point out how difficult it is to value the toxic assets that the new agency will buy. This leads to a very good chance of a huge taxpayer transfer to the financial institutions. Or it will not solve much.

Then there is the ban on short-selling by the SEC. This is a completely idiotic policy and I will post on this. See this article, for example. Banning short-selling to stop a financial crisis is like banning reporters when a war is going bad. Attack the messenger. The short-sellers were not responsible for the toxic debt. But those responsible prefer to blame the short-sellers to deflect attention on themselves.

The Crisis Spreads to Emerging Markets

The financial crisis has spread to emerging markets:

Argentina’s bond markets were savaged on Tuesday as credit risk rose to all-time highs amid a broader surge in risk aversion towards emerging markets.

The move came as Russia’s stock market suffered its biggest one-day fall since the financial crisis of 1998, the South Korean won dropped by its most in a decade and the Ukrainian stock market fell 14 per cent.

Trading has been suspended on the Russian exchanges as shares nosedived:

Russian shares suffered their steepest one-day fall in more than a decade on Tuesday, losing up to 20 per cent, as a sharp slide in oil prices and difficult money market conditions triggered a rush to sell.

This is the biggest one-day dive since the August 1998 crash of the ruble. It is the combination of the credit crunch leading to margin calls and the fall in oil prices which (as we noted in a previous post) is the key fundamental driver of the Russian economy.

AIG bailed out

I was wrong by 12 hours or so. The Federal Reserve will make an $85 billion loan to AIG in exchange for warrants that would give the government an 80% stake in the company (a warrant is a contract issued by a firm that gives the right to purchase shares -- it is like a call option, but not traded on exchange). The government had to act to prevent the firm from going bankrupt. See this article, which notes that the agreement does not require a shareholder vote.

The key problem is that AIG was the counterparty in a huge number of credit default swaps. It is important to note that these derivates are traded over the counter, rather than on an exchange. This means that there is no exchange that bears the risk of default of a party to the transaction. Instead it is the counterparty that is liable. Hence, if AIG were to go bankrupt there would be massive counterparty risks. See this article by Felix Salmon for more on this settlement risk. This is what apparently forced the hand of the government.

Russian Stock Market

Many observers have argued that the decline in the Russian stock market since the outbreak of conflict in Georgia shows that Russia is being punished by foreign investors. For example, Dan Drezner wrote:

Russia is paying a price for its actions. Last week Russia's RTS Index dropped 7 percent, and has fallen by 33 percent since July. Last month $20 billion left Russian markets in search for safer havens. Moscow has had to intervene aggressively in foreign exchange markets to defend the ruble.

This seems to be a common thread. But how then to explain the fact that the RTS fell faster before the crisis then after? As my colleague Cliff Gaddy has noted:

In the four weeks before the invasion, the RTS lost more value than in the four weeks after -- $192 billion before and $167 billion after. In fact, the Russian market has been declining since early July.

Cliff points out in this Moscow Times article the extent to which the fall in the Russian stock market is due to the usual culprit, oil prices. You can get an idea of the argument by looking at this chart of what has happened to the RTS:

You can see that the decline in the RTS really starts when oil prices fall. The fall due to Mechel (see my old post on this) is just a blip as is the Georgia crisis. lThe prior sharp fall is the dropping of electricity giant UES from the index.

Now let us look at oil prices. We see a similar pattern:
What is unexplained is they the RTS started falling when oil prices were still rising. Here I think the answer is the world financial crisis. May 19 was also an interesting day on Wall Street. The S&P 500 started to fall and this sucked capital out of emerging markets. Let's look at what happened to the S&P500 during this period.



So the basic story would be that oil prices explain most of the fall in the RTS, not a response to Georgia, and that the initial fall was due to the crisis facing most emerging markets.

The Crisis Unfolds

Two interesting articles on the crisis. Joe Nocera explains the role of denial in the problems of Wall Street and the demise of Lehman. Ken Rogoff argues that ending bailouts, as is the case with Lehman, is crucial to the adjustment process.

Leverage

This article in the Economist illustrates how leverage is complicating adjustment. Financial institutions are highly leveraged. As their equity falls liquidity falls much faster.

Even if markets can be stabilised this week, the pain is far from over—and could yet spread. Worldwide credit-related losses by financial institutions now top $500 billion, of which only $350 billion of equity has been replenished. This $150 billion gap, leveraged 14.5 times (the average gearing for the industry), translates to a $2 trillion reduction in liquidity. Hence the severe shortage of credit and predictions of worse to come.

Leverage bolsters profits on the way up. It is dangerous to forget that what goes up can come down. Galbraith's book "The Great Crash" has a great discussion of what happens when leverage applies in reverse.

Now its AIG

AIG, the largest insurer in the US and a member of the Dow Jones 30, is the latest financial institution at the center of the storm. The major ratings agencies have issued downgrades (see here) and this is greatly increasing the need an emergency transfusion of cash. As the Wall Street Journal notes:

With AIG now tottering, a crisis that began with falling home prices and went on to engulf Wall Street has reached one of the world's largest insurance companies, threatening to intensify the financial storm and greatly complicate the government's efforts to contain it. The company is such a big player in insuring risk for institutions around the world that its failure could undermine the global financial system.

AIG is a major participant in the market for credit default swaps. It is essentially selling insurance to hedge funds and investment banks. Indeed, it is heavily involved in selling insurance against defaults in the market for mortgage-backed securities. Hence, the sub-prime mess hurt it especially. As its stock falls it needs more capital to fund its positions. As a counterparty to large portions of the financial system its collapse would be hard to contemplate. (I am betting that when I wake up Tuesday, the Fed and Treasury will have announced a plan to prevent this). Tonite the NYTimes reports that:

Federal Reserve officials were in urgent talks with Goldman Sachs and JPMorgan Chase on Monday to put together a $75 billion lending facility to stave off a crisis at the American International Group, the latest financial services company to be pummeled by the turmoil in the housing and credit markets.

Why might AIG be rescued when Lehman was allowed to go bankrupt? Two main differences. First, Lehman had time to adjust and did not. Second, while huge Lehman was not as likely to cause knock-off systemic risk as AIG. It is just too much at the center of action.

One problem AIG is facing is the fallout from the Fannie-Freddie bailout. Secretary Paulson designed that bailout so that shareholders would lose. Investors must thus anticipate that if there is a rescue it will help creditors but not equity holders. But if you anticipate this why would you invest in AIG now? Better to wait and see what Paulson announces.

The other big problem is the demand for liquidity. As everyone tries to improve the quality of their balance sheets, they sell assets. With all sellers and no buyers prices fall further, which requires more sales. It is like standing up to get a better view at the football game. Doesn't work if everybody does it. But if everybody is standing, staying seated is even worse.

Lehman goes bust

Lehman Brothers hurtles towards bankruptcy, see here. The Treasury and the Federal Reserve have clearly chosen to draw the line on bailouts. Whether this stems the tide remains to be seen, but the thinking seems to be that the market had time to adjust to Lehman's problems, so that the chance of a systemic crisis is lessened.

Lehman's troubles arise from a familiar source. As this article in the Washington Post notes,

Lehman, the number one underwriter of mortgage-backed bonds last year, amassed a giant portfolio of properties and mortgage-related securities. But the value of the assets began to sink last year amid a spike in mortgage defaults by homeowners with subprime credit.

One thing to look for now is what happens to the market for credit default swaps. Traders have suggested that even solid firms are finding it hard to buy such insurance now. This could be an interesting weak (note also Bank of America purchasing Merrill Lynch and the problems AIG seems to be facing).

Trade Deficit Swells

The US trade deficit swelled in July. Details here. A big part of the increase was huge oil imports, due to higher volumes and the very high price.

Update on Role of China in Fannie -Freddie bailout

The WSJ has an article on the bailout of Fannie and Freddie which illuminates the role of China and other foreign investors. Here is a relevant portion:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Like many investors, foreign governments, particularly central banks and sovereign-wealth funds, believed the U.S. government implicitly stood behind Fannie and Freddie and would prop them up to prevent a failure.

The point to remember is that foreign investors hold a lot more (an order of magnitude more) US assets then their holdings in Freddie and Fannie. So the threat to withdraw even some of them could have destroyed many other financial institutions.

More on the bailout

Most of the analysis of the Treasury's takeover of Fannie and Freddie focuses on the need to cope with the housing crisis. But the most important motivation to do this now was to prevent a financial crisis. It is important to note that a large portion of the debt of the two corporations was held by foreigners.

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

This capital inflow is a response to large US current account deficits. The debt of the GSE's, while not explicitly guaranteed, clearly bore an implicit Federal guarantee (as is now totally evident). Foreign investors who purchased GSE debt were naturally worried. If the GSE's went bankrupt they would perhaps gain cents on the dollar. The bailout announced by the Treasury will hurt shareholders, but will probably keep bondholders whole. Hence, the bailout reassures foreign investors at a time when we need them.

Of course what remains to be seen is whether the current bailout plan will suffice. As many have noted (for example, Paul Krugman here, or Mohamed El-Erian here), we are now in a process of de-leveraging. This is the reverse of the process in the boom when leverage is used to maximize returns. Now the race to safety means a rush to sell assets to bolster balance sheets. But what is good for the individual may not work for the economy as a whole. The rush to sell drives down prices which further worsens balance sheets and leads to more selling. Liquidity dries up. This is Irving Fisher's debt deflation. Japan went through this in the 1990's. Can we escape it?

Fannie and Freddie Nationalized

The Federal Government announced today its takeover of Fannie Mae and Freddie Mac. Floyd Norris has a good column on the announcement. The problems there were a classic case of moral hazard. The two institutions had at least implicit federal guarantees, so they could borrow at low rates. But they were privately managed so they took risk to bolster profits. As Norris notes, they served two masters, and this really got them into trouble.

It was during the long housing boom that the seeds of destruction were sowed for Fannie and Freddie. They appeared to be very profitable, so pressures mounted for them to find ways to finance housing for poorer Americans, often living in areas where banks had historically been hesitant to lend. Congress set goals for such lending.

As the housing boom proceeded the share of home loans that they purchased increased dramatically. See this article from Jim Hamilton for some excellent analysis of the role of Fannie and Freddie in generating our current crisis. As Jim notes,

The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

The question is why did these two Government Sponsored Enterprises grow so fast? Part of it is the fact that Congress wanted more mortgage loans made to expand home ownership. And the bigger part is that Fannie and Freddie grew to earn more profits, using their borrowing advantage to grow their market share, with the taxpayer bearing the risk.

Financial Crashes and Incentives

Joseph Stiglitz, Nobel Prize winning economist, has an article in the New Republic on excessive risk taking and our financial crisis. He writes:

In recent years, financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other. I am among those who believe that consenting adults should be allowed great freedom in what they do--as long as they don't harm others. But there's the rub. These high-rollers weren't just gambling their own money. They were gambling other people's money. They were putting at risk the entire financial system--indeed, our entire economic system. And now we are all paying the price.

Stiglitz discusses the incentives to take excessive risks, not surprising for someone who earned his Nobel Prize for information economics.

I think that this is the right focus, but I think the discussion could be sharpened by asking why hedge funds have incentive schemes that reward managers for excessive risk taking. Specifically, why has the system of "2 and 20" (two percent management fee and 20% of profits) survived. This system rewards excessive risk taking since in any good year the manager will earn large profits but the losses go to the shareholders. Other financial institutions face regulations to prevent excessive risk-taking but hedge funds keep their strategies as proprietary secrets -- after all, it is their trading strategies that is the only source of their rents. But why would rich people invest in funds with such incentive schemes? That is the question. We know why managers love it. This is the puzzle we need to solve.