The Mystery Of Asset To Capital Ratios

Paul Krugman, in yet another attempt to assess the rescue plan, raises some interesting issues but demonstrates a serious misunderstanding of a basic and critical point:

Thinking the bailout through

...

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets.  And if that’s the real plan, Congress has every right to balk.

His point (a) is well taken.  However, point (b) is simply not theoretically accurate.

Firms have capital to support their business activities.  If they are undercapitalized they need to either (a) raise more capital or (b) scale back their business activities.  By selling $700 billion of troubled assets to the Treasury financial services firms are scaling back (or exiting) a line of business.

Imagine, *hypothetically*, that across the financial services sector these $700 billion of troubled assets were supported by $70 billion of capital, i.e., a 10-1 assets to capital ratio (that is lower than the average leverage across all lines of business but most business lines are less risky and can support higher leverage).

Selling $700 billion of assets to the Treasury reduces the sector's collective balance sheets by $700 billion and frees up $70 billion in capital which then becomes available to support other activities.  Will the financial services sector still be undercapitalized after this happens? Maybe, maybe not.  But Krugman ought to at least acknowledge the theoretical possibility that the Treasury plan can solve the capital problem by allowing firms to shed assets rather than raise capital.  There is no *theoretical* requirement that the Treasury pay premium prices in order to boost the capitalization of the financial services sector to an appropriate level.

As to why Krugman is stuck on this point of premium prices, I can only guess.

Let me be clear - as a matter of fact, it is possible that the financial services sector will still be undercapitalized after selling $700 billion of assets.  But as a matter of theory, it is also possible that they will have adequate capital after this sale.  For Krugman to state as a theoretical certainty that "the plan does nothing to address the lack of capital unless the Treasury overpays for assets" (his emphasis) is simply not accurate.  In fact, the plan does something to address the capital problem - it allows firms to de-leverage by shedding assets. 

Whether it does enough, I don't know.  Given the resources and reporting available to the Treasury, the Fed and the SEC, I suspect they have a reasonably well-informed opinion on this point, and I certainly hope that by the end of the week our also Congressman also have a well-informed opinion.  I also hope the reality-based community can formulate their objections to this rescue package on the basis of, well, reality.  Heaven knows there is plenty to which one might object.

MORE:  Matt Yglesias is bamboozled I see.

KIDDING?  Newt Gingrich sees this as an opportunity to restructure out tax code and our national energy policy.  All by the end of the week?  Geez, maybe Congress could work through the weekend and solve Social Security and health care, too.

Comments

[Barney Frank]

However, point (b) is simply not theoretically accurate.

I'm only a logger and buyer and seller of
timberland along with some investment experience and this point is glaringly obvious even to me. That a trained economist either can't understand it or is too dishonest to include it in his analysis should be enough to force him into another line of work.
I'll hire him to set chokers, as that appears to be about all he is intellectually qualified for.

[Rick Ballard]

"I can only guess."

C'mon, it ain't that hard.

XYZ Corp. needs a KPMG sig on the financials to continue as a "healthy" running dog capitalist. KPMG has heard that once upon a time there was another accounting firm named Arthur Andersen which disappeared from the face of the earth after having signed the financial statements of Krugman client, Enron.

XYZ Corp. has a bundle of assets of a peculiarly stinky composition, the value of which is Something but nobody knows How Much. XYZ's CFO says 82 cents on the face value dollar and KPMG says "look, buddy, that garbage is behind The Door to Level Three and if you want our sig then you write it down to 8 cents". The CFO puts up a valiant struggle, writes all the stinky stuff to 8 cents.

One day, Darth Paulson shows up and says "Mr. CFO, you have until noon tomorrow to tender all Stinky Stuff to Uncle Sugar for 40 cents on the dollar. Take it or leave it. Good day." Mr. CFO takes a deep breath (remember, to him it's 82 cent Stinky Stuff) and says "Sure, Darth, we'll deliver this afternoon."

Former Enron advisor Paul Krugman then writes a column about how Paulson bailed out XYZ Corp. by taking assets off its hands at 500% above their book value. Krugman is a very stupid partisan hack but even he can see that one coming. Think of all the garbage column inches he can fill with that type of baloney.

[R Flanagan]

Re Krugmann's (b) I think his argument is that even removing 700 billion from the composite balance bank balance sheet will have no effect upon equity and thus would still leave it undercapitalized.

These assets have already been marked to market. Their sale to the Treasury will replace these written down assets with the same amount of cash . Thus it will have no effect upon equity, and accordingly upon the unsustainable 30/1 debt to equity ratio.

In order to resume normal activity the banks need more equity , not just the liquidity resulting from swapping written-down sub- prime loans for Treasury's cash.

[baked alaska]

http://www.nytimes.com/2008/09/22/business/22global.html?hp

As the day wore on, some raised their concerns with the Treasury Department, arguing that foreign institutions were both big employers and major players in the American capital markets. By Saturday evening, the language had been changed to allow any financial institution “having significant operations” in the United States.

While Mr. Paulson has agreed with that argument, the Bush administration is also leaning on foreign governments to pitch in with bailout programs of their own as needed. “We have a global financial system and we are talking very aggressively with other countries around the world, and encouraging them to do similar things, and I believe a number of them will,” Mr. Paulson said on Sunday.

[Extraneus]

OT, but if the root cause of the problem is that banks were forced to make bad loans against their better judgement, I hope that fact isn't lost in the details.

[Charlie (Colorado)]

These assets have already been marked to market.

I don't think this is true: no one knows what the correct market value is.

[RichatUF]

Extraneus-

if the root cause of the problem is that banks were forced to make bad loans against their better judgement, I hope that fact isn't lost in the details

You'd think so, but the new buzz word is going to be "reverse redlining" to go along with the old stand by "predatory lending".

I'm not too confidant that Paulson will be able to herd all the cats in congress the more I thought about this over the weekend. I suppose he could leak something blaming Dem's for stalling causing the market to drop 500 points, but going through another roller coaster week might be too much stress for some of the players.

[Charlie (Colorado)]

Baked, could you at least try to contribute something more to the argument than cutting and pasting out-of-context patches from someone else's article?

And could you at least try to learn the extremely simple half-dozen characters needed to make a simple hyperlink?

Here's it's like this:

- Type '<' followed by 'a": '<a'
- type 'href=' followed by the URL in quotation marks: 'href="http://www.nytimes.com/2008/09/22/business/22global.html?hp"'
- type '>'
- type the link text, like 'link'
- type '</a>'

All together <a href="http://www.nytimes.com/2008/09/22/business/22global.html?hp">link</a>

link

[bunky]

The fire marshall estimated the crowd to be 70K at Palin's appearance at the Villages in Florida.

Media response: "nothing to see here, move along."

[acr]

We need to give away billions more in foreign aid like Asia Bank and then we can get free money from China!

Still a member of the private banking global conspiracy?

[Mistu]

TEST

[Barney Frank]

I don't see how the Dems could risk being seen as causing this to fall apart.

[Extraneus]

I'm not too confidant that Paulson will be able to herd all the cats in congress the more I thought about this over the weekend.

After reading Verner's post from the other thread, which catatlogued all the times since 2001 that Bush proposed Fannie/Freddie reforms but was stymied by the Democrats, it seems likely that they decided in advance that this end result wasn't such a bad thing for them. If that's true, then how could Paulson hope they'd participate in good faith? All he can hope to do is appeal to their sense of not wanting their fingerprints on it.

[Barney Frank]

Baked, could you at least try to contribute something more to the argument than cutting and pasting out-of-context patches from someone else's article?

charlie,
I think your request and baked's intentions are at cross purposes.

[Pofarmer]

"The fire marshall estimated the crowd to be 70K at Palin's appearance at the Villages in Florida. "

Holy cow, I hadn't heard a thing about that. Whoa.

I don't see how the Dems could risk being seen as causing this to fall apart.

They'll just blame Bush and lack of support for "affordable housing" and "assistance for homeowners in trouble."

Hide and watch.

[Charlie (Colorado)]

I think your request and baked's intentions are at cross purposes.

Remind me sometime to write on the inadequacy of the written word to convey sarcasm.

[Pofarmer]

WOW

Of course it's not an MSM link.

Sarah Palin's visit to Florida draws thousands of supporters

By Bill Cotterell • Florida Capital Bureau Political Editor • September 21, 2008

This place must have been packed out.

LUN

[baked alaska]

Tanta on Krugman and the GSE's

[Barney Frank]

Remind me sometime to write on the inadequacy of the written word to convey sarcasm.

Apparently we need to coauthor a post on it.

[Charlie (Colorado)]

Oh, this is interesting: It appears that one of the CDS issues is that they fall through the cracks in bankruptcy law.

[Charlie (Colorado)]

Apparently we need to coauthor a post on it.

Or you should write it, and I, read it.

[SteveMG]

Baked:
Here's what you can do, please.

Summarize the linked story - highlight the main point you want to make. Perhaps include the nut or key graf from it.

Then provide a link to the story.

Don't copy and paste several long paragraphs.

Engage with people. Otherwise, we'll just ignore whatever point you're trying to make.

If you're arguing in bad faith, then forget all of this.

Thank you.

[Charlie (Colorado)]

Congratulations, baked, you both pointed to something of some interest and managed to type a hyperlink. Very good.
It's also interesting that it seems to support the theory we've been developing, eg, with

In the schizoid reality of the GSEs, when they had their "shareholder-owned private company" hats on they did plenty of envelope-pushing. When they had their "affordable housing" hats on, they rationalized dubious theories of credit quality ... to beef up their affordable housing goals....

[Charlie (Colorado)]

Don't copy and paste several long paragraphs.

Or at least contribute some text of your own, some argument, some (as Steve says) summary.

You've learned to hyperlink, this should be within your powers as well.

[Pofarmer]

Interesting. CBS makes no note of the size of the crowd at the Palin rally.

LUN.

[Rick Ballard]

Rich,

I think the Dems cave early. They'll put a couple of bells and whistles on it but they really don't need a recap of "how we got here" running for two weeks before they have to convince voters that they've really done anything in the past two years.

[baked alaska]

Mike Tucker, a local fire marshal, estimated 60,000. But reporters on the ground, including AP's Brendan Farrington and my colleague Ken Vogel, would only say "tens of thousands," suggesting the marshal's estimate was on the high side. The St. Pete Times's Adam Smith had another fire official in the crowd say it was about 25,000.

link

[RichatUF]

Extraneus-

since 2001 that Bush proposed Fannie/Freddie reforms but was stymied by the Democrats, it seems likely that they decided in advance that this end result wasn't such a bad thing for them

The Dem's* can always count on the Malkin Purity Wing. Remember the Bush proposed reforms were only "talking points".

*Which does remind me, the Dem's didn't put up much of a struggle after their initial bluster, when Paulson went to congress to get authority to deal with Fannie and Freddie. That was also very broad.

[DrJ]

Otherwise, we'll just ignore whatever point you're trying to make.

That's what I do.

[Pofarmer]

The visit drew a few contrasts between Palin and Obama running mate Joe Biden.

The largest was the crowd. Some people had to wait in line about 90 minutes just to park their cars. Biden’s largest crowd during a visit earlier this month was about 2,000.
knew absolutely nothing,’’ said Tyler Deeds, 19, who made the drive from Auburndale 90 miles away and waited more than 5 hours to see Palin. ‘‘I couldn’t even tell you who the governor of Alaska was.’’

But Deeds, who plans to enter the Navy soon, said he ‘‘tends to cling to my guns and religion’’ and he quickly grew excited about Palin’s candidacy.

Joan Guay, 81, dabbed bottled water on her arms as she waited for Palin in the broiling heat. She said she previously supported Democrat Hillary Clinton.

This story from the Chicago Sun Times only says "Tens of thousands."

[FCD]

'To reiterate: An Alaska governor who was virtually unknown a month ago and is the number two on the presidential ticket may have doubled or tripled the crowd for a sitting president.'

Sure it's not Congress and the President's budgets?

Florida really has no way to forget what dems did there under Clinton. Obama would have skipped if he was smart.

LUAP

[RichatUF]

Charlie-

It appears that one of the CDS issues is that they fall through...

That's a pretty interest article, thanks. Maybe we can get cathyf in here to talk about CDSs and CDOs to show how they are interrelated to the MBSs-I don't get it.

I was reading the Paulson draft and his authority to buy "mortgage related assets" is broad and wonder if it includes the credit default swaps on the underlying mortgage bonds. I'm still confused and have been reading the referenced papers-how in the hell did these guys think up this stuff?

[Charlie (Colorado)]

I'm still confused and have been reading the referenced papers-how in the hell did these guys think up this stuff?

Dude, Wall Street is full of the smartest people I've ever dealt with.

Sadly, the culture is also perhaps the crookedest I've ever seen, and I grew up in a Democrat machine town.

[Pofarmer]

how in the hell did these guys think up this stuff?

The whole POINT is to rabbit hole where the goodies are. They were trying to get folks to buy crap at premium prices using fancy statistical models. Worked for a while. Lot's of folks got fabulously wealthy. Me, I just feed the cattle twice a day, maybe they'll buy one of my steaks.

[RichatUF]

Charlie-

It's not that I think it is "dumb", it's just so opaque (not only are the MBS sliced and diced, but the CDS are also sliced and diced) I don't see how someone (or a team) could sign off on something which seems to have nearly unlimited downside. Some major banks are already sueing hedge funds that didn't have enough money to cover the swaps the hedge funds wrote-the banks are out the money for the premiums paid, stuck with the real estate, and have to fund a team of lawyers $600/hr to figure it all out.

[Charlie (Colorado)]

Rich, I'm sorry, I was less than clear. the point is that the culture is optimized to people who are really really smart, and crooked as a Chicago alderman. So you get together a couple of lawyers, some quants, and a partner, and they figure out this scheme and wargame it out. The quants say "this should make this much money" and the lawyers say "there's a very small probability you could actually go to jail for this" and the partner thinks about another eight digit bonus and growing up to be Secretary of the Treasury or Governor of New Jersey and, with a gleam in his eye, says "okay, then let's go for it."

If it works, everyone else says "why don't we have that product too", so pretty soon they do have the same product, or something similar.

In this case, the other part about it is that it appears (from that article and a couple others I've seen) that CDSs really aren't covered by insurance and such regulation, or if they are they're held as "arm's length" corporations that insulate the parent from the liability. It's not like frontrunning and naked shorts, which are technically illegal although often practiced. It really isn't illegal, and the people who started them have long since cashed their checks.

[Rick Ballard]

Rich,

The Lehman BK should provide some insight as to the true value of the CDS market. I suspect that it will turn out to be slightly less functional than advertised. Some of those things make no doc 100% mortgages look like shrewd deals.

[RichatUF]

Charlie-

Thanks. For some reason I've been grouchy all day.

[Verner]

Is it kiss Florida goodbye time for Camp Obama? Between the geezer ad, all the Che t-shirts at his rallies, his distain for the military and the soft on Iran stuff, he's mannaged to p-off just about every voting block in the state.

And did we mention Mark Foley, who was found innocent of all charges this week, while his sucessor has a little sex scandal of his own, complete with a 250,000 payoff to an assistant for keeping her mouth shut.

Yep.

[Charlie (Colorado)]

Thanks. For some reason I've been grouchy all day.

Possibly because I've had a headache all day, I didn't think you were being grouchy: I didn't show my work.

[RichatUF]

Rick-

The Lehman BK should provide some insight as to the true value of the CDS market. I suspect that it will turn out to be slightly less functional than advertised. Some of those things make no doc 100% mortgages look like shrewd deals.

I believe it. The reason I'm kicking the tires on this thing is I sort of curious if Paulson is trying to buy up the entire market, or at least a big part of it, so regulators can have an easier go at it. It would also explain in part why he wants his authority so broad such that participants can't appeal to any court-his decisions are final. He's got Fannie and Freddie (that was a "credit event"), AIG, now this new facility he's trying to negotiate. The Fed (through AIG) and the Treasury (either through Fannie/Freddie or this new facility) could end up being one party or both for alot of these swaps. If I were a hedge fund looking to collect, I'd make very sure every i was dotted and t crossed.

[Verner]

I don't think anyone should be embarrassed to say that they don't understand CDSs--from what I been able to gather, even the people who traded them didn't really understand what they were.

What I think the general public can understand--and correct me if I'm wrong--is that when a significant percentage of the housing market is backed by loans based on nothing more than how much the house "might" appreciate over time, "creative" instruments were needed to try and reduce the risk. "Creative" but basically worthless, and backed by almost nothing--but still used on the books to back up the bad stuff that the lending institutions continued to crank out at an escalating pace--even when the loans were failing, and the housing market was going soft.

But that's not how this "process" was presented to many rich clients and investors, many who have recently had to turn in their county club memberships, and are now involved in class action lawsuits against various brokers etc. for not being frank about the risk involved.

In any case, it still boils down to the main cause--the subprime market. Because it seems, without that, you wouldn't have needed all the shaky CDSs in the first place.

[glasater]

Charlie--Be careful what you say about quants. Cathyf is a "quant":)

[Charlie (Colorado)]

Charlie--Be careful what you say about quants. Cathyf is a "quant":)

So am I, or was, when I worked in the Street.

[Pofarmer]

In any case, it still boils down to the main cause--the subprime market. Because it seems, without that, you wouldn't have needed all the shaky CDSs in the first place.

Yep. The way I figure it is the smart guys were trying to figure out how to get all this trash off their books and onto somebody elses, so they had to hide what it was in "creative" ways.

It seems to me that the easiest way to have solved all this would be a rule saying you don't sell or trade a mortgage anyway but whole. Would have nipped the whole thing in the bud.

[Rick Ballard]

Rich,

Here's an interesting Asia Times piece concerning the thrills of high finance pertaining to CDS. A little kicker to roll around the palate "Banks that reported that they are fully hedged on their various exposures to US subprime, problem assets, and corporate defaults all had bought protection using CDS from companies like AIG, which itself is estimated to have sold some $500 billion in credit protection overall. "

BTW - did you know that GS and MS wanted to become real banks?

Neither did they.

[Steve]

Great site!

Would you like a Link Exchange with our new blog COMMON CENTS where we blog about the issues of the day??

http://www.commoncts.blogspot.com

[Charlie (Colorado)]

Well, no, I don't think so. The problem with CDSs is that they are, at root, insurance. I did a piece at PJM talking about how insurance works, and while it's about health insurance, it's the same basic model: you get a lot of people to pay you a little more than their share of what it could cost if a bad thing happened to one of them. Then if the bad thing happens, you can pay them back; they're basically betting with you that the bad thing will happen, while you're betting it won't.

Of course, if the bad thing does happen, you'd better have the money to pay them, or there'll be trouble.

You can calculate how much you need to keep on hand (the "reserve") using well-known math. Of course, like all math, it's only as good as your assumptions.

What happened with the CDSs is that people made bad (favorable to them) assumptions, and when the Bad Things started to happen, they didn't have the cash.

In this case, the Bad Thing was that these mortgage backed securities turned out to have a run on the bank against them. That meant that, at least arguably, the CDSs should have paid off. But they don't have the cash.

And the rest was history.

It seems to me that the easiest way to have solved all this would be a rule saying you don't sell or trade a mortgage anyway but whole.

I'd be surprised if they were splitting off pieces of individual commercial mortgages, if only because they were too small in general to bother with. What you'd want to do is aggregate a bunch of mortgages, because the larger the number the smaller the overall risk. (That's that variance thing again.)

That's not saying it never happened, just that I'd be surprised.

[RichatUF]

Rick-

Thanks for the article-usually don't make the rounds to Asia Times, should start putting it on my list.

I'm surprised on the GS and MS news.

[RichatUF]

Charlie-

That's not saying it never happened, just that I'd be surprised.

That's what I thought those SIVs and CMOs were-pools of MBS sliced up into 1/64's and re-animated with Gaussian statistics into high return Frankenstein wholes. And I thought that is what the CDOs were-pools of CDS contracts sliced and diced and repackaged as Frankenstein's Bride.

I may be wrong.