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.

[cathyf]

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.

I'm with chaco here. But I'd also add that

1) it's not just Wall Street -- it's LaSalle Street, and Midtown, The City, etc...;

2) even more than the crookedness, it's the adrenalin junkies. They are crooked because it's fun.

[Charlie (Colorado)]

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.

yeah, but the underlying MBSs wouldn't cut up the mortgages. Maybe I misunderstood your point.

[Charlie (Colorado)]

1) it's not just Wall Street -- it's LaSalle Street, and Midtown, The City, etc...;

Yeah... it was a synecdoche. You're absolutely right.

2) even more than the crookedness, it's the adrenalin junkies. They are crooked because it's fun.

I used to play softball with a bunch of currency traders. Oh my God.

[Charlie (Colorado)]

I'm surprised on the GS and MS news.

It makes sense, logically. It gives them easier access to the Discount Window for liquidity issues.

[glasater]

t's the adrenalin junkies. They are crooked because it's fun.

Back in the days when I was a blackjack dealer and poker dealer we called it gamblers rush.

I quit that business when on the verge of losing my faith in humanity. But it's coming all back like bad deja vu.

[Pofarmer]

Well, I was thinking more along the lines of the CDO's and other instruments, not the underlying MBS's.

How many levels of this shit were they trading?

[Verner]

In other words, the CDSs were made to look like they "Could" pay off, even though they didn't have anything to back them up. If they hadn't presented the product in that way, who would have bought it? That's what I meant by "creative" instrument. In reality, now that the original "insurance" purchaser has to depend on them, they have pretty much vanished into thin air.

To a normal person like me, who doesn't have a degree in finance, it sounds insane. At least with health, home, car etc. insurance companies, you have actuaries who can calculate risk, and whose industries are regulated. I've read that some of the people who sold CDSs, who were in insuring billions in loans, only had a few million in cash available. That sounds insane.

My question is, when a lender bought "protection" from those who issued CDSs, what proof was required that they could do what they said they could do in case of massive defaults in the housing market? I mean, did these people just say "trust us?" That's the way it looks to me.

[Riverman]

"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:"

Though I think your intuition is correct, you are misunderstanding Krugman's argument. He clearly states in one of his essays that if the problem is one of liquidity then the current plan for addressing it may suffice. But he also states that if the problem is one of insufficient capital in the industry that problem will not be solved by simply selling securities to the government.

His latter point is certainly true, since selling one asset (the securities) for another one(cash) does nothing to alter the asset to capital(net assets or total asset minus liabilities) ratio, unless as Krugman states the securities are sold for more than they are worth. Meanwhile, his suggested solution of the government purchasing an equity interest in the ailing firms does reduce the asset to capital ratio since both assets and capital increase by the same amount after such a transaction.

[Tom Maguire]

He clearly states in one of his essays that if the problem is one of liquidity then the current plan for addressing it may suffice. But he also states that if the problem is one of insufficient capital in the industry that problem will not be solved by simply selling securities to the government.

His stating it does not make it so. Continuing...

His latter point is certainly true, since selling one asset (the securities) for another one(cash) does nothing to alter the asset to capital(net assets or total asset minus liabilities) ratio, unless as Krugman states the securities are sold for more than they are worth.

His latter point is certainly *not* true or the entire concept of de-leveraging is meaningless.

Although it is literally possible that investors would expect the same level of capital to back either highly risky mortgage back securities or T-bills, as a practical matter they would not.

But regardless, it will not be the case that the sellers leave their sale proceeds in a new asset, such as T-bills.

On roughly the same day (and hour) that the sellers receive the cash from the Treasury they will move to reduce their short-term borrowings.

Net result - a smaller balance sheet with fewer assets, fewer liabilities, and the same level of capital. That is an improved capital ratio, contra Krugman.

[Charlie (Colorado)]

In other words, the CDSs were made to look like they "Could" pay off, even though they didn't have anything to back them up.

No more so than any insurance. I also hit that one on my Bear-Sterns piece: it's a thing called the "Gambler's Ruin". Say you're playing a simple game flipping a coin, where you have to lose 100 times in a row. Now, the odds against that happening are about 1.2676506 × 10^30 --- call it 130,000,000,000,000,000,000,000,000,000 --- to 1.

That's small, but it's still bigger than zero.

If only a few of the CDSs had become valueless, there wouldn't have been any problem. There still might not be a problem --- only no one knows how many MBSs really have lost value, or how much. It might be all of them. In which case the CDSs are insolvent: Gambler's Ruin.

Maybe none of them.

Most likely of all, maybe just a few more than the managers guessed, in which case the CDSs are insolvent because of lack of reserves. That sort of thing is why there are laws that apply to most insurance --- but apparently not this.

[Charlie (Colorado)]

My question is, when a lender bought "protection" from those who issued CDSs, what proof was required that they could do what they said they could do in case of massive defaults in the housing market? I mean, did these people just say "trust us?" That's the way it looks to me.

Verner, the thing is, this is true of any insurance. Let's take a kind of extreme example: let's say that someone started an insurance company to sell term life insurance to everyone who worked in the World Trade Center towers, and only the Trade Center towers.

This is a relatively select group; high average income, but generally relatively healthy and in a relatively low-risk group. The term life premium could be pretty good; if it were organized like a Credit Union, with an officially non-profit corporation, even the administrative costs would be low.

After diligent work, they get everyone in the building signed up, from Cantor-Fitz to janitors, and have a party in Windows Over the World to celebrate.

On 10 September 2001.

The thing is that with perfect calculations, and absolutely impeccable actuarial standards, they will still be insolvent and unable to pay their claims. The chances of 3000 of their customers being murdered on the same day were so small, and the costs of paying the claims so large, they would have been completely overwhelmed.

Even if the CDSs had been very conservatively run --- and I'm not claiming they were --- the truth is that they couldn't have possibly kept reserves for the case where most or all the underlying securities defaulted.

Or look at it another way: if they had kept that much in reserve, the premium would have had to be very slightly more than the face value of the securities.

[Charlie (Colorado)]

Although it is literally possible that investors would expect the same level of capital to back either highly risky mortgage back securities or T-bills, as a practical matter they would not.

Tom's right here --- it is literally possible --- but it would be perverse. There would be no premium for higher risk, and no one would use anything but T bills.

[Verner]

Thanks Charlie. But there seems to be one flaw. It's not like you flip one coin one hundred times. There were thousands of subprime loans that were exposed to the same enviroment--therefore, it would be logical to assume that say, if we had another terrorist attack, and the economy went a little shaky, you would have a large percentage of those loans going bad at the same time. That's cause and effect, not chance.

It would also be pretty obvious that any retreat in housing costs would trigger thousands of bad loans, because if people have nothing down, have no assets that the banks can go after, and within a year the house is worth less than what they owe, there is nothing keeping them from walking away. What would they be afraid of? A bad credit rating? They didn't have one to begin with, or they wouldn't have needed a subprime loan.

If I can see all this, why couldn't the geniuses?

Many people, most famously Warren Buffet, saw this coming,and pulled away from this stuff. Easy to see why. I am just astonished that they were allowed to get away with it. But then again, what other way could they have done it?

The government pushed the banking system into this mess, Fannie Mae oblidged, and backed the junk with OUR money, cooking the books so that no one would know just how bad things were and traditiditional methods of securing mortgages simply wouldn't hack it in the Brave New World.

And we're surprised that a bunch of jackles made piles of money! It seems like the government had to let them do it, because if not, no bank would have been able to offer subprime to low income buyers as they were being told (and threatened) to do.

[Charlie (Colorado)]

If I can see all this, why couldn't the geniuses?

Didn't they?

But at least while it lasted, it looked good: bonuses got paid, profits got made. You make profits on insurance by making sure your premiums are lower than your competition, but still higher than your actual cost of claims. If no one was defaulting, there were no claims.

And remember, we still don't know if these securities have no value. I read somewhere that the premium was usually about 6 percent of face value. If so, they were betting that the losses would be less than (1.0-0.06)=0.94 --- and 0.94 is comfortably within my old 0.91 to 1.0 range.

It is entirely within the realm of possibility that when it all unwinds, nobody had actually done anything wrong --- except that the opaque structure of the MBSs and CDSs and CDOs and SIVs and XYZs and PDQs were such that when the market lost confidence, no one could regain it.

[Verner]

Yes Charlie, I can see what you're saying, but I don't think this is like most insurance at all. For example, everytime we have a hurricane, or massive flooding, insurance companies pay out billions of dollars, and somehow remain solvent, and are able to do what they have promised they will do. They are regulated. They must have the assets to pay for claims, or they wouldn't be allowed to operate. That doesn't mean that they have enough money to pay for every thing that they insure at all times, but they have to have a pretty good idea of what they would need in a very bad scenerio, and charge the appropriate premiums to their customers--depending on risk.

Obviously, that's not the case with the current crisis, Because, for one, not all subprime loans are in default. Second, it's not like the current situation was so far removed from the realm of possibility that it seemed unlikely to ever happen--because plenty of people have seen it coming for a long time.

Now if what you're trying to say is that these loans were so risky that no one could have ever addequately insured them unless they charged a premium that was almost the value of the loan, then maybe what we should be really saying, is that no one should have been making the loans in the first place.

And as simplistic as it may sound, as a tax payer who is now left holding the smelly sack, that's my question. Why did the government inisist on lenders making these loans in the first place. Fannie Mae, backed by our money, seemed to be the great enabler. How did they get away with it?

[glasater]

From Spengler:

In effect, Americans borrowed a trillion dollars a year against the expectation that the 10% annual rate of increase in home prices would continue, producing a bubble that now has collapsed. It is no different from the real estate bubble that contributed to the Thai baht's devaluation in 1997, except in size and global impact.

Wasn't Soros involved with that deal? Sure sounds familiar.

[George G]

Soros was involved more in the currency crises fallout. The mess in Asia seemed to me primarily the consequence of zero percent interest rates in Japan. The Japanese corporations used this to create a construction bubble in Thailand while their banks engaged Korean merchant banks to funnel massive amounts of US$ into Inonesia - all converted pretty well immediately to Rupiah. The payoff was in mutual back scratching through the crony networks.

When the panic hit, the Japanese banks tried to suck everything back out and crashed the Baht, then the Rupiah and finally the Won by foreclosing on their Korean intermediaries.

Soros turned his hand to screwing the surviving Asian currencies but got stymied by Mahatir in Malaysia ( he occasionally got things right).

In the meantime Tom's hero, Dr Krugman, turned up in Indonesia and persuaded Pres Suharto to stop the rot by establishing a currency board. This would create a fixed rate for the US$/Rupiah at about 33% of the panic stricken rate. To do so of course required Indonesia to put up billions of US$ and they actually didn't have any at all- that's why the problem was there.

Soeharto was rumored to be considering the appointment of Krugman as Finance Minister while a horrified Rubin and the IMF watched the Rupiah speed from 2700 to almost 20,000 to the dollar. AFAIK the doctor has never retracted his belief that a currency board was the answer - despite the abject stupidity of such a suggestion. Rubin finally manged to dig him out of Jakarta, possibly with the threat of a firing squad.

There you are Tom, back on topic or at leaset close enough.

[fedgovernor]

It's a shame that there's so much financial illiteracy in this country amongst the press:

1) The mortgage-backed securities on the balance sheets of commercial banks in this country are today, worthless. This is the crisis.

2) This fact has not been recognized by banks. In other words, these securities have not been, for the most part, marked-to-market. If they were today marked-to-market, the value of them would be $0.00. This leads to immediate insolvency (see below).

3) A bank such as Washington Mutual has about 25% of its balance sheet in these securities. If they were suddenly marked to market at $0.00, then Washington Mutual would be insolvent and federal bank regulators would shutter the bank. Banks are required to have a capital-to-asset ratio(where most other businesses are not required to maintain this.) A WaMu insolvency would likely cause runs on other banks. This is the fear.

4) Since there is no market for these mortgage-backed securities, the government is going to create a market by announcing it will purchase them. I think Krugman's point is that this will immediately create a value for the securities, where there was no value before. The government will be, by definition, overpaying ... since nobody was willing yesterday to buy something that today the government is willing to pay for, the government is paying more than the market would have.

5) Now that the government will be announcing what the value of these securities are, banks will be forced to mark-to this new market. They will be unable to sustain the fiction that these securities are too difficult to value or merely make up values that bear no resemblence to reality (which is what they're all doing today). The government is going to "set the value" by announcing how much it's going to pay (or at least by announcing how it's going to decide how it's going to pay.)

This will, in certain circumstances, free up capital that is shoring up bank balance sheets (in banks that have marked-to-market these securities below the value that the government will eventually set), but it also has the distinct possibility of removing capital from the marketplace (in the instance of banks which have marked-to-market these securities at a value higher than that which will be established by the government).

My bet is that the bankers have been hedging (lying) and marking to market these securities at a rate far higher than the government will pay for them.

This could force some banks into insolvency and create the very runs the bailout plan was meant to prevent.

I bought a gun and sacks of rice yesterday.

[Rick Ballard]

You've got about twenty pounds of horse manure stuffed in a five pound sack there, fedgov. I sure hope you're holding onto to it tightly.

The FAS mark to market rules are pernicious enough to force the accounting firms which sign off on those financial statements to wear belt, suspenders and a truss when setting the value of Level Three assets. Krugman knows it and the entire purpose of his blather is a set up for future whining and sniveling when the markdowns become markups.

If you believe what you wrote then I'm surprised that you aren't sitting in a cave, waiting for the end.

[GMax]

Sorry not all MBS are zero. A stream of cash from an underlying pool of mortgages that 96.5% of people are paying on time, and most of the rest are only behind a payment or at most two is not worth zero.

My simple analysis ignors the fact that many of the senior traunches of the pools are both overcollateralized and credit enhanced and thus have lots of places to look to recover investment and make a return.

Now there are some low level traunches, especially "residuals" which probably are worthless, but this is only a fraction of the total and trust CPAs are not going to sign off on Financial statements which include total wishful thinking when the rules clearly require a mark to market. If it looks like the senior traunches eat up all the cashflow, then it will already be on the books at zero.

Some midlevel traunches may be using a slightly more favorable discount rate that what the Fed will use. So some additional write offs at any given institution come be forthcoming.

But lets assume WAMU does take some additional writeoff but sells off 25% of their assets for cash. What they do is let the hot funds, which are above market rate CDS and money markets run off and they use the cash to pay off these deposits as they leave the institution in search of 25 basis points of higher yield. So the entire balance sheet shrinks 25% and if the additional write off are less than 25% of equity, WAMU actual gains in the capital to assets ration not falls.

Hope you like eating rice, I think a sack would be lifetime supply for me.

[Swanson TV Dinner]

"I bought a gun and sacks of rice yesterday."

I tried to advise these morons they'd be wise to rotate their food and water stores already.

They still think a negative plus a negative equals a positive.

[Tom Maguire]

If only a few of the CDSs had become valueless, there wouldn't have been any problem. There still might not be a problem --- only no one knows how many MBSs really have lost value, or how much. It might be all of them. In which case the CDSs are insolvent: Gambler's Ruin.

Verner beat me to it, but as with the World Trade Center life insurance example there is a huge covariance issue. People should have understood that a real estate portfolio stuffed with mortgages from Las Vegas and LA did not have sufficient geographic diversity to perform AS ADVERTISED.

[clarice]

Why is it so impossible to devise a software program which can unbundle for valuation purposes these securities--that is, ascertain which underlying mortgages are in each security so that it might be possible to ascertain their value?

[spongeworthy]

Rick Ballard's first comment on this thread is required reading. The balance sheets carry assets that are severely undervalued because nobody's making a market in them. The recovery on these assets is likely to be more than the government will pay, and the government will pay more than market.

We always assume the market will pay you what an asset is worth. In this case that dos not apply. Krugman should know better but he can still read Rick's comment and wise the hell up.

[Charlie (Colorado)]

Why is it so impossible to devise a software program which can unbundle for valuation purposes these securities--that is, ascertain which underlying mortgages are in each security so that it might be possible to ascertain their value?

It's not. What's impossible is to unwind these things and figure out the value in a week during a panic.

[GMax]

Bingo for Charlie.

The computer programs exist, they were run by the investment bankers to value the pieces before sale. They can be run again with new values and assumptions ( early payoff assumptions, default and foreclosure assumptions etc ).

[Charlie (Colorado)]

I think we're mostly all agreeing in general. It seems to me that this is a little off track:

Verner beat me to it, but as with the World Trade Center life insurance example there is a huge covariance issue. People should have understood that a real estate portfolio stuffed with mortgages from Las Vegas and LA did not have sufficient geographic diversity to perform AS ADVERTISED.

I may have missed something, but were the CDSs insuring that the MBSs would "perform as advertised"? Or simply against their completely losing their value completely, defaulting?

Now if what you're trying to say is that these loans were so risky that no one could have ever addequately insured them unless they charged a premium that was almost the value of the loan, then maybe what we should be really saying, is that no one should have been making the loans in the first place.

No, and I think that's just the point GMax was making as well. A calmer examination of it suggests these securities aren't valueless. Most of the loans are good --- the default rate is less than 50 percent by a good ways. For one of these MBSs to completely lose its value, all the mortgages would have to default and have no recovery value, and about the only way I can imagine that happening is if an asteroid crashed into Las Vegas --- and even that wouldn't work if there is any geographical diversity in the bundle.

But "the price of a thing is what that thing will bring" and in the current environment, and with the lack of transparency, there's no one who will buy these things. While that's true, the "mark to market" value is zero even though they have an underlying value.

And as simplistic as it may sound, as a tax payer who is now left holding the smelly sack, that's my question. Why did the government inisist on lenders making these loans in the first place. Fannie Mae, backed by our money, seemed to be the great enabler. How did they get away with it?

Well, that's kind of the question, isn't it? The short answer, I think, is that when people tried to rein in, the FNFN lobbyists descended on Congress --- largely, but not exclusively, on Democrats --- to stop it.

But the other thing is, as smelly as it may be, I think there really is a pony in there. What I've read is that the $700 billion figure is against things with a residual value of between one trillion and two trillion dollars.

[Charlie (Colorado)]

Krugman should know better but he can still read Rick's comment and wise the hell up.

But consider the odds.

[Rick Ballard]

GMax,

They would be running on an instrument that is aged, as well. I don't believe that the public understands that an MBS is self-liquidating. The concept that I see promulgated is that "well, it's composed of 30 year mortgages so it's going to take 30 years (like a bond) for it to ?".

I believe that the 9% factor that Charlie was using is the combined prepay + default rate. The prepay rate is a function of the movement of mortgage interest rates and the sequence on default is delinquency, charge off and recovery (I'm a little hazy on recovery). My understanding is that a mortgage is first noted as delinquent, charged off 100% upon foreclosure and then the proceeds from the foreclosure sale booked back in as cash on the asset side - is that correct?

IOW - if the 9% prepay/default rate is correct then a $1,000 MBS will 'naturally become a $624 MBS at the end of five years (with 'normal' interest rate fluctuations). At five years, an MBS won't contain many of the problem children no doc, 100%ers at all so a Stinky Stuff MBS issued in 2004 is smelling sweeter by the day.

[Verner]

I bought a gun and sacks of rice yesterday."

I'm an historian. I already have a cabinet full of guns, a bag of rice, and a nice country ham hanging from the rafters of my basement. Has nothing to do with the current mess. Just a recognition that things never happen, until they do. And there's a lot of history to back me up on that.

[GMax]

The concept that is used is duration. Its a calculation that takes into account the prepay rates ( which included refinancing the market is lower ) as well as sales plus any involuntary prepays which are mostly foreclosures but would include insurance payoffs from a catastrophe like a Hurricane.

Duration on a pool of mortgage is probably around 9.something on new pools, I have not looked at this stuff in many years but that was true once upon a time when I was current. In other words the pool of 30 year mortgages were forecast based on historicals to have a functional life of about 9 years. Not every loan would pay off that soon but enough would that the stragglers would average out to that number.

So yes, I think you are right about the public understanding not being so great, hell there are folks in the industry that only marginally understand duration and tons who can not calculate it.

[Eric E. Coe]

These mortgages must involve a service agency (bank, whatever) of some sort that collects the payments and checks them off the payment schedule - nowadays this implies database-backed software to do all this. This database (or plural databases) contains all the information needed to correctly value (or at least value the performance of) the mortgages... pulling it all together for the mortgage pools and from there to the derived securities is simply a matter of having the proper IT systems set up to do it. And nowadays, since computing is cheap, there is no excuse not to have a current evaluation number that is recomputed on a regular reoccurring basis from the fundamentals.

So it seems that "lack of transparency" is basically an IT problem - the various actors involved need to pony up to build accounting infrastructure, to make sure that information about the underlying asset pool filters up to the derivatives based on them. Any regulation that comes out of this should mandate this.

Moreover, is there any way to write regulatory language that would mandate such transparency for anything new that the "Really Smart Guys" come up with in the future?

[Verner]

But the other thing is, as smelly as it may be, I think there really is a pony in there. What I've read is that the $700 billion figure is against things with a residual value of between one trillion and two trillion dollars.

Don't know how old you are Charlie, but when I was a kid, they still had dimestores. The store in my neighborhood would stuff various items of varying value into opaque brown paper bags and sell them for 25 cents. Some of the bags would have a handful of penny candy, and were not much of a deal, while a few of them might have a toy worth a dollar.

So do you mean that now what we have is the feds buying 700 million dollars worth of grab bags? I can understand the bundling of mortgages and trying to spread the risk, but what I simply don't understand is who allowed them to stuff the bundles into a bag that won't allow anyone to see exactly what's inside. The contents should be written on a label on the front of the bag.

I believe in market capitalism, and less is more as far as regulation goes, but I can't believe that there's no one controlling all of this when the tax payers of the US were ultimately the party guaranteeing the loans.

[Verner]

Make million billion

[Verner]

Oh Man FABULOUS piece in bloomberg that SAYS IT ALL!

How the Democrats got us into this mess.

McCain needs to hit this hard, and put it into terms that the general public can understand.

The only reason we're here is because FANNIE MAE brought us. And the democrats blocked any attempt to reign it in.

Raines need to go to Club Fed for the rest of his life. And he should take Dodd and Frank with him.

Print it out and shove it in the face of any democrat who tries to tell you this is Bush's fault.

LUN

[Verner]

Money quote from the piece:

``It is a classic case of socializing the risk while privatizing the profit. The Democrats and the few Republicans who oppose portfolio limitations could not possibly do so if their constituents understood what they were doing.''

[Verner]

Does anyone know exactly which Republicans opposed Portfolio limitation?

Please name names if you do.

I want them gone.

[AndyJ]

The root cause of the problem is the accounting rule FAS 157 which requires companies to mark-to-market. The fire sale by one holder of a thinly traded security drives down -ALL- similar securities. The more these assets drop in market value the more capital has to be raised... This debacle could have been avoided by suspending FAS 157... Or at least exempting the bundled mortgages since some were bad but most are good... But the blind bureaucracy could not see the difference between a single mortgage or a bundle...

The other rules that forced the insurance company to pay out on the bad debt, even when the debt was still performing pulled down the house of cards...

FAS 157 trashed the value of every mortgage in America. It was only enacted in November of last year... Small rule with big consequences. Now the solution will change Wall Street, Congress and create huge opportunities for those who are sitting on cash. Buying good mortgages at $.25 on the dollar is always a safe bet...

Look at the panic and political ineptness rising to the surface. I note that Obama has voted "present" on his issue.

[PeterUK]

"They still think a negative plus a negative equals a positive."

No that was Semanticleo our resident eunuch.

[boris]

In the land of Assclownistan even the self anointed "Lion Of Semantics" is just another mouth breather troll so stupid it forgot to submit a posting to the Assclownistan "Lion Of Syntax" (whichever troll that is) which might have suggested phrasing like:

"Unlike algebra on Wall street a negative plus a negative equals a positive ..."

Instead of the bass-ackwards:

"This ain't algebra, where a negative plus a negative equals a positive."

And now considers it quite unfair that its clownish foolishness is subject to ridicule.

[Charlie (Colorado)]

Moreover, is there any way to write regulatory language that would mandate such transparency for anything new that the "Really Smart Guys" come up with in the future?

In a word, no. Not, at least, without preventing any innovation in financial markets at all.

[PeterUK]

"Lion Of Syntax"

I think that was the Lion of Ex-Lax.

[Charlie (Colorado)]

Don't know how old you are Charlie, but when I was a kid, they still had dimestores.

Old enough that they were called "the five and dime" when I was a kid.

I think you're more or less on the right track, but now consider. In this situation, we've got a whole bunch of bags --- because I'm a mathematician and not an arithmetician, I'll make it easy and say there are 7000 of them. We know that they, all together are worth about $1 billion (conservative: that's the lower bound I've seen.) As you say, some of them have goodies, and some of them have a horse-apple, and we don't know which is which.

If we buy one of them for $100 million, we might get a goodie worth $147 million, or we might get a horse-apple, worth as much as TCO's intellectual contribution to the argument.

But if we buy all the bags, we're guaranteed we're getting $1 trillion worth of stuff for $700 billion.

[Charlie (Colorado)]

DAMMIT!

[Barney Frank]

I don't believe that the public understands that an MBS is self-liquidating.

In other words the pool of 30 year mortgages were forecast based on historicals to have a functional life of about 9 years.

Last figures I heard were around seven years, perhaps less, on mortgages and five years on MBSs.

[Sasha Baron Cohen]

"And now considers it quite unfair that its clownish foolishness is subject to ridicule."

I PLAY a character of immense intelligence and social sophistication called 'Borat'

You ARE BORAT!!!!!!!!!!

BTW; Context is not an aberrant sex act.....