Joseph Stiglitz, Paul Krugman, and Jeffrey Sachs have all now published articles debunking the logic behind Tim Geithner’s bank rescue plan. The Stiglitz article does the best job, showing how the plan perfectly mirrors all the bad practices that got us into the financial crisis in the first place. All three articles attempted to give a numerical example of how the bailout would work in order to illustrate the perverse incentives involved. All three also skipped over the crucial leap in logic that shows why the plan would lead participants to overpay for subprime mortgage assets. Call me crazy (or dumb) but I don’t think most of the public is that familiar with probability theory, much less risk-neutral valuation techniques, so I thought I’d break it down here.

Here’s the Krugman version of the example: imagine an asset that pays $150 with a 50% probability and $50 with a 50% probability. How much would a normal investor pay for it?: $100. Now, imagine the government were loaning the investor 85% of the total through a non-recourse loan. A non-recourse loan in this case would mean a loan you pay back if the asset pays off $150, but if the asset pays off $50, you give the government the asset and have to pay back nothing (i.e. the asset is the only collateral). How much would a normal investor pay under these conditions?: a little over $130.

All the examples left it at that. Maybe everyone’s a math whiz except me (a real possibility) and could follow that no-problem, but this took me a second. Here’s the breakdown:

The “normal investor” in the example above is a risk neutral investor. As this nice article explains, a risk-neutral investor is someone who doesn’t need to be compensated to hold risk. This type of investor will value the asset in the example at $100 because this is the expected payoff:

Expected payoff = .5 * high-return + .5 * low-return = risk-neutral value

where high-return = $150 and low-return = $50

i.e.

.5 * $150 + .5 * $50 = $100

If the investor were risk-averse, he would want to pay lower than $100 so that he would get some compensation for the risk of holding the asset. If the investor were risk-loving, he would pay more than $100 for the possibility of getting $150. In other words, assuming no interest, the risk-neutral investor would pay a price that would make his expected profit equal to zero–he pays the expected return (in a world with interest, he would pay the expected return discounted (reduced) by the risk-free interest rate, since he’s risk-neutral and could just as well invest an equal amount in the risk-free asset).

So what happens when the risk-neutral investor gets a 85% non-recourse loan? Using the assumption that the investor is risk-neutral, we start with his expected profit equal to zero, i.e. he/she pays $x for the asset, where $x equals the expected return.

So, without the loan, we have:

expected return = price paid

i.e.

.5 * ( $150 ) + .5 * ( $50 ) = $x

or,

.5 ( $150 - $x ) + .5 * ( $50 - $x ) = 0

so $x = 100

Examining the last equation, ($150 - $x) is what you get if the asset pays off; let’s call it the good state. ($50 - $x) is what you get if it doesn’t pay off; we’ll call it the bad state.

good state = ($150 - $x)

bad state = ($50 - $x)

With the government loan, the good state stays the same. The government loans you 85%; you put up 15% (in the real plan, you’d put up 7.5%, but no matter); when the asset pays off, you get $150 and pay the government back. So your good state under the loan is:

good-state* = ( $150 - .85*$x - .15*$x ) = ( $150 - $x)

Same as before. Your bad state changes, however, since, under the loan, if you get the bad-state payoff, the government loses what it gave you and gets the asset in return, and you lose what you put up, i.e. 15% of the purchase price. In other words, the bad-state payoff for you is:

bad-state* = ( -.15*$x )

Putting it all together, under the loan:

.5 ( $150 - $x ) + .5 (-.15*x) = 0

Solving for $x, we get:

$x = $130.43

This gets us to the point all the articles made: without the loan, the risk-neutral investor would pay $100; with the loan, $130.43. In other words, the government is providing a 30.43% subsidy to the banking sector for this asset purchase. Considering that, under the real plan, the amount loaned (what’s called a “haircut”) is actually closer to 92%, and that the the government puts up half the equity, and you can see the anatomy of a historic act of theft taking shape (in the above example, you would put down $19.56, or .15 * $x, so under the real plan you’d put down half that). As is plain from this breakdown, the primary idea behind the plan is to get investors to overpay for the toxic mortgage assets, and thus to transfer wealth from taxpayers to bankers. As with previous bailouts, this plan does nothing to ensure lending will resume; it simply rewards those who invested in the bad assets in the first place, in the hope that they learned their lesson and will do better in the future. Obama’s corrupt coddling of his campaign contributors continues.

In financial news, Tim Geithner has at last unveiled the administration’s plans to deal with the toxic assets infecting bank balance sheets. The plan assumes, contrary to all evidence, that the problem currently facing the global financial system is one of liquidity, not solvency–i.e. if mortgage-backed assets were properly valued, they’d be worth much more than currently, so if we just make a market for them, banks will be able to sell them at good prices and thus recapitalize their balance sheets. In reality, as Paul Krugman was quick to point out, the mortgage backed assets really are crap, buying them (even at a premium) won’t render troubled banks solvent, and it’s not a certainty that people will buy them at a premium. Above all, in my mind, is the following human fact: if you give someone $100 to invest for six months and, at the end of six months, they give you back $0, you’d be unlikely to give them $100 again: the plan ensures current management isn’t fired–indeed, it seems to be designed expressly to avoid that possibility–whereas nationalization would. The problem of undercapitalized banks would be solved if they could raise capital, but who is going to invest money with the same people who burned it with such abandon?

In other news from my world, there’s been developments in the saga of my friend, Stoner Mark, who I wrote about below. To recap, Stoner Mark is a friend of mine who lives on the West Coast. To make a living, Stoner Mark deals pot in a nice provincial city. Recently, his head filled with dreams of a new cell phone and more vacation time, Stoner Mark made a large purchase of what was supposed to be high-quality greens, blowing through most of his savings to do so. Instead of the boon to his business he thought it would be, the pot turned out to be crap, and now he’s broke and his mortgage is coming due, so, like many of us, he’s in need of a bailout.

When all this happened, stoner Mark called me first for a loan, which I provided, and then for advice. Like a good friend, I told stoner Mark that his only real solution was to bite the bullet: sell the house, move back home with his generous parents, and get his life in order (i.e. figure out how to be something other than a drug dealer). He also had two deadbeat stoner roommates at the time; I suggested that, as hard as it would be, he needed to throw them out in the cold. Since then, Stoner Mark hasn’t called (and no one has answered my plea for advice to give to him!); I’ve learned that he’s been surviving on loans from his other friends and from his parents and is desperately trying to get rid of the bad greens.

Well, just yesterday, oddly at the same time I was absorbing the details of Geithner’s new plan, Stoner Mark’s parents called me in an angered state. It turns out that, not long after they first called me for advice, Stoner Mark got in touch with them and came clean about the situation. They were, of course, shocked and appalled to find that their son was a drug dealer; Stoner Mark’s brother, a lawyer named Todd, was in such a state of rage at what he saw as his parents’ subsidizing Stoner Mark’s deadbeat lifestyle that he had to get psychiatric attention. After much soul searching, however, they realized that it was both good for the family and the right thing to do to help him. Then, outrageously, he convinced them to help him in the most ridiculous way imaginable: they offered to just give him $5000 to cover his losses! I was so shocked by this I called Stoner Mark, trying to see what effect this would have on him. I tried to be casual, not letting on that I’d spoken to his parents.
What was he up to these days, I asked, was he still in trouble? No, everything was fine again, he managed to use the money from his parents (which he called a loan but they insisted they gave to him not expecting to be paid back) to essentially cover his living expenses while he dealt with the bad pot. He used the rest of the money to buy good pot to mix in with the bad, which is what I’d feared he’d do with the loan I originally gave him. He’s now getting his business back in order with the help of the loan; he’d lost a lot of customers from having the bad pot for so long. I asked him, diplomatically, if he had any plans to find a new source of income? His response: “of course not, man, this is the life!” I tried another angle: I asked him how good his suppliers were, if he’d be able to still buy good stuff and make a healthy margin down the road if he didn’t have money from his parents? Not to worry, he said; yeah, the new stuff was pricey, and yeah, the good stuff is more expensive these days, but he’s making bank again, he’d be able to afford it. It sounded like the same kind of dreaming that led him into the situation.

Maybe I’m just old-fashioned, but I find the whole thing maddening. If a drug dealer buys crap product, his business should go down, it’s just the American way. After I talked to Stoner Mark, and realizing that I was crossing boundaries, I called his parents back, I was just too livid. “You see what’s happening, don’t you?” I said to them. He’s just going back to drug dealing, you’ve enabled him to continue to be a drug dealer. Suddenly, they turned on me: “at least it’s something he does well”, they said. Can you believe that! They think he should continue to sell drugs, at least he can do SOMETHING. They’re little baby is destroying a nice West Coast community with bad ganj and they are proud of him; they’re even willing to subsidize his market!

It’s just amazing. Thank God the country isn’t ran this way.

Three sets of facts:

As reported in the Times and elsewhere, AIG is still paying bonuses and won’t disclose the recipients of their bailout funds, mainly counterparties to credit default swaps at large investment banks.

The Fed itself has resisted inquiries by Congress to disclose AIG counterparties who are receiving bailout money, and has denied past requests from the media for information on recipients of bailout money and the types of collateral they were accepting for emergency loans.

The Markets Group at the Federal Reserve Bank of New York is responsible for implementing monetary policy, pursuant to directives from the FOMC. They do this via trading relationships with the primary dealers, entities tasked with/empowered to trade government securities with the Fed.

The Federal Reserve Bank of New York is run like any private corporation: there’s a private board that appoints a CEO, the Bank President, currently William Dudley and previously Timothy Geithner. The NY Fed’s current board:

Class A
elected by member banks to represent member banks
Richard L. Carrión (bio) 2010
Chief Executive Officer and Chairman
Banco Popular de Puerto Rico
Charles V. Wait (bio) 2011
President, Chief Executive Officer and Chairman of the Board
The Adirondack Trust Company
Jamie Dimon (bio) 2009
Chairman of the Board and Chief Executive Officer
JPMorgan Chase

Class B
elected by member banks to represent the public
Jeffrey R. Immelt (bio) 2011
Chairman and Chief Executive Officer
General Electric Company

(two vacancies)

Class C
appointed by Board of Governors to represent the public
Lee C. Bollinger (bio) 2009
President
Columbia University
Denis M. Hughes (bio) Deputy Chair, 2011
President
New York State AFL-CIO
Stephen Friedman (bio) Chair, 2010
Chairman
Stone Point Capital, LLC

I.e. the CEO of a major investment bank, the CEO of a major corporation with a huge financial services arm, the chairman of a company that invests mainly in the financial industry (Stephen Freidman), and some other people (at least one of whom makes over a $1 million a year).

A simple proposal: how about a little more representation for the public on the Fed’s board, and maybe a little bit less for the financial industry? It is no doubt reasonable to have major member banks represented by their own, that’s cool. But in the world after The Fall, it may be better to start thinking of finance as a public utility, as Martin Wolf of the FT has suggested, and it’s various governmental supporting institutions as utility regulators. It should be easier for voters and the media to demand accountability on bailout funds if the public had more seats at the Fed’s table, and especially the NY Fed, given it’s special role in monetary policy implementation. Throw in a mayor, or an ex-governor, or maybe just a few average Joe Blow homeowner’s, and maybe the Fed won’t feel as skittish about asking for fuller disclosures of e.g. subprime mortgage exposures from major financial institutions.
This is a simple proposal for a slippery issue: In normal times, the Fed relies on the primary dealers to implement monetary policy via the conventional methods, mainly open market operations that move the benchmark interest rate up or down. Since the Fed relies on the primary dealers for this purpose, they try to make it nice for them: they don’t survey their activity, a fact that resulted from regulatory changes in 1992 which, according to the FRBNY website, were conducted partially to remove the false impression that the Fed regulated these institutions. (One change is that the primary dealer surveillance unit at the FRBNY was dismantled and a system of market-monitoring was developed.) Regulatory concerns such as whether they have enough capital to be operating properly are monitored not by the Fed, but rather by the SEC and the Treasury.
In abnormal times such as now open market operations to bring the interest rate down don’t work anymore because the rate is already at zero and can’t go down any further. In this case, the Fed has taken the extraordinary step of lending directly to major financial institutions (banks and non-banks), including the primary dealers (most notably through the Primary Dealer Credit Facility, but also through other “unconventional” lending programs). These new measures have created issues of accountability: many argue that some of these banks, including primary dealers such as Citigroup, are insolvent. I.e. someone wasn’t monitoring their capital adequacy properly, and now they are “zombie banks”–essentially failed institutions worth nothing that are propped up by government capital injections (institutions which, in turn, spread disease by undermining the incentive structure and margins in lending markets through highly-risky lending aimed at resurrection). Someone now needs to determine if they are solvent or not (the purpose of the Treasury’s “stress test”) and, if not, bury them. Lending needs to be restored to the economy, however, so for the time being the Fed is relying on the assumption that banks are solvent and that they simply need liquidity to get back on track, so they’re pumping them full of taxpayer money in the hope that these institutions will start lending again.
So, adding this all up, the primary dealers and their crony institutions are in a wonderful position to blackmail the Fed into preventing disclosures of where exactly all the taxpayer money is going. If the Fed or the Treasury start opening the institutions’ books to public scrutiny, they can simply stop participating in the lending facilities or use bailout money to de-leverage instead of starting to lend again at lower expected rates of return. As the economy falters further from lack of credit, the policymakers will be blamed for allowing Rome to burn and political pressure will lead, happily, to more bailout funds (and more ill-gotten bonuses). As zombie institutions are thus propped up the forestalled disclosures will, in turn, further delay the discovery of insolvencies by the public.

So how do we detonate this situation? One solution may be to give the public more say on the NY Fed’s board. Another (though historically fraught) solution may be to just place open market operations under the control of the public Federal Reserve Board, instead of the private FRBNY.

A post in my ongoing series on the long-term aspects of the current economic crisis:

Our Crumbling Chinese Castle:

My previous post in this series posed the open question of whether and how financial chicanery on Wall Street –what I’m calling silly paper games–could lead to permanent wealth destruction in the US and a potentially prolonged slump and, if not, what exactly then is causing the ongoing economic crisis? It remains an open question whether this crisis is simply one of the financial sector, whereby the unraveling of some bad practices led everyone to panic, meaning there could be some fix to the banks that will pull us out of this; or whether something deeper happened, if there was some process of real wealth destruction that would lead us to a long period of pay-back.  Paul Krugman’s latest column presents a clue in reviewing the Fed’s Survey of Consumer Finances, while Martin Wolf in the FT provides a whollistic narrative of the economic crisis, charting how a massive increase in the “leverage” (or “indebtedness”) of both the financial and household sectors was the underlying cause of the financial crisis.

Though I do hope to return to the issue of securitization in depth, the contributions from Krugman and Wolf have given me the ultimate answer to my question. The question was, how could financial sector mismanagement lead to actual wealth destruction. In other words, where did all the money go? Money is, in many ways, a putative thing–it exists in the mind (and on the balance sheets of corporations and households, to be sure, but these exist in a fluid continuum with banks and, thereby, ultimately with the Fed, and the Fed can create more money simply by increasing the size of the liability side of its balance sheet (through, e.g., buying government securities), a process governed ultimately by people sitting around and staring off into space while contemplating statistics (as someone who’s seen part of this process, I can vouch for the fact that it is largely the work of imagination)).

There are in the world, however, real things that make up our economy–food, construction materials, services like haircuts and car repairs, etc. etc.–and our primary concern in a recession is the inability of people to get enough of these things. The work of finance is to assign these activities relative values, either through the application of wisdom or the making of markets, and to determine ways to ensure they continue in an efficient way through proper resource allocation. This is done by funneling surplus wealth (savings) generated by certain activities to other, underfunded activities. The villagers join together and realize that a lot of the farmers have extra horses; the villagers agree that the extra horses will be loaned to till a new field on the outskirts of town so the younger farmers can have land of their own; the new farmers agree to give the old farmers sacks of grain in exchange for the loaned horses. Modern finance is a complex version of this. The financial sector (the villagers) essentially determines how many sacks of grain the horses are worth by establishing markets for such assets (the horses), and establishes formal processes for the old farmers to be paid back.

The question about our current economic crisis is then this: is it a matter of the villagers panicking and becoming doubtful about the horse deal, or are the new farmers actually fundamentally unprepared to farm?

Ok, that was confusing. Let’s try again: the real question is whether this is just a banking panic or something deeper, like the collapse of a major credit bubble. Evidence is beginning to mount (and, indeed, has been mounting for some time) that it is the latter.

What happened? Martin Wolf has it like this (for those of you without FT premium access): the economy as a whole began to steadily accumulate debt starting in the 1980s, with households in particular increasing their share of debt. In the past 8 years or so, this trend accelerated, with the financial sector in particular rapidly increasing their debt (or “leverage” as they liked to euphemistically call it). One of the first things you learn in economics classes is that, in closed economies, i.e. one’s that don’t trade, savings equals investment. If the financial sector went on investing, their needed to be commensurate amounts of savings. Where were the savings, though? If household debt was increasing as well, it definitely wasn’t coming from US households (indeed, the US savings rate plunged towards 0 as time wore on). Luckily, we’re an open economy. Thus, the second part of Martin Wolf’s story: China, or, more accurately, global imbalances. The financial deficit created by massive US and other developed-country borrowing and spending (we weren’t the only ones engaged in insanity) was financed mainly by poor countries sending their excess savings to us. (To finish off Martin Wolf’s story, the third factor in the crisis were the complex debt instruments such as securitized mortgages that allowed private and particularly household sector debt to increase so rapidly; this seems like a footnote at this point.)

So the question was, could financial sector mismanagement lead to actual wealth destruction? The answer is, wrong question: there was no wealth destruction really, just a lack of wealth creation, with the deficit being made up by borrowing wealth from developing countries. Or, the answer is, yes: we were destroying the wealth of Chinese workers through excessive spending facilitated by financial sector mismanagement.

This brings us to your Dark Comedy Hour take-home message: no amount of schooling will help you understand this crisis, it will simply confuse you. The real crisis goes like this: we spent money we didn’t have–Chinese money–and now we have to pay it back. This will take a long time. Our country’s magnificent growth over the past 30 years was, by and large, an illusion! We’re like the new farmers who, having borrowed the horses, realized we didn’t know how to farm and decided to play polo all day.

So we’re entering a prolonged depression comparable in size and scope to the Great Depression and that will require a fairly permanent shift in spending habits. Why permanent? It is highly doubtful that a situation in which we do nothing and China gives us money to spend on their goods is sustainable. It is an instance of poor countries giving their money to rich countries for free.

That, in turn, raises another question: why would the poor countries do this? Fortunately, the answer to this is a simple cocktail of 1) export competition, 2) cultural backwardness, and 3) political corruption.

On export competition, the main reason the developing countries were willing to send us their surplus savings is that China had what I would term a predatory export policy: China’s dollar peg, whereby their currency is kept artifically low in order to make their exports cheaper than that of other countries, is maintained by forcing companies that sell to the US to exchange their dollars for renmenbi (the Chinese currency); the Chinese then reinvest this money in US Treasury securities. This decreases Chinese spending power and increases US spending power. (Again the real money/fake money dichotomy is useful here from several angles: the Chinese make real things–trinkets, widgets, etc.–and make profits. They then steal this money and issue fake money, sending the real money back to us and, since we don’t make anything with it, it becomes fake again.) This recycling process has the effect of lower Chinese spending power: if the money were kept in-country, their currency would have to rise, leading to average Chinese being able to buy more from abroad (and from us). We, in turn, have our spending power artificially inflated: the increased buying of US Treasury securities decreases the interest rates that they can fetch, lowering US interest rates in general, making borrowing cheaper and spending thus easier. Why would the Chinese stay poor on purpose, besides trying to put all of their (mainly Asian) competitors out of business?

This brings us to 2) cultural backwardness. The following may make me seem like a haughty westerner, but I say So What?: as the Olympics showed, the Chinese have a lot of pride in themselves and are not as wary as they should be of authority. It’s the type of place where the leaders would force a girl to inadvertently lip-synch a song so they could match the prettiest girl with the best voice. Give them many years of double-digit GDP growth and they’re liable to not only start getting comfortable with one-party rule, they might actually join those who are depriving them of political freedom in a national pride-off. All this despite the fact that, unlike in Western countries, average Chinese enjoy no social safety net (i.e. health care, social security, medicaid, etc.) and instead must save to cover these costs, thus all the savings they send to us. Which leads to…

3) Political corruption. As protests across China showed, a lot of Chinese who haven’t shared in the boon emanating from export growth have felt disenfranchised of late. The protests, along with more recent signs of a broad slowdown in exports, showed cracks in the Chinese facade. Nevertheless, the Chinese really have been slowly attempting reforms to bring market forces to China and introduce political freedoms. Thus, a potentially frigthening strategy on the part of the Chinese Communist Party has become apparent: use currency manipulation to sustain growth, build political legitimacy, and to destroy the export sectors of competitor countries. Increase the number of stakeholders in export growth as a means to stifle domestic protests from rural elements–i.e. build a middle class. Once these stakeholders have been established, allow the currency to slowly appreciate while gradually introducing political freedoms. Lastly, take credit for all this to maintain power and influence over the new middle class.

Despite being effectively a war against the poor, it’s not a bad plan in the grand scheme of things. It’s a lot better than a bloody revolution as a means to political freedom. The plan is frightening, however, when you begin to wonder what happens if the export growth slows. This is what is happening now. For as our Chinese castles, with their home theaters, three car garages and two SUVs, flat screen televisions and wet rooms, crumble to the ground, the Chinese export-sector workers are returning home permanently in droves, suddenly unable to find work and make the remittances that were supporting their families.

China took steps to release it’s currency peg last year, but has abruptly reversed course as the US slump has worsened. This is understandable. What is less understandable is how, with spending habits headed for a permanent shift in the US, the Chinese Communist Party can maintain control of their country. Rural protests were already growing in frequency.

No one’s perfect though: just as the Chinese leadership faces pressures from the bottom to somehow reignite export growth, the US leadership feels pressure from the very top to get money back into the American wealth destruction machine. Light Touch Tim Geithner and his ilk are now bending over backwards to ensure the banks are not nationalized, wasting hours of taxpayer time and money trying to come up with ever more elaborate schemes to avoid nationalization and the inevitable firing of all their friends and cronies on Wall Street, and preventing the badly needed write-downs of toxic assets in the process. Somehow, the bankers still think they can go back to work “levering up” their institutions debt to 30 and 40 times assets, and make the attendant imaginary bonuses to lead their kingly lifestyles.  Eventually, everyone is going to have to wake up: the Chinese will have to start allowing their people to enjoy their own wealth, and we will have to spend much less; our bankers will have to realize that they are not kings and that, even back when there were kings, there were only a few of them.

It’s just a little worrying that the last time the world woke up from something like this, they called it a world war.

In financial news today, Treasury Secretary Tim Geithner, or Light Touch Tim as he’s known on this blog for his penchant for insulating the market from regulation or even scrutiny, unveiled his framework for bailing out the banks. I had the privilege of attending an inflation conference at the New York Fed today and, while I was zoning out as conference presenters presented model-based estimations of inflation risk premia and the like, I was struck by a series of text messages from my dumb friend, stoner Mark. Stoner Mark is in severe distress and, at the risk of exposing him to the scrutiny of the DEA, I’m going to explain his situation to you. What would you do in a situation like this?:

So stoner Mark lives in a house out in the Pacific Northwest in the kind of place where a kid with no skills could still own a house, or at least a mortgage on one (stoner Mark admits he has no skills, I’m not being mean). He lives with two other stoner friends in a wonderful stoner heaven–faded couch, magazines and bottles strewn everywhere, the 4-foot high glass bong, however, incredibly clean, Comcast on-demand, etc.–that he finances through odd jobs and mainly, of course, selling pot. Stoner Mark’s goals are low, admittedly, but he has achieved them (and who among us can even say that much? Not many). Nevertheless, stoner Mark has ambitions to pay off his house and sometimes fantasizes stonedly about getting a shanty by the beach, or a BlackBerry, or a 6 foot high bong.

Following this kind of train of thought, about a month ago or so, Mark withdrew a large portion of his savings to score a major supply that could last him for potentially many months. He was also promised very high quality ganj from the source, the kind of stuff that you could repackage a little light and still fetch full price for a vial (readers, for future reference, please keep in mind most of my friends are not like stoner Mark; they are, instead, captains of industry, shark financiers, old bull lawyers, etc.; the kind of people who wear fancy watches. Stoner Mark’s an old friend). Mark’s eyes turned green at the prospect of an elevated lifestyle. His two stoner roommates were also enthused, promising to scare up eager customers in exchange for some of the take (being old friends of his, they also pay little or no rent, so they felt they should contribute). Money in hand, he went off to meet the source in what I imagine is some wooded cove, or possibly a cave, off in the mountains. Like many things involving large amounts of cash and shadiness, the deal didn’t go quite right. Dude was shadier than first thought, he had some friends with him, there were distractions, something. Stoner Mark doesn’t want to give the details. In any case, upon returning home, he realized he had garbage bags full of what was, essentially, crap.

A couple more crucial things about Mark’s situation: firstly, as I said, he has no marketable skills. The only other thing he’s done besides cleaning gutters was using his pot money to finance a small smuggled cigarette business that helped people avoid vice taxes. Secondly, like many stoners with low self-esteem, he has rich, overbearing parents who will discipline him to a point but ultimately bail him out of any situation; this in turn grants him the illusion of independence along with a certain cavalier attitude that often melts into sheepish denial when the risks he takes don’t turn out right. This has made him an annoying but somehow exciting friend to have. His roommates are of broadly the same type. Nevertheless, a few problems have arisen with his MO: his parents are nearing retirement and have lost a lot of their nest egg in the financial crisis, so their bailout next time will mean he moves home; stoner Mark is also a ladies man so this won’t fly.

Stoner Mark is, therefore, in a panic. Either he finds some way to off the pot, eats the loss and tries to survive, which would probably result in him having to either get more remunerative roommates or give up his house, or he fails in offing the pot at a sufficient rate to stay on his feet and ends up with his parents. He could risk his dignity and ask his parents for a loan which could possibly allow him to buy some good pot to mix in with the bad and sell that, maybe; but this sounds like a long shot, and involves more debt. His roommates have by now found out about the situation (they were in denial at first, trying to sell the stuff to their friends, some of whom bought it, but many of whom figured out it was crap). Mortgage payments are coming due in a month and there’s nothing left in the bank to pay up.

I learned about this situation because Stoner Mark, who I don’t talk to all that often, called me up last week to essentially ask for a loan. His parents also called me out of concern after a recent trip to his house. My head says no loan but alas the heart says yes, but I figure I’m only buying him time (I could also tell I was at the end of a long list of people he was hitting up). He’s since called back for advice, as if I’d know what to do.

Dear readers, what should Mark do? He’s got a house full of crap pot, no money, and bills coming due. He balked at my advice of throwing himself on his parents mercy, moving home and getting his life back together. He actually got defensive about it, being all like “what kind of man do you think I am?”, a question I didn’t answer. My second piece of advice was to use the time he bought himself by taking my money to start figuring out how to get rid of the roommates. He’s since got rid of one, cleverly clearing out the converted garage the kid was living in to rent out to a neighbor for their car. Stoner Mark then rapidly spent the neighbor’s first payment on a weekend in San Francisco, where he said he was going to sell pot, but I doubt it. Sometimes I think stoner Mark should just face the consequences, but alas, I am his friend (and, of course, he has no marketable skills). In any case, the parent route might not even work because his parents might have to go back to work to pay for themselves. I somehow don’t see stoner Mark at Burger King slaving to support his parents.

I also realize the irritating possibility, suggested by the San Francisco trip, that he may use my loan for something other than paying his mortgage, like buying more pot for the mixing scheme, or maybe just to smoke, or perhaps taking another vacation. He may just pocket it, or use it to keep his other stoner friend around. This would anger me greatly, but I think there’d be little I could do about it besides not make him another loan, but I am a softy. He could use it for the cigarette scheme, which wouldn’t be as bad somehow because it involves work, but I would still be angered.

If there are readers out there, please send suggestions for stoner Mark, and cc Tim Geithner.

As the blue-mist enveloped years of our collective nightmare come to a final end and begin to recede into the distance of memory, we pause for a moment to consider what we’re passing through today. After all the Carnage, the Double-Talk, the Straw-manning, the Witch Hunts; after the awful deluge of bullshit we’ve weathered from the Republican PR machine; after the three frigtening years of male asshole empowerment weathered approximately between 2001 and 2003; after all the self-congratulation and glib analysis; after 8 years, in short, of a bad trip, we finally see the sunrise (with a blue O in it, oddly enough).

Could it have been paradise, though? When Bush stood on the wreckage of the World Trade Center and said the world would hear from us; when some banker, posing for a moment as a public servant, stood outside the stock exchange a week after 9/11 and said “and now, our heroes will open this market”; when millions of Americans first unpacked their flat-screen TVs, plopped down on their Ikea furniture, and first tuned in to American idol, were we still living in some kind of reality? Or was it all just a dream? Perhaps: the TVs were bought with borrowed Chinese money, Wall Street turned out to be a Ponzi scheme, the search for fleeting celebrity and superficial attractiveness turned out to be less than our souls could strive for, and what the world heard from us was that we were mean and didn’t think things through. Maybe, then, it was all just a dream, some strange parable from God that wafted out of the blue smoke of a collective national bong hit taken some time between the breaking of the Lewinsky scandal and Novemeber, 2000, as reasonable people tried to ignore the growing menace of the Christian right–a cosmic practical joke meant to warn us about the dangers of complacency towards the silly. Maybe.

All one can see now is that we have an inauguration today, but this time, it’s not a man who is being inaugurated, but a brand new nation. We stand and watch the pampered scion of a faux aristocracy bow out to a man who, like many of us, had to figure out how to be an American, and one who now wants us to work together for a better future.

So we say bye bye to the intoxicating blue smoke of the Bush years, that haze of pleasant unreality, those mornings of nothing, that blessed lack of purpose, that sense of blah, that surety in hedonism. Say your prayers and line your pocketbook, hug your wife, go to church, all is well. But now I’m lazy, I’m tired, I want my dream back; I just registered Republican in October. I’ve reached my middle-young-adult-hood and now we get inspiration? I’m ready for the picket fence, the mortgage, the TV and the lazy boy.

Our long national nightmare is over, and all I want to do is stand on the sidelines and make snarky comments. Mr. Bush: as a person who entered college when you entered office, let me just say, you really fucked us.

“Securitized lending is here to stay. Regulatory changes provide incentives for traditional lenders to securitize loans. Capital reserves are higher for institutions to hold whole loans vs. rated securities. Institutional lenders such as life insurance companies are now buyers of CMBS and banks are beginning to offer securitized loan programs.”

Ah, securitization, that most ironical of words. The quote above was taken from a now-priceless article in the February 6, 1998 edition of The Atlanta Business Chronicle, an article entitled “Mortgage-backed securities make it easier to find loans.” The article was written by two members of a commercial real-estate firm in an attempt to talk up the burgeoning market for commercial mortgage-backed securities; given that the excesses in the commercial market were far more contained than those in residential mortgages (possibly because it’s harder, though not impossible, to fleece businessmen than the average consumer), we assume that Messers. Petosa and Long are still employed and still promoting the virtues of securitized lending.

We here at Bye Bye Blue Smoke (ok, I here) hope to take a more skeptical view of the boom in securitized lending in the next series of posts. (Ok, I checked, their firm, FINOVA Capital, filed for bankruptcy in 2006, assumedly far after Petosa and Long left the firm so maybe, through some miracle of internet visibility, they can help me out.) Like many frightened Americans, I’ve been wondering how the sudden and massive destruction of wealth that occurred over the past 6 months, with substantial numbers of Americans losing a large fraction of their retirement savings and several major banks collapsing, could have been caused by chicanery by Wall Street bankers–that is, how a bunch of dudes playing with computer bits could have caused the destruction of real wealth–and whether that loss must persist. I’ve been nagged by the following quasi-philosophical question: if silly games with paper, which involve no real productive activity, are assigned an economic value, and then, those same silly games with paper are shown to have no economic value, how could the subsequent reassignment of their value cause actual wealth to be lost? Could it? In life, we have activities we do and the values we assign to them; we assign those values so we know what those activities can be traded for. In the Second Gilded Age, the financial industry grew, with more and more of it engaged in silly games with paper; for a time, these games were assigned great value, and it’s players were paid fees; then, the games were found to be without value; we can’t get the fees back, but surely, aside from that hopefully negligible loss, we should be able to simply go back to a world where the silly games are assigned no value and start anew. This is possible, right? If so, how do we do it?

Should be a simple question with a simple answer, but, unfortunately, it’s not, or all the smart people in the US government wouldn’t have been so hysterical about it for the past 6 months. Why is it hard? Well, for one, we know that one of the silly games with paper was run-away securitized mortgage lending or, more to the point, leveraged investing in subprime mortgage-backed securities by large Wall Street banks. So there’s lots of bad subprime mortgage-backed paper out there–the silly paper in the silly game. Why not just burn it all (i.e. write it off) and start over? The assets were created pursuant to imaginary, not productive, activity–the playing of silly paper games. If the value of the assets is imaginary, pretending the assets don’t exist should be a good strategy. Simple, no? Well, no. This is essentially what the TARP, or Troubled Asset Relief Program, that bastard of a cure-all legislative action that amounted to $700 billion no one knew the purpose or use of, was supposed to do: Print money (imaginary money) and use it to replace imaginary assets. Problem solved, right? Well, what if you borrowed money that was ultimately produced by doing real things (selling produce, building machines, transporting cargo) and invested it in imaginary things like subprime mortgage paper (i.e. the mortgages of people who can’t afford their mortgages)? Then you’d need to take the imaginary money the government gave you and use it to pay back the real money you wasted on the imaginary assets. Insofar as this helps you redeem the real money (and pay it back to the real person you owe it to), all is well for the economy (well, at least for the private sector: government debt will increase, but the government can borrow at lower rates than households, and they can print money).

To slip uneasily from metaphor to history, this exchange of real money for fake (or, fake money for fake assets to redeem real money) was what Henry Paulson, the (current-at-the-time-of-me-writing-this-but-hopefully-by-now) former Treasury Secretary, was originally charged with and was planning to do–that is, he was planning to use TARP money to buy bad assets so banks could take them off their books–but, for reasons that remain unclear, he chose to use the money to inject capital into banks instead. How this turnaround came about will be the subject of a subsequent post in our series , but for now, one wonders if the exchange of printed money for imaginary mortgage-backed securities to pay back the real money of creditors would have done the trick? If so, it fits easily into a simple, if modified, model of government counter-cyclical activity: a sudden increase in the demand for money (to cover losses on mortgage paper) meets with an increase in the money supply by the government (through buying the mortgage paper). If not, however, we’re left with the horrible prospect that these silly paper games can cause real and lasting destruction of wealth. This is a frightening prospect and, indeed, it may be the reality: Paulson’s choice of using capital injections into banks instead of buying bad assets should have theoretically allowed the banks to work collectively to do what the government would have effectively done through purchases–write off the bad assets and move on. For some reason, they couldn’t do it. Why? Are the imaginary losses far greater than the $250 billion they’ve been given? Are they unwilling or unable to write off the values of securities that may have some, though very little, value? Or, can they not get these assets off their books because these assets are their books–i.e. so much real money has been pumped into these imaginary assets that, without redeeming at least some of the real value, these banks would become insolvent?

Given that, whatever would have worked, we continue to find ourselves in a seemingly intractable financial crisis, we assume going forward that, even if the TARP had been executed with Obama-ish smoothness and professionalism and some mechanism was established to effectively buy the bad assets, the crisis would probably still not have been averted. So we ask ourselves, what is this silly paper game called securitization, and how does it affect our lives? The rest of this post will introduce the concept and attempt to provide historical context. In subsequent posts, I hope to analyze it’s role in the growth of American consumer practices and culture over the past 40 years, whether securitization itself will survive as a common practice, and what role, if any, it will play in the new economy. A large part of this task for the blog and everyone else, though, will be telling a coherent story of the history of securitization itself and tracking its effect on the availability of credit, a story that remains largely untold. (To that end, I hope to find more articles like the one above.) And it’s a story with consequence, because, if my hunch is correct, and the very model of securitized lending as a means to direct investment capital to consumer credit is fundamentally flawed, it could mean that we’ve been living in an imaginary castle for the past 35+ years that’s about to come crumbling down.

So, to begin, what is securitization? Securitization is, basically, the selling of debt payments in the form of a security (a security is just any financial obligation (a stock is a security)). So, a mortgage securitization would work like this: There’s, say, three families with mortgages at three different locations somewhere in the Northeast. I’m a mortgage banker who owns these mortgages, so the families’ payments are going to me. I currently carry the risk that one or more of these families will stop paying me. I don’t like this, particularly because I know these families personally and one in particular is kinda dodgy. My big banker friend, however, keeps calling me and saying he’d love to buy these mortgages off me. Annoyed by the possibility that at least one of these families won’t pay, I say to my banker friend, sure, pay me $1000 extra and I’ll sell you these mortgages. He says great, pays me $1000 plus some percentage of the mortgages and now he owns them and can worry about that dodgy family (to ease his mind, I choose not to tell him about the dodgy family). All I got to do now is collect the payments from the three families and immediately pass them on to my friend. My big banker friend, being a whiz with numbers, quickly finds three other mortgages he’s bought from another guy like me that are all located in the Southwest. Based on a mathematical analysis of the basic parameters of the mortgages, and considering the geographic dispersal of them, my friend then creates a security whose value is backed by the debt payments from me and from the dude like me with the Southwest mortages. Later that afternoon, my friend, a real mover and shaker, is already on the phone marketing his new security. It has two levels (or tranches): senior, and subordinate. If you like risk, invest in the subordinate: the interest rate it pays will be higher than that for the senior, with the tradeoff that the subordinate absorbs losses first, losses which would occur if one or more of the families stopped paying their mortgages. If you don’t like risk as much, therefore, you can invest in the senior side of the security, and you’ll then be insulated from losses since the subordinate tranche will absorb losses first. Lastly, my friend says, don’t worry, the mortgages that back up this security are dispersed all across the country, so the prospect that they’d all default at once, due to, say, a bad regional economy, is low. The potential investors take the bait and agree to buy the security. My friend is likely paid a fee for setting this whole thing up, and the security will work like a bond, paying a regular interest rate to the two tranches of investors and then paying some value at maturity above the original purchase value. The security can then be traded like any other bond.

So that’s a securitization. Despite the mind-boggling complexity of financial instruments that industry insiders and media commentators like to advertise, it doesn’t take an financial economist or any other form of rocket scientist to see the possibility for perverse incentives in this model. One need only observe that only I personally know the families whose payments I’m selling to see that something is wrong. The crucial historical point is that this way of doing business is fairly new; what’s essentially happening with securitization is a shift from a financial system based on banks–i.e. me lending to families without the benefit of my friend to sell their mortgages to–to a financial system based on securities markets. This shift has been a long process by which the George Bailys and Mr. Potters of the world are replaced by me and my pink-shirt-and-vodka-martini Wall Street friend (he’s that type of guy). To finish off this post, then, we return to the article cited above to set the stage for a historical review (which will occur as soon as I can find some historical material on securitization).

Financing

Mortgage-backed securities make it easier to find loans

Atlanta Business Chronicle - by John Long and Tony Petosa

In our ongoing scrutiny of Tim Geithner, the Treasury-Secretary designate, we witness light touch Tim forgetting to pay nearly $40,000 in income taxes and hiring an undocumented person as his housekeeper. And in disclosures today covered in a New York Times editorial, we see even further evidence of tax malfeasance, and a potentially disturbing pattern emerging. In my previous post on Mr. Geithner, I liberally cast aspersions on his character, painting him as a darling of Wall Street, a serial self-ingratiator who spent more time sucking up to industry than regulating, and whose primary accomplishments may well be imaginary; in an act of supreme disloyalty to my former employer, I even suggested that he represents the very worst of the self-aggrandizing and self-congratulatory culture of Wall Street, a culture that looks with disdain at the very economy it is serving and from which it skims its out-sized profits, a culture that would not hesitate to engage in tax evasion simply as a matter of principle, a culture–above all–steeped in the self-serving, disingenuous rhetoric of market fundamentalism that was both the scepter and the shield of the corporate robber barons of Bush’s now-dead Managerial Revolution.

I was glib at the very least, haughty at the very worst, but given that, as I assume, no one is reading this, I assumed it was alright. After all, though Mr. Geithner seems to represent the consummate self-assured Wall Street personality, he didn’t actually have any finance industry experience and had dutifully spent most of his life in the service of the public. (And anyway, who else is Obama going to pick? At least Geithner’s smart, experienced, and semi-new.)

Now, however, I feel vindicated. You’re going down, Timmy G! You and the rest of the mandarin mauraders of the Bush years are about to be thrown on that old dust heep of history. Paulson was the end of the line. Your revolution is over! Government is back, and it’s for the people this time. Pay your taxes!

A very merry Christmas to all from your blogger. On this day, as we celebrate the entry into our world of the great philosophy of love brought by Man’s savior–the philosophy that at last declared that happiness cannot be found in conquest, but only in cooperation–we contemplate retail sales. Particularly, I put forward a behavioralist theory of the upcoming retail sales Armageddon:

As any foreign observer of this country can see, Americans spend a lot on Christmas gifts. Its an obvious part of our culture and, considering that American spending drives world growth (at least until now), our spending is obviously excessive (given most definitions of “excessive”). Why is this the case? I propose it is because the deepest American insecurity is that related to the size of your bank account. Money is our deepest pathology, capable of destroying seemingly stronger institutions like friendship and family: All your friends are suddenly rich, but you’re not: What if you can’t buy them a gift as expensive as one they could get you? What would that say about you? (It would say you’re a loser.) Can you still hang out with them? Or, you’re suddenly divorced; what if you can’t spend as much as your ex-spouse on your children at Christmas? What would that say about you as a father? (Loser again.) You hang out with a bunch of stoners in dead-end jobs. Suddenly you’re gainfully employed. What does this say about you? (You’re a winner with loser friends.) Can you still smoke with them?

This psychology is not unique to America, obviously, but the excessive spending is, and the two are clearly related. Christmas is one of those times, like the dinner-with-friends or bridal shower, when one must, of necessity, reveal some information about one’s bank account, and most people would prefer not to be entirely truthful. Luckily, credit has largely made that possible.

Not this year! This year, we get the opposite: instead of everyone worrying that their gift counterparties are richer than they are, this time everyone knows everyone else is broke. So instead of mutual status-anxiety-assured spending, we’ll get mutual restraint. And let’s just watch the retail carnage unfold!

Merry Christmas and a happy Dark Comedy Hour New Year to you all!

This is just priceless. I saw these delightful Marsh (NYSE:MMC) ads in the New York subway. I don’t think we’ll see this type of pitch for a while. From the release:

Marsh Flips View of Risk “Upside” Down
With Bold New Branding Campaign

NEW YORK, April 30, 2007 – Marsh Inc., the world’s leading risk and insurance services firm, today announced the launch of the most ambitious branding campaign in the firm’s 136-year history by encouraging businesses to focus on another side of risk – the “upside.” The campaign, created by the New York office of Ogilvy, seeks to disrupt the traditional view of risk as a liability to be avoided by asking the reader to also consider finding opportunities in risk.

The integrated branding effort includes print, out-of-home, direct mail, event marketing and online components. The central element of the campaign is the print component, which focuses on specific areas like climate change regulations, supply chain disruptions and expansion into China, then outlines the risk-reward paradigm. Immediately intriguing, the ads question the “risk is negative” belief and literally turn the concept of risk on its head.

Out of home ads employ a similarly unique approach by taking traditionally positive words and exchanging them with the word “risk.” These ads feature phrases such as “Risk Upon a Star” and “To Risk Perchance to Dream.”

The messages are designed to encourage risk managers and other senior-level business leaders to break with historic norms and look at risk differently. Rather than being solely something to guard against, Marsh believes managing risk smartly can give proactive companies a competitive advantage in their marketplace.