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.

What happened to the calming, ancient presence of the distinguished, prudent banker–the slight wrinkle under the eye, the spectacles, the impeccable haberdashery? Was he a fraud all along? Was it the computer that intruded on his quiet world of velvet, oak, and marble–fine bound copies of banking and securities law standing behind him like pillars underpinning the national character–and filled it with wild dreams of quantitative risk management. Where are you, Dean Witter?

Nearly a month after his appointment, a major news organization has finally decided to shed some editorial light on the record of Timothy F. Geithner, President-elect Obama’s choice for Treasury secretary. The Times editorial has given voice to concerns your humble blogger has felt since the appointment was made (full disclosure: I used to work in Tim Geithner’s New York Fed as a research underling*): at a time when the market fundamentalist brain-lock that has held Washington in deregulatory mode for so long at last seemed to be slipping, here goes Doctor Change nominating a man whose primary credential seems to be his ability to ingratiate himself to Wall Street, and whose primary achievement as New York Fed President prior to the crisis seems to be not regulating the credit default swap market. When we all should have been longing for Elliot Spitzer, we got Light Touch Tim instead. Is this change we can believe in? (I couldn’t resist.)

It is difficult to fathom the workings of a mind as vast as the President-elect’s, but one could see that, at least on a person level, Geithner and Obama are a good match. Both are intellectual, laid back, stylistically “cool” like Kennedy, in that they are consensus builders capable of synthesizing large amounts of information; both are also 47 and play a mean game of basketball. They both also distinguish themselves in that they chose to fly mostly under the radar before achieving the highest office they could fathom: just as Obama did not get behind any major pieces of legislation or champion any major reforms in his time in the US Senate, nor publish a single piece of legal scholarship during nearly 12 years as a law professor, likewise Mr. Geithner was fairly invisible to most of the public during his the crucial crisis management episodes of the past year, despite being one of three top players, and prior to that was lauded for his ability to work behind the scenes. Despite being a criticism, this understatedness in Obama has revealed itself to be a mark of a pragmatic, non-ideological, and very deep thinker, unwilling to compromise good analysis for quick action or a facile sound bite. In Mr. Geithner, we don’t yet know what the coolness will reveal itself to really be–intellectual integrity, consummate consensus decisionmaking, or simply an ability to ingratiate himself to people (your blogger notes that his first job was for Henry Kissinger, which adds to his pedigree, but one hopes that masterful peddler of self-flattery didn’t see something of himself in his boyish hire).  We don’t know, but we can guess!

Let’s focus on the credit default swap episode referenced above. The first third of the article praises Geithner’s non-Spitzer qualitites, with Robert Rubin pointing out his elbow-less-ness and a former Lehman executive praising his ability to get people to work together. The second third of the article witnesses Geithner identifying the potentially catastrophic implications of the size of the credit default swap market (“twice the size of the US economy”), and reminds readers of Geithner’s responsibility to ensure prudent risk management practices are being followed on Wall Street. The last third of the article features Geithner using that light touch, convening a working group of major Wall Street banks and, to paraphrase the article, gently goading them to fix their own problems. In the last few paragraphs, the crisis has been averted, and the financial industry is gleeful at Mr. Geithner’s gentle shepherd approach.

What did Geithner miss in his review of the credit-default swap market? For one, that market was instrumental in the collapse of AIG, so Geithner surely missed something (unless his gentle prodding of Wall Street executives can be considered sounding the alarm). Credit default swaps are financial contracts that are traded over-the-counter (meaning there’s no centralized exchange to set the price for all contracts like there are for stocks, rather, contracts are written and traded, essentially, person to person); this raises issues of counterparty transparency–who owes what to whom, especially if the contracts are being traded rapidly (which Geithner addressed at the time). The contracts usually work something like this: say GM has issued debt, $1000 of which I hold; understandably, I’m afraid GM won’t pay me back. In response, I go to my friend, who we’ll call Jim, and I say, Jim, I’ll pay you $5 a month if, in the event that GM says they can’t pay me back (default), you pay me whatever I lost from that (in reality, either $1000 minus whatever GM is able to pay me back, or Jim gives me $1000 and I give him my bad debt contracts, but let’s just call it $1000). Jim, being an idiot, agrees. In other words, credit-default swaps are insurance contracts for bond holders.

Now let’s imagine another world in which Jim is much smarter. Jim sells me the credit-default swap (Jim would be the seller in the above example), so he gets the $5 a month, but he knows GM will default and he’ll be on the hook for (nearly) $1000, so, after some time passes, smart Jim goes to his friend, dumb Bob, and says, hey dumb Bob, I’ll pay you $4 a month if, in the event GM defaults, you pay me $1000. Smart Jim is now in the clear: he’ll get paid $5 a month from me and pay $4 a month to Bob, pocketing $1 risk-free, and if GM goes down, he’ll be paid $1000 by Bob, which he’ll give to me, and all will be well (though one does worry that dumb Bob, despite his dumbness, might be doing the same thing and, though I’m not good with numbers, that gives me an uneasy feeling. Where, for example, is he going to get that $1000 from? (I hear he owes money all over town.))

As NPR’s always-masterful reporting makes clear, I was right to worry about dumb Bob. What Geithner seems to miss was that the credit default swap market was being used for speculative purposes, not just for insurance–too many smart Jim’s and dumb Bob’s fleecing average me. Like dumb Bob, many were using the market to gamble on the solvency of companies–i.e. they didn’t actually own any debt–and were borrowing to do it. NPR talked to traders, yielding a plainly disconcerting picture, especially given the magnitudes involved ($26 trillion, according to the Times). Geithner was responsible for asking himself, what if GM goes down? Where does that leave dumb Bob? To his credit, he does seem aware of the problem, questioning whether a market designed to add stability to the financial system will indeed do so in times of distress, but a simple survey of traders, or a quick question to the working group, might have yielded questions about dumb Bob, and perhaps about his friends sanguine Sally and risky Rhonda too: In other words, if a default does occur, how do you keep the losses from multiplying? Say dumb Bob doesn’t have $1000 and GM goes bust. He owes Jim $1000, and Jim owes me $1000. Etc.

What does this episode tell us about what type of Treasury Secretary Tim Geithner will be? Well, for one thing, he’ll be a learning Treasury Secretary, as Geithner did seize an opportunity to correct his mistake in the credit-default swap episode (albeit in June of this year), establishing a centralized exchange for the contracts so everyone will know the state of Bob and Jim and Sally. What else can we infer/guess? Consider the approach Geithner took: convening a working group, agreeing on common problems, and then encouraging the banks to fix the problems themselves. I see this as the Geithner MO–avoid confrontation or any appearance of giving censure at all costs. Usually a good MO. But what about his regulatory responsibility? Are the changes that need to be imposed on the financial system going to be achieved by consensus with the major stakeholders in the current system? Why didn’t he push for a centralized exchange in 2005? Were the Wall Street bankers afraid that people like me wouldn’t want to buy credit protection from people like dumb Bob (dumb Bob is a senior investment banker) if I couldn’t know about Risky Rhonda? Were they all too able to convince someone with no investment banking experience or academic credentials directly related to the field that their way was best?

Hard questions. More important than anything in such an improvisational period is the question of style. I propose that one overarching cause of the current financial turmoil was temperament. When one thinks of the ancient act of lending, choosing who amongst the desultory crowd is likely to see a project through to profitability, I imagine the most prudent individuals, exacting, cold people willing to look at a person and say, “What kind of person are you?” and to judge the answer with full knowledge of the folly of man. I don’t imagine the culture of Wall Street, such as it was before the fall. Deal-making is for the prudent, not the over-exuberant. So what does it say that Geithner was so well liked on Wall Street? That they praised him in the same tones they reserve for themselves–bright, intelligent, detached?

The stakes are high for Mr. Geithner; your blogger’s first impulse, shouted at his computer screen, was that Geithner’s appointment would instantly preclude the type of overhaul the financial system really needs, an overhaul that would start with the realization that finance is a public utility (Martin Wolf of the FT has written extensively espousing this point of view). There are contrary signs that Geithner is thinking bigger. As he wrote in June 2008, “At present the Fed has broad responsibility for financial stability not matched by direct authority and the consequences of the actions we have taken in this crisis make it more important that we close that gap”. Sounds a bit more Spitzerish.

It also sounds like his considerable intellect is developing it’s own point of view on regulation. One is reassured that, after a year and a half in the eye of the storm, the type of weekly macroeconomic classes Geithner ordered for himself at the Fed won’t be required at the Treasury. For now we await his first move, and meditate on whether the President-elect served himself well in choosing someone so much like himself, or, more to the point, one so much like the hedge fund managers and money-managers who helped him get elected.

*Note to readers: though your blogger did enjoy some in-person exposure to Tim Geithner while at the Fed, my posts obviously reflect no inside knowledge, except that I’m still bitter they weren’t able to turn the heat up in the winter.

As workers across the country resort to 60′s style protest tactics to get their due, one wonders if the revolution of 1968 might have just been delayed by 40 years of exceptional monetary policy, political distractions, Republican tax give-aways, and Bill Clinton. No doubt, the fabled alliance of students and workers dreamed of so poignantly by Daniel Cohn-Bendit and his followers on the barricades of Paris has finally been realized in the person and movement of President-elect Obama; the revolution shall follow and all we squares need wonder is how we’ll fit in. I’m buying my Che T-shirts now before the movie release drives up their prices, but before we get there, I humbly offer my contribution to the zeitgeist (contrarily, all unauthorized reproductions or performances of the following song shall be prosecuted with zeal and relish).

Where have all the dollars gone?

Where have all the dollars gone?
Long time passing
Where have all the dollars gone?
Long time ago
Where have all the dollars gone?
Borrowers spent them, every one
When will they ever learn?
When will they ever learn?

Where have all the borrowers gone?
Long time passing
Where have all the borrowers gone?
Long time ago
Where have all the borrowers gone?
They’ve gone bankrupt, every one
When will they ever learn?
When will they ever learn?

Where have all the bankrupt gone?
Long time passing
Where have all the bankrupt gone?
Long time ago
Where have all the bankrupt gone?
Gone to see the grown-ups in Washington
When will they ever learn?
When will they ever learn?

Where have all the grown-ups gone?
Long time passing
Where have all the grown-ups gone?
Long time ago
Where have all the grown-ups gone?
You won’t find them in Washington
When will they ever learn?
When will they ever learn?

Where have all the bankrupt gone?
Long time passing
Where have all the bankrupt gone?
Long time ago
Where have all the bankrupt gone?
Covered with dollars, everyone
When will they ever learn?
When will they ever learn?

What caused the financial crisis? I’m sure you’re dying to know and, as a consummate financial industry insider, I can tell you. Perhaps the most puzzling aspect of it all is: how can a bunch of chicanery by traders on Wall Street lead to real wealth destruction. The answer:
Plasma screen televisions. Everybody wanted one; they borrowed on their homes, they forewent more reasonable mortgages in order to afford them, and then purchased large houses and renovated dens to surround them. All the mortgage paper was sold to crazy bankers, who themselves were reassured by high definition plasma screen images of hot blonde financial journalists in small dresses purring of mortgage-backed bliss. Then, as plasma screen televisions everywhere hypnotized millions with images of highly detailed bare flesh, mezmerizing ads for juicers, sweating athletes, and explosions, people bought guns, exercise equipment, juicers, and lap dances. No one paid the banker. So where did all the money go? Look no further than all the plasm screen televisions. Them and iPods.
So how do we solve it? Figure out a way to turn iPods and plasma screen televisions back into money, and give it to bankers.
In other words, this thing doesn’t end.