For troubled sleep

The question for the evening: What if the freezing up of credit is a market response to an anticipated and ugly recession, and Bernanke is seeing it through the lens of his Great Depression research, and applying the wrong medicine? Modern financial institutions are global in ownership, clientele, and employees, so it is preposterous to think that they show loyalty just because they recieve a fat check from the country where their stock happens to be listed. It is certainly true that a bailout would have helped the national financial institutions in the great depression, but isn't it naive to expect international institutions to deploy their capital in a shrinking economy when there is greater opportunity elsewhere in the world?

If we are heading into a three year recession followed by a period of inflation, the DJIA will try to find its way to around nine or ten thousand. So today's move would have happened over the next few weeks, even if the bailout legislation had passed overwhelmingly -- and if the bailout passes on wednesday or thursday, then the Dow will probably go up by a few hundred, but won't get back the full move.

Why expect banks to increase their lines of credit to overstretched consumers, when the two main sources of consumer wealth -- real estate and stocks -- are down twenty and thirty per cent? Even if the banks are recapitalized by the bailout, they may well decide that it makes more sense to focus on customers in developing and expanding economies rather than mature and contracting ones.

Problems with the new bailout plan

Paulson originally wanted to stabilize markets by participating in them. This plan destabilizes markets by creating a whole set of separate and complicated markets.

What's the quick answer?

(a) Full authority for Paulson, but he needs to have more on the line. I like the idea of military rank and military justice. See if he is willing to face a firing squad if he is convicted of malfeasance. If he were, it would show that he is willing to put something on the line, and it would show the markets that he is genuinely earnest about doing more than saving Goldman Sachs counterparties. At the very least he should be liable to be fined his entire net worth. Bringing Buffett on board might stabilize the markets, but I doubt very much that he would be interested.

(b) Full disclosure of all banks. The current plan has a situation where a bank that goes to Paulson calls itself into question during the negotiation (before it is clear how much equity Paulson would ask for) and a bank that doesn't go to Paulson might still have bad paper on its books. So simply saying that all banks have to take immediate write-downs, but that equity infusions will be available to cover their insolvency (i.e. more like Sweden). But something that forces all banks to open their books completely.

(c) If it turns out that the credit markets are in a tailspin, allow Paulson to get involved in the short-term debt markets. If McDonald's needs to borrow short-term money, and the banks are too terrified to lend even though McDonald's is genuinely AAA, then the USG should not rely on the banks as intermediaries: it should just step up and buy the short-term commercial paper.

It reminds me of "Mister Johnson" -- each attempt at a bailout leads to a larger successive attempt. What would the next one look like if banks say, "our shareholders deeply thank you for the lifesustaining loot, but we'd really rather sit on our cash for a while, just to intellectually digest the Lehman bankruptcy, and, besides, the United States is heading for a major recession anyway, so it is a bad time to have any paper out at all"? Under the original Paulson plan, Hank could intervene in any market he wants to stabilize it (i.e., he could buy up short-term corporate paper). Under the new plan, the markets are at the mercy of their participants, and Paulson's effect on most markets is mediated by the psychology of the banks.

Strange repetition?

So every year, Americans have been spending about 700B more money than they have been making. Their reason? They felt richer than they were, because of increased housing values.

Now they are feeling poor, and thinking about paying down some of their accumulated debt. If this happens, of course, whole sectors of the economy will collapse.

But is that a bad thing? Isn't it just the natural human cycle of lean years and fat years? Could it be that Greenspan's criminally loose monetary policy extended the fat years to the point where the lean years will also be extended?

So what if credit markets are freezing because of a broader cultural change away from a service-based economy?

{ The Target commercial implies -- by the vintage car in at "the new car wash" -- that the freespending service economy of the last twenty years was an oedipally misguided act of rebellion, and that we are returning to traditional values if we send the service economy in a tailspin by focusing on simple pleasures brought about by cheap Chinese imports. The second commercial taps into the Oedipal pleasures of our fathers' generation, showing that one of the joys of poverty is to give humiliating haircuts to one's sons. }

On futher reflection

The more I think about it, the more I like Paulson's original plan -- markets are too dynamic to micromanage a government sponsored market manipulation. Every addition added to the Paulson plan increases the number of ways that markets could outsmart it and thereby decreases its chances of success.

However, I would change the clause Paulson's plan is the part where he declares that the decisions of his team would be above the Supreme Court, or any legislative or executive or judicial authority, and replace it with the stipulation that dust settles, a jury of twelve randomly selected Americans will review all actions of his team, with the right to impose any penalty they see fit -- including death by firing squad -- if they decide that he and his team have behaved in an unpatriotic way.

If Paulson really is a Patriot, and his plan is on the level, then he has nothing to worry about.

Rice and Beans for everyone!

From one perspective 700 Billion dollars is just 2K per American, but if it turns out that the world is heading into dark economic times, 700B could buy enough rice and beans to feed every person on earth, for about two years. And if shelter is an issue, it could buy everyone rice and beans for one year, with enough left over to buy a nice tent.

But let's just imagine that there is a "natural" price for real estate, and that price is basically what people can afford (as a percentage of anticipated future income, or anticipated rents). Now let's imagine that the Federal Government gets stuck with a giant portfolio, that will cost nearly a trillion dollars if real estate prices return to sane levels, but will make a profit if they stay at insane levels. Now let's imagine what kinds of strange market manipulations the government will do in order to protect that portfolio.

Like a lot of addictive personalities, Bush favors simple solutions to complex problems. His favorite solution is just to go shopping.

So America is in a deep crisis based on the fact that our economy borrows more than it makes. Consequently, lenders are less interested in lending, and consumers are less interested in consuming. All this sounds natural.

Jump-start the economy by pushing money into the hands of financial institutions in the hopes that they will keep lending Americans more money so Americans can continue to buy things that they can't afford? Why is Bush so sure that this will work? And how does it become a long-term solution to the problem of over-consumption?

Pay caps for failing banks is one of the stupidest ideas in history. First thing, those banks are in trouble because Goldman Sachs and Morgan Stanley were paying for top talent, and they were left with the dregs. The banking system is freezing up because a bunch of underpaid castrati don't have the balls to put some money on the line. Now Paulson wants to institutionalize Goldman Sachs' hegemony, by legally prohibiting those banks from participating in the marketplace for talent.

This is what a compromise looks like?

And, besides, have the senators ever heard of "trading"? It is where one party transfers something to another party. If there really is pay cap limit to participate in the bailout, look for people to establish shell companies with pay caps (but plenty of equity) that simply cycle trades to the fed.

Two boardroom tricks, which would be second nature to a Goldman CEO

1. If something is about to fail, propose an impossible solution. When others prevent the impossible solution from happening, escape blame, because you tried to fix it, and others wouldn't let you.

2. When others refuse to accept your impossible solution, accept the worst aspects of their solution. Explain that they are making a big mistake by sabotaging your solution, and that you expect their solution to fail, but that you are being driven to accept it by their lack of cooperation and trust When their solution fails, you will end up looking better.

What does it mean to accept a pay cap for all beneficiaries of the Paulson bailout? Bush and Paulson claim that the entire economy will be the beneficiary of the bailout -- so are we finally going to get a sane income tax, with everybody's income maxing out at 400K?

Capitalism in action

So what really happened? A bunch of mid-level managers -- trusting the mid-level managers at ratings agencies -- lent Lehman money, only to have it vanish.

Then their bosses said, for a few days, "hey, we can't trust the ratings agencies, so let's hold off and not lend people money for a bit".

Then the ratings agencies, as a public relations move, to prove that they had spine, lowered AIG's credit rating one notch, but that slight change in credit rating triggered unanticipated contractual obligations that would have created a self-fulfilling prophecy that would have forced AIG into bankruptcy.

At this point, nobody wanted to lend money to the two most powerful institutions in America, Goldman Sachs and Morgan Stanley -- particularly because the ratings agencies had shown themselves to be not only incompetent, but capricious (i.e., but GS and MS had unhedgable risk of a ratings agency event that might have also driven them into bankruptcy).

Since Paulson's social life is intimately bound up with Goldman, he had to find a way to save them (which is not a bad thing -- it is a very strange civilization where a twenty eight year old CFA at a ratings agency can bring down trillion dollar companies with the stroke of a pen). So he offered insurance to money market funds, basically saying that they could keep the difference between the risk premium and the par value. I have yet to see how this insurance will be priced (i.e., if you build on the eastern side of a mountain, you should have a lower premium than someone who builds on a sand bar), and whether the premiums will correlate with the risk premium determined by the market -- or whether the existence of the fund will undermine the market mechanism and get rid of the risk premium.

With Warren Buffett's bet on the new Goldman bank, it is tempting to say that Paulson and Bernake's dire financial crisis will be averted by market forces. Five days ago, it looked as though Goldman might collapse because the regular banks and money markets were unwilling to provide short-term liquidity. Now, even without a bailout, Goldman Bank will thrive as it takes business from the regular banks. "Oh, you guys are going to behave in economically irrational behavior and leave food on the table? Well doesn't capitalism dictate that economically rational parties step up to the plate?"

The real purpose behind the FNM and FRE takeovers

Is the same as Paulson's ambitious goal in buying up 700B of debt. Even if the Government buys it at "fair value",the successor administration is locked into a tight monetary policy because monetary policy will determine the profitability of the portfolios. What Paulson is primarily concerned about protecting his 500M from inflation, not protecting the financial system.

The upshot of Paulson's proposal is that, because he doesn't have a clear plan, he needs absolute authority. Wonderful.

The thing about financing the bailout with a securities transfer tax, like they have in England and other places is that, in England and other places, American financial firms devour the local lunch, for the simple reason that the securities transfer taxes create a prohibitive barrier to entry into the market place, while the marginal cost of applying electronic systems across borders is far less than the cost of developing indigenous systems.

Stay thoughts on the financial crisis

1. I liked the way Paulson handled AIG -- simply taking over a profitable company with the eventual surplus probably going to taxpayers. I liked the way Paulson handled BSC, though I think he could have been better on the backstop, particularly after JPM increased the share price from two to ten: if JPM wanted to pay more, it should have given that money to the government and not the shareholders. I was shocked by the way he handled LEH, but I still can't figure out why LEH's debt was marked at close to zero by the money market funds. I also like the way that Sweden handled its financial crisis -- taking over the banks and then selling them back a few years later for a profit. But there is a big gap between Paulson's deft handling of AIG and his new bailout plan -- it is as though dealing with AIG and LEH left Paulson shell-shocked, and now he is trying to convince people that feverish sleep-deprived plans are the perfect solution.

2. One of the reasons that Paulson carries so much weight is, of course, the invisible alpha-juice that is the result of centimillion dollar pay packages. As an organism, he is not particularly impressive -- however as an alpha, he can sure swing it around.

3. The whole crisis is not an argument against free markets, and it is not an argument for more regulation: it is proof that a hybrid economy with both regulation and free markets creates incentives to game the system. Witness, for example, GS and MS becoming bank holding companies, in order to crowd less clever people away from Paulson's giveaway trough.

4. The ultimate political fallout of this mess should restore popular American support for the estate tax. It is one thing for Paulson and a clique of thieves and schemers to get their invisible alpha-juice, but it is quite another to pass that juice down for twelve generations.

5. It's funny that everyone says that "taxpayers" are going to be handed the bailout bill. Does anybody other than those people holding ten trillion dollars of bonds really believe that we won't just inflate our way out of this mess?

6. This the first financial crisis when many of the bloviating heads are younger than I am.

7. It's a shame that McCain didn't win in 2000 and a double shame that he has early-onset Alzheimer's now. It is hard to imagine all this having happened during a McCain administration, and it would be almost sweet to watch him, slightly addled, in the sunset months of his Presidency -- rather than sweating through terrifying projections of his disintegration over the next eight years.

UPDATE: Is it really possible that Congress is going to substantially modify the plan?

Dig deep!

Everybody wants to talk about this crucial election, but while they are talking, the overlooked fact is that it is literally possible to buy votes for the candidate you like. In our political system, money pays for "walking around money" for various vote wranglers, pays for minibuses, pays for voter registration drives, pays for extra signs, pays for people to pass out early voting information in key areas, pays for refreshments at house parties, et cetera. When you donate money, you are not just giving the candidate money -- you are giving the candidate money that they will for votes. So, for all the people in non-battleground states who complain about being disenfranchised -- under our glorious system you are exactly as disenfranchised as you want to be.