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Tuesday, March 31, 2009

Geithner vs. Krugman

The implosion of the private credit system--the product of inadequate regulation and easy money--has blown a huge whole in our monetary system. That damage has been done is no news; what is remarkable is the scale of the massive bailout, which includes funds issued by the Federal Reserve, which borrows on Treasuries issued it on behalf of the government.

Everyone agrees something needs to be done. In crafting a workable solution, two opposing camps have formed, one with Nobel-prize winning economist Paul Krugman, and Obama and Geithner on the other.

Geithner and New York Times columnist Paul Krugman entered into a war of words last week. Krugman is calling Geithner's plan "cash for trash." In the New York Times Monday, Krugman quoted an article by Simon Johnson in The Atlantic magazine:

...elite business interests--financiers, in the case of the U.S. --played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed..."

Krugman writes that Johnson sees "America's current difficulties as 'shockingly reminiscent' of crisis in places like Russia and Argentina--including the key role played by crony capitalism."

Krugman and Johnson could have been repeating what I've been saying on this very blog weeks before the mainstream regurgitated this "news" that the crisis and its solution have been tainted by corporate influence over the political and regulatory processes. I even brought up Michael Hudson's article, "The Oligarch's Escape Plan," which outlines similarities between the Russian oligarchs and the way the bailout was being handled.

Some would say the banking industry is, and was, still being represented by the Federal Reserve in the person of ex-Fed governor of New York, Geithner. Can we trust our gut, common sense, and what Krugman says? Or do we believe Geithner--who was and is part of the same system that directly contributed to the crisis?

On TV, the case Geithner makes for the bailout is logical, and sounds like it might work. Yes, adding more capital allows the financial entities to lend more. But will consumers spend? Our economy depends on ongoing borrowing by consumers--Americans are saving instead. Can increased government spending replace consumption that's declined?

While Geithner's plan may be credible on an intellectual level, my gut tells me he can't be trusted. Apparently most Americans agree with me. Over 50% believe the bailout should end, which indicates political momentum is against Geithner's proposition, that the Treasury needs to buy up the so-called toxic assets, or begin a public-private partnership to liquidate the securities. Obama has wrapped a lot of political capital up in the bailout.

Why are people like Geithner so worried? The answer to this question comes in the under-publicized truth that the banks are under-capitalized--having been allowed to double down on their reserves, in what would have been impossible had banking laws and regulations not been tampered with. Subsequent to lending themselves and each other too much, they then bundled financial products into derivatives, swaps, futures, and other overly complicated, hard- or impossible-to-value debt instrument which of course provided huge short-term profits.

Making these assets toxic is the fact many of these securities have Credit Default Swaps--a type of insurance against default--attached to them. Should the value of these debt securities crash, the CDSs will kick in, and incur huge payments on the issuer of the CDSs, who happen to be the same banks and financial companies whose balance sheets positions have deteriorated.

As the financial entities issuing CDSs are all interdependent, should CDS issued by one company not be payable, all CDSs could quickly become worthless.

We can't summarily write off the CDSs, as they're part of a contract. Or can we? Congress did end up taxing AIG retention bonuses, so maybe CDSs can simply be retroactively annulled. Then the markets could discount the underlying security as if the CDS weren't there. Better to take the damage upfront.

Geithner does seem to realize the need to allow the market for these securities to function with a minimum of intervention. At least Geithner is wise enough to know that the market is a far better source for evaluating the worth of the securities than any government agency. He's wise to let private sector professionals determine what constitutes fair value. So why doesn't he just leave the sector alone?

Well, as I said above, the banks are exposed to double jeopardy on paying the CDS attached to the Collateralized Debt Obligations and other debt. They owe each other vast sums and once one bank defaults, they all could. Should a ripple effect begin it's possible all the cherished big names on Wall Street might actually owe more than they can pay. Already derivatives holdings and obligations far exceed the depositor base--JPMorganChase has some $90 trillion or so.

If a collapse were to occur, would banks simply raid depositors' accounts, causing a run on the FDIC? As I said in my last post, libertarians view the FDIC bank guarantees as a moral hazard that encourages risk-taking.

CDSs have discouraged many of the debt securities from being sold. Why buy something for 80 cents on the value if the CDSs kick in at 70 cents? The only reason buyers would pay more for a CDS-insured debt security is if they think the insuring company--often the same as the one issuing the security--can cover the cost of default.

Government buying up of the CDS-insured debt, at above-market prices, shows a lack of confidence in the ability of the issuers of the CDS to pay in the event of default on the underlying security.

Now Geithner is trapped between letting free markets set prices and setting the prices itself. The worth of these securities can't be determined very well under contrived circumstances, where government guarantees and loss stopping prop up prices.

No one in the private sector wants to make a mistake or take losses when the government will subsidize the losses to some degree should they be incurred. The intent of the bailout to subsidize losses on behalf of private banks encourages gaming the system, by selling the worst debt to the government or through a market it supports.

Successful government intervention will require ongoing interventions as a self-fulfilling prophecy for as long as the government is actively participating. No government involvement in pricing can be good over the longer term: it's like setting bread prices in a communist bakery; they might be good for consumers, but no one wants to supply the wheat at such low prices so the shelves go empty.

Constant meddling hinders free market activity, reducing prices as the result of a massive injection of risk, which accompanies any market subject to political control.

Whatever excess profits might have been lost to regulatory burdens that could have been imposed but weren't far exceed the tens of trillions in home and stock equity losses. Hard-core market fundamentalists like Larry Kudlow have to eat their own words as the bailout costs incur huge deficits that must be remedies by higher taxes, or inflation, sooner or later. Worse, Kudlow and others who view regulatory burdens as an impediment now have to depend on the political consensus in Washington to keep the bailout, and prospects for a recovery alive.

In my opinion, the financial system is simply too unstable right now to support a recovery. Until we can stabilize our dollar and our federal spending, we can't expect a sustained recovery. And as I've said, until we tackle the inherent instabilities in our monetary system--like the creation of private credit and derivatives--we can't restore our financial system which is the backbone of our economy in the post-industrial age.

I'd reiterate that the bailout intends to re-inflate the debt bubble. The banks and Federal Reserve are clearly the main players in this effort. Not only did they issue the most toxic debt, they also are on the hook for Credit Default Swaps if borrowers default on the underlying securities.

Last fall's hurried rush to flow so much money to the banks and companies like AIG demonstrates how fearful top officials were by the prospect of system-wide defaults. It bears mentioning that subprime mortgages only compromise 2% of Mortgage Backed Securities. Larger by many multiples are risk obligations on the Collateralized Debt Obligations and other forms of derivatives unrelated to subprime.

So the bailout isn't really about bad mortgages, it's about preventing the banking system from collapsing as a consequence of its greed. The CDOs and CDSs brought in huge profits for people like former Treasury Secretary Paulson, who made over $300 million while heading Goldman Sachs, a major recipient of bailout funds.

Managing perception

Hitler said that the big lie was more easily sold to the public than the little lie. The big lie is clearly the idea that it will be worse for us all if we don't submit to the administration and its call for bailout funds.

There's an entire perception management effort afoot. By controlling what Americans hear about regulatory breakdowns, the easier it is to convince the American people about necessity of the bailout, how it's administered, and its size.

Over-selling the plan diminishes its credibility, so I hope Geithner has been working on smoother delivery of his message. Geithner's delicate treatment of perception shows how the credit crisis is also a crisis of confidence. However, the more effort is expended to create confidence in the system, the more circumspect it becomes.

It's important not to let the American people see what really happened. It's possible that the spigots of federal money creation expended to re-inflate the bubble could still be turned off, which would mean that Federal Reserve would have to go it alone. Already, they've issued billions in debt based on unprecedented backstopping of toxic debt.

By instigating the crisis through easy money policies and a lack of regulatory oversight, the federal government is now compelled to mask its role in failing to reign in the banks. So complicit our government has been that it was actually sued by former Governor of New York Elliott Spitzer for failing to control shady behavior by mortgage lenders.

Who knows how effective the government will be in covering up the regulatory failure and easy money policies that precipitated the crisis. One key factor in holding people responsible is Americans' willingness to stay informed and participate politically. Many are apathetic, believing neither party represents their interests.

Skepticism doesn't justify disengagement from the political process, it should precipitate greater involvement. Thomas Jefferson said eternal vigilance is the price of liberty.

The disconnect between the cause of the regulatory failure and the clean-up also exploits American's very limited understanding of finance. If Americans knew that the dismantling of Glass Steagall directly led to the crisis we're experiencing today, they'd be outraged at their representatives, and reject the two-party political status quo entirely. It was Democrats that helped pass the Financial Modernization Act in 1999 that gutted Glass Steagall. These key changes in regulations and the law came as the direct result of the banking industry's lobbying efforts.

The elite are surely gambling on Americans never learning enough about the origins of the crisis to do anything about it. As long as Americans are fundamentally ignorant as to the causes of the economic crisis, they're easy prey to any insider actions that attempt to compensate private sector investors for their losses in risky derivatives. Unless Americans catch on to the need to rebuild a regulatory framework, abuses of the monetary system by the Federal Reserve and its member banks will continue.

According to plan?

Some conspiracists have gone so far as to suggest that the dumbing down of America is attributable to an pre-planned agenda by the uberclass Bilderberger/Trilateral Commission elite bent on making the "sheople" easier to manage, less able to understand the failures that led to the problems of their making. Once conditioned not to think or question authority, we're susceptible to a repeat, another abuse of the public trust and draining of public coffers.

Whether or not an evil organization is bent on world domination, we Americans are dumbed down in economic matters and thereby allow those in charge to design a solution that benefits the elite at the expense of the general public. We trust blindly, out of ignorance.

A theory that accompanies the dumbing down one is often that of financial exploitation: turn the people into peasants, then bilk them for all they have. Yet in the most recent financial crisis, we see the beggar-thy-neighbior policies typical of capitalism-on-steroids have really been used in competition between rich people for each other' money, as the Madoff case demonstrates.

Yet the investor class can't tolerate so much exploitation of the system, even if that system invariably leaves them better off. Short of a steady regulatory climate, no structure is stable enough to allow the systematic looting of the new peasantry, although I guess emptying the Treasury is the next best thing. Plundering public resources for the benefit of the wealthy class could continue until the dumbed down can somehow summon up the wits to wake up from their slumber and confront the investor class, pitchforks in hand, ready to storm the castle gates, or the mansions on the Upper East Side as in Gangs of New York.

The fact remains that the uber-capitalists who gamed the system are now reaping huge rewards for investing in a class of debt securities that the for-profit banking industry created, or their losses are being limited by government intervention.

Getting my bailout

If we've dumbed down, I guess it's time to capitalize on the ignorance of the masses.

Hey well if the banking industry can get away with it, why not me? Well, unfortunately for the Detroit auto industry, controlling the flow of government bailout expenditures is no easy task, even if you are a vital-for-national-security industry like automobiles, one that hardly as expendable as banking, which appears to be little more than shoving piles of money around. Now making steel and making cars, that was real work back in the day America was a real man's country.

In keeping with this exploitation theme (isn't this what unrestricted free-market capitalism ends up being about, how to get yours?) I came across a good post in businessinsider.com, "Five ways to scam the bailout". One commentator, Mark Meyers, had this to say about the bailout plan:

It's an elegant stock manipulation engine. First my hedge fund buys ten million shares of Citigroup at $2.50. Then I go in with the government on a hundred million in toxic assets, risking 3 million of my own money and paying whatever I have to pay. I assume other hedge funds are thinking along the lines I am and so are also buying this stuff. As the toxic assets are removed from Citi's balance sheet, the stock price inevitably goes up. I sell my ten million shares at $3, covering 100% of my potential loss on the toxic assets and pocketing 2 million in additional profit. If the toxic assets appreciate, I split the profit with the government. If they don't, it's not my problem. And Geithner is happy, because he and I have started to re-inflate the bubble. Through market manipulation, we've once again created value where there isn't any. On Monday, when Geithner announced the plan, Citi gained 41%, so it's already working. Of course, it won't be long before we're bailing out the FDIC.

Not so sure how good the bet on Citigroup stock will be long-term, but maybe the kind of people who benefit from bailout activities are only in it for the quick money.

Lower down the post, a comment by brian also offers a more technical explanation of how CDOs (Collateralized Debt Obligations) are bundled and sold which you may want to see.

I admit to my own perplexity at the complexity of the derivatives market and how much I learn from posts like brian's, coming well after the point I thought I knew how they worked. Despite my lack of knowledge about derivatives, I do know enough about how they work to recognize their dangers. If anything, all the surprises that I get in my protracted derivatives learning experience should send red flags up.

Credit Default Swaps and other Structured Investment Vehicles compromise a large portion of the systemic risk remaining. Mortgage foreclosures are a serious problem indeed, with ripple effects, but their problem is largely in how to value them once they're bundled and resold.

When an issuer of Mortgage-Backed Security bundles mortgages which are then sold, the connection between the debt security and its collateral are greatly distanced. By bundling and re-selling mortgage-backed securities, the banks have managed to disconnect assets from their debt security. A single MBS tranch could contain a thousand houses.

By piling on tranches of debt, at different levels of risk, the value of the underlying mortgage is obscured. Yes, the tranch system does allow for classification of risk, as brian explains in his post. But the process of securitizing the debt, and mixing mortgages into a single security is inherently unstable.

The market for that kind of debt was created under the false presumption that Credit Default Swaps, a type of insurance--or insurance fraud depending on your view of how collectable they truly are--, could cover the consequences of a default or, worse, systemic collapse throughout the credit markets.

* * *

As much as we'd like to vilify Geithner, or even Obama, I've argued that it's not so much the individuals responsible but more the political system, which supports corporate patronage. At its core is a re-election scheme that repeats the injustice of cash exchanged for influence. Winning politicians bestow regulatory and legal changes that reward corporate benefactors that contributed to their campaigns.

There is however a price to pay. The more that the political system intrudes into the economy, the more subjected to the ebb and flow of political control our economy becomes.

The more the Federal Government spends, the more vulnerable our overall economy becomes. Government spending always creates inefficiency in the private sector, as the Federal trough makes for far easier slurping than making money the old fashioned way. If more and more Americans get their incomes from the government, it's inevitable that there will be more taxes, or that the currency will simply be over-produced, causing monetary inflation. Tax burdens are already at record levels, surely they can't go up any more.

Government spending has an Achilles Heel: it fosters dependency on federal spending among the recipients, which include corporations receiving contract revenue, citizens employed by government, and direct beneficiaries. The increased spending and aura of entitlement it spawns reflect political pressure on incumbents to keep the money train flowing.

Military spending exemplifies governmental inefficiency. Now if the US were to suddenly cut off war spending, an amount of over $400 million PER DAY, JUST FOR IRAQ, we'd see the recipients of that military spending experience an overdue contraction. Now if you're think that money we spend on our military is spent efficiently, consider that over 40% of the Pentagon's budget flows to private contractors.

In economics, eventually the consequence of an imbalance will have an effect somewhere else, disrupting or redirecting supply and demand. Ultimately the war spending sends cash to companies that are less efficient than those that must compete in the private sector. Government contracts become a crutch--crucial in keeping employment from dropping even more.

Now in Keynesian terms, the government should be spending more in down times. But Keynes also stated that government should be saving, or lowering debt, in good times. Well, unless the period from about 1999 on can be considered bad times, we have a Republican-led Congress and Presidency responsible for the largest expansion of Federal Spending ever. Their constant prattling about lower taxes flies in the face of their track record on government expansion.

Not only did we not retire debt during the good times, Clinton plundered from Social Security, though he did manage to avoid creating the warfare state that our present economy seems dependent upon.

Government deficit financing requires constant search for more and more investment capital. Foreigners have long filled this need, but the appetite for cash is simply too large to fill. The Fed's reckless lending of Treasuries for trash has hardly made this problem easier.

People tend to flock to the safest debt during times of great uncertainty. These are US Treasuries, which the Fed has in abundance. Unfortunately, the more unstable the overall market for debt, the more attractive Treasuries become, and the more are bought, creating what economists call "crowding out," where lending to the government drives out lending to private sector companies, driving up their costs of borrowing.

Building a bigger trough will mean weakening our fiscal situation, and lead to less borrowing and slower growth in the private sector. And as market conditions contract with higher borrowing costs--as the recession can't be stopped through the power of Federal spending alone--tax revenues dip and even more borrowing is required.

Eventually the Federal Reserve will start spending trillions to buy up the Treasury debt simply because no other investor will. Now while this might inflate the price of Treasuries, the supply of money will actually go up...way up. This is monetary inflation, where increasing prices come not as the result of too much wages being paid to wage-earners or money being spent by consumers, but rather from too many dollars being spent by government, which enter the credit system via the Fed (see last week's article by Chang for more on the Repurchase Market which finances the Fed's activities.)

Now there has been a shadow banking system created which has expanded the de facto money supply. I heard that the amount of this money being lent and traded based on swaps, repurchase agreements, and other forms of derivatives exceeds the supply of public money. The creation of a vast private credit bubble based on debt securities has changed fundamentally the variables which economists must study when evaluating the supply of money.

It's no coincidence that financial companies constitute some 40% of our GNP. In actuality these people make nothing. Yes they do provide loans in the retail banking market, but essentially they are moving piles of money around. Through a lack of regulation, they were able to create a shadow banking system which generated vast profits for insiders.

Of course the economic consequences of this free-market capitalism have "come home to roost," to borrow the words of former Obama pastor, Rev. Jeremiah White. Private credit money evaporated, and with it our entire monetary system has been shaken to its core. Unless we gut the shadow banking system, and reinstitute Glass Steagall, we're likely to see the effects of more uber-class control over our monetary and financial system.

Judging by how far the Obama administration and Congress appear willing to go to protect the banking system from its own malfeasance, the financial companies lobbying has paid handsome dividends. The scale of the public borrowing which we've undertaken shows just how far our government is willing to go to save the banks.

Our Treasury drained, and our ability to borrow in the future greatly diminished, the long-term interest of the people are being sacrificed. Increased self-reliance could emerge as a result or we could simply see more government, acting as a surrogate employer, displacing investment and jobs typically generated within the private sector.

Ironically, in trying to save the banking system, we could be destroying the value of our money. So much excess borrowing to prop up the failed shadow banking system could make dollars too plentiful and thus cheapen their worth. While exports could rise, we have little left of our manufacturing base to exploit the comparative advantage of a weak dollar. Besides, other nations appear to be suffering from weakening currencies so American exports might not be any cheaper in those countries.

Obama may be able to straighten out the bankers, but in the end it'll be the private market--the one for investment capital--that'll shake out the bad debt and punish those who own it. Should the Federal Government intervene, or allow its fiscal authority to be undermined to support a broader intervention, the reordering of the banking system will be much slower in coming. And no, just because regulations cut some profits doesn't mean they should be discarded. This crisis proves that the costs to everyone--rich and poor alike--will likely be far higher if insiders aren't held accountable.


The lower video--Geithner's Meet the Press appearance--contains a lot more hard information than the thin soup offered by the ABC panel in the video above.

Follow-up by Arianna herself. She brings up Obama's comment on Jay Leno that Geithner had been doing a great job, just like Bush said of FEMA director "heckuva job Brownie" during Katrina. Arianna was also on CNN's Larry King Friday night.


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