Pass the Spittoon, Mortgage Meltdown Edition

I confess: I get annoyed beyond measure when I read articles like this one from Alan Zibel and J.W. Elphinstone of the Associated Press, which ran in my local paper this week. It manufactures drama where none is warranted. Here's the hook:

Just when consumers and the U.S. economy need banks to lend more freely, the mortgage industry is making it harder to borrow — even for those with good credit.

Mortgage insurers, whose backing is required for borrowers who can't afford the traditional 20 percent down payment on a home, have already flagged nearly a quarter of the nation's ZIP codes where they refuse to insure some home loans.

I'm already annoyed in three ways, and it's just two sentences in:

1. Consumers and the U.S. economy do NOT need banks to lend more freely. Banks lending too freely is what got us into the current mess.
2. The traditional 20 percent down payment for a home exists in part because mortgages are nonrecourse loans--the property is the only security the lender has in the transaction. While some reductions of that number may be appropriate, it was the abandonment of sensible lending standards that got us into the current mess.
3. The word "some" in the last sentence smuggles in quite a lot. If the meaning of "some" were made plain early in the article, we would stop reading and disregard the article as not worth our time.

We do find out what "some" means later on in the article:

In recent weeks, mortgage insurers have flagged more than 9,600 ZIP codes in at least 34 states where they won't insure certain types of home loans — those for investment properties or second homes, those with riskier adjustable-rate or interest-only mortgages, or for buyers making down payments of less than 3 percent.

"Some" home loans are now revealed to be loans that are extremely risky--loans whose pervasive use are what got us into the current mess--in areas where house prices are declining the most. So a shorter version of the article is that mortgage insurers are now not willing to insure loans that they shouldn't have been insuring earlier. That this is a good thing has completely escaped the notice of the two authors.

If This Meltdown Were a Movie

Ben Bernanke would be played by Harvey Keitel, reprising his role as Winston Wolf if we're lucky or Victor the Cleaner if we're not.

The responsibility for this financial meltdown does not rest with him. It was his predecessor, Alan Greenspan, whose stewardship of monetary policy set the stage for the debt-laced consumption rampage of the American consumer and the leverage-soaked financial carnival of mortgage lenders and investment bankers. (If you're keeping score at home, Greenspan still doesn't get it.) Based on his performance so far, I'm nominating Ben Bernanke to the All-Madden team of central bankers.

Bernanke has two broad categories of options:

1) Damned if He Doesn't

Bear Stearns just collapsed--it cannot pay its creditors. What was a liability to Bear Stearns was an asset to some other investor. That asset now has no value. If the other investor was also a financial institution, then it has fewer assets relative to its liabilities and is now less solvent. It may not be able to pay all of its creditors. And so on, all through the leveraged financial sector.

The Fed can act to prevent or mitigate this cascade. Looking at the prospect of contagion, the Fed has acted on two fronts. It has lowered short-term interest rates to prop of asset values across the economy. As discounting for risk has increased, discounting for time has decreased. The Fed has also intervened in specific episodes, directly backstopping private actors like JP Morgan who have stepped in to assume the liabilities of the likes of Bear Stearns.

Bernanke can't sit idly while large financial institutions crumble. There is a perception, if not the reality, of too much collateral damage in the process.

2) Damned if He Does

The Fed is supposed to be the economy's lender of last resort. If a solvent but illiquid bank needs short-term cash and cannot find it on the private market, the Fed should make credit available. Without this backstop, financial institutions would be less willing to take leveraged positions in support of beneficial economic activity.

But sometimes financial institutions take these leveraged positions in support of exceedingly risky activities. This is particularly true when they hold a put option to sell the activity to someone else if its value falls. Any intervention by the Fed extends that put option to would-be speculators, if not today, then certainly in the future.

You can call this Samwick's Law if you like:

If an institution is deemed too big to fail, then it is only a matter of time before it finds a way to get big and fail.

When you provide insurance against outcomes that a financial institution cannot control, you distort incentives on the activities it can control. Specifically, they take on more risk. To address the immediate problem, Bernanke invites the next one. Snotty bloggers two or five or ten years from now may be hanging the next crisis--runaway inflation, a persistent liquidity trap, even more spectacular bubbles in financial markets--around Ben's neck.

The task of finding the least worst way to do the wrong thing is a thankless one, but Bernanke is persevering admirably. Let's see what he does at 2:15 today.

Life is unfair, and so is the bailout

My commentary on the Bear Stearns bailout aired on NPR's Marketplace this evening. Here's the teaser:

The collapse of Bear Stearns prompted the Fed to once again cut interest rates. Commentator and economist Andrew Samwick says whether you call it a bailout or a rescue, all Americans have a stake in the outcome.

And here's an excerpt:

Two questions immediately come to mind: Is this fair, and should we care? The question of fairness is easier to answer -- of course it isn't fair. Bear Stearns' fall from grace was its own fault. It was the high-wire act in a leverage-soaked financial carnival.

And yet those in the corridors of power have intervened on the perpetrators' behalf. Some people call this "socialism for the rich." Even that's too generous -- under socialism, the rich would be paying higher taxes during the boom times. No, "fairness" is not a word that describes this bailout.

So life is unfair... Does that mean we should care?

Enjoy!

Samwick Media Watch

I'll be on NPR's Marketplace this evening, putting in my 1% of a share of Bear Stearns stock on the goings-on in financial markets. The theme--is this fair and why should you care?

Find your local station here.

Bair 1, Abernathy 0

We'll give FDIC Chairman Sheila Bair credit for this bit of lonely prudence in a financial sector gone mad:

"There are significant uncertainties regarding our projections, and given the challenges facing the banking industry and the likelihood of more bank failures, I believe preparedness should be our overriding concern," said Sheila C. Bair, FDIC Chairman. "Because we are anticipating more difficult times, it would be prudent to continue to build the deposit insurance fund at the pace allowed by the current rates and the remaining credits. As we build up the insurance fund, banks and thrifts should be taking steps to bolster their capital and reserves.

This was her very sensible justification of the FDIC's board's decision to keep the assessment rates charged to insured banks and savings associations unchanged for 2008. And into the fray jumps Wayne Abernathy, now the executive vice president at the American Bankers Association, who is quoted as follows:

The decision today could mean that as much as $20 billion or more of bank services will now not be available to invest in new jobs and new businesses this year, precisely when new jobs and new business investments are most needed.

So, according to this logic, it makes sense to blame the FDIC for its prudence rather than the worst offenders represented by the ABA for their recklessness for the absence of $20 billion dollars from the banking system in the near term.

It is amazing what a change of employer and address can do.

Ben Bernanke Waves a Handkerchief

As the old saying goes, when America sneezes, the rest of the world catches a cold. A second day of selloffs in overseas markets prompted the Fed to cut 75 basis point cuts in both the discount rate and the federal funds rate. From The New York Times this morning:

The Federal Reserve, responding to an international stock sell-off and the likelihood of a sharp drop in America on Tuesday morning, cut its benchmark interest rate by three-quarters of a percentage point.

The Federal Open Market Committee lowered its target for the federal funds rate on overnight loans between banks to 3.5 percent, from 4.25 percent.

In a statement, the Fed said: “The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households.”

“Moreover,” the statement continued, “incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”

In a related action, the Fed approved a 75 basis-point decrease in the discount rate, to 4 percent.

Within minutes after the announcement, trading in stock-index futures, which had been presaging a deep slide on American stock exchanges Tuesday, retraced much of their earlier declines, which had been driven by a second sour day in Asia and Europe.

The reaction of the overseas markets is what strikes me as excessive. Conditional on that, a rate reduction of some magnitude (if not 0.75 percentage points) is not much of a surprise. It should make for an interesting week in the financial markets.

More on the Florida Financing Fiasco

Some e-mail feedback on the last post reveals that David Evans and co-authors at Bloomberg Markets Magazine have been on the case for months. This is very good investigative reporting of the subprime meltdown in financial markets and the case of Florida in particular. Put these on your required reading list:

• Peddling Tainted Debt to Florida (February 2008)
• The Subprime in the Schoolhouse (January 2008)
• Unsafe Havens (October 2007)
• The Ratings Charade (July 2007)
• The Poison in Your Pension (July 2007)

I warn you--if you go into anaphylactic shock at the sight of the words "declined to comment," have your Epi-Pen ready. Our justice system should make a point of getting involved to clean up this mess.

A Surprising Place for a Run

I have from time to time had the pleasure of commenting on the reporting of Mary Williams Walsh of The New York Times, where she covers pensions, state and local governments, and some other topics. Over the holiday, I read her excellent article, written jointly with Kirk Semple, on the burden that poor investments by the state of Florida have had on local communities. The opening paragraphs:

PORT ST. LUCIE, Fla. — On Nov. 28, Marcia L. Dedert, finance director of this rapidly growing city, called the administrators of Florida’s state-run investment pool to ask whether it was still safe to park her city’s money there. She was hearing talk of urgent withdrawals by others worried about the pool’s investments in debt related to subprime mortgages.

After the pool’s manager told her the money would be all right, Ms. Dedert recalled, she deposited $135 million in bond proceeds. But less than 24 hours later, the administrators froze the pool and blocked withdrawals to halt a full-blown run.

Now the city cannot touch the money. And rest of the $371 million it has in the pool is also off-limits unless the city pays a 2 percent penalty.

Port St. Lucie is among hundreds of local governments in Florida that were drawn to the pool by its air of reliability and the promise of higher returns than banks offered. They now find themselves grappling with the consequences of having their money frozen.

Some have had to borrow money to meet day-to-day obligations. Others have had to shift money around for the time being or consider postponing long-planned projects.

For Port St. Lucie, the timing of the freeze could not have been worse. The city is trying to recreate itself as a center of the biotech industry and had just issued $155 million worth of bonds to lay roads, water pipes and sewer lines in a planned “jobs corridor,” where it hopes to house the companies it is courting from out of state.

I question why localities actually need this service from the state. Given investment amounts in the hundreds of millions, there are any number of banks and financial service companies with whom they could contract directly. People with accounts as small as 0.1% of Port St. Lucie's account get treated very well by financial service companies. Why tie up your money with a state fund that thinks it's doing you a favor instead of going to the professionals who would actively compete for your business?

Money Talks

Apparently, some folks in Ireland are dismayed by how much money hedge funds have made with short positions in their nation's stock market:

A HIGHLY secretive coterie of London and New York-based hedge funds has made hundreds of millions in profits from driving down Irish share prices.

Last week, Anglo Irish Bank boss, David Drumm, criticised hedge funds which were shorting Anglo shares, adding that it had been hugely damaging to the bank, which has shed almost half its value since June.

For the first time, the Sunday Independent can reveal the identities of the principal hedge funds targeting the Irish market.

We should take a moment to be clear about what's happening here and how grownups settle these sorts of disputes. The hedge funds made profits not because they drove down Irish share prices. They made profits because they sold Irish shares, ... and then the prices of those shares went down. The hedge funds cannot make the shares go down and stay down simply by betting that they will--other traders need to agree with them.

If Mr. Drumm has a different opinion about the appropriate price of his bank's stock, then he should be thanking the hedge funds for offering him a cheap opportunity to buy it back.

Citigroup, Yeah, Right

It's been quiet of late on the pension front, as the parade of stupid ideas for how to further erode workers' retirement security seemed to be over. Interrupting the silence are the events in this recent article by Jonathan Peterson of the Los Angeles Times with the inviting title, "Pensions May Be Outsourced." It begins as follows:

WASHINGTON -- Would you feel comfortable if your company sold off your pension plan to a big bank?

This month, Citigroup Inc. got the green light from the Federal Reserve for an unusual deal to take over the $400-million retirement plan of a British newspaper company.

In exchange for getting its hands on all that cash, Citigroup will run the pension plan -- investing the money, paying the benefits and taking on the liability previously borne by Thomson Regional Newspapers. And it's eyeing similar moves stateside.

Let's not mince words here. There is no upside for the workers and retirees. Federal regulators should put a stop to this immediately. If Citigroup (yes, this one) can convince the plan sponsor that it can provide financial management services in the most efficient manner, then the plan sponsor should be allowed to employ Citigroup for its investment management. However, the plan sponsor must still be the entity that guarantees the pension payments to the plan participants. The plan participants should always have recourse to the plan sponsor. That should not be outsourced.

Read the whole article. If you are like me, you will roll your eyes, possibly to the point of permanent damage, when you get to this part:

Ari Jacobs, head of the Retirement Benefits Advisory Group at Citigroup in New York, said American employers seemed "very interested in opportunities to reduce or eliminate the risks associated with their pension plans." He added: "We in the U.S. are looking at a similar model" as the British deal."

A lot of these companies -- including some that are our clients -- are asking, 'What are our alternatives now that we've frozen the pension plan?'" said Scott Macey, senior vice president and director of government affairs for Aon Consulting.

Until now, the alternatives have been to pay off workers with cash or to buy annuities from insurance companies, which then continue to pay the benefits.

But now, financial companies such as Citigroup say they could do the job more cheaply than insurance companies -- and with greater expertise at managing risk. Insurance companies, for example, face costly state-by-state regulation that pushes up the price of annuities.

"As a financial institution, we believe we're better at managing financial risk than anybody else," Citigroup's Jacobs said. "That's our core business."

(Yes, that Jacobs fellow seems to be talking about the risk management virtues of this Citigroup.) If the plan is frozen, then the plan sponsor can simply prefund the present value of expected payouts with purchases of government bonds and eliminate interest rate risk by duration matching the bonds to the expected payouts. That's all that needs to be done if what is being done is purely in the interests of the plan participants, and any number of financial services or insurance companies could be contracted to do it.

The reason plan sponsors perceive there to be risk is that they feel like they should be using the pension fund to invest in stocks, so that they can claim the risk premium in the present value calculations of their obligations and prefund them with less money today. That sleight of hand is what generates almost all of the problems in pension regulation.

And where there are investors looking to get something for nothing, there will be investment firms willing to give them nothing for something. Normally, I'd say they are a perfect match for each other, except that in this instance, they are playing with the pensions of workers and retirees.

The Wisconsin Naming Partnership

This is a brilliant idea:

Alumni Give $85 Million to Name Wisconsin School of Business
The Wisconsin School of Business at the University of Wisconsin-Madison has received an unprecedented gift totaling $85 million from a small group of alumni who have formed the “Wisconsin Naming Partnership” to support the school’s mission.

This innovative partnership provides a naming gift that will preserve the Wisconsin name for at least 20 years. During that time, the school will not be named for a single donor or entity. This unprecedented naming partnership will uphold tradition and greatly enhance the value of the school to students, the campus and the state.

The Wisconsin naming gift is the first of its kind received by a U.S. business school. Conventional business school naming gifts adopt the name of a single donor in perpetuity. By preserving the Wisconsin name for 20 years, this gift leaves open the option of future naming gifts.

UW-Madison Chancellor John D. Wiley calls the gift “a creative act of philanthropy and a major milestone for our university.”

Why would a school want to keep open the opportunity to name itself? The answer seems to be that the price tags for naming business schools are going up faster than just about anything, including the returns to university-managed endowments. Perhaps this is because naming schools is the province of the ultra-rich, who get where they are because they can build wealth faster than conventionally managed funds. So if the school sells the name today and invests the money, it gives up the opportunity to sell the name for a higher current value later on. Wisconsin's solution is to rent the name for 20 years. It allows the school to use a large gift today, without foreclosing the possibility of a much larger naming gift in the future. To really determine how much value it adds, we would have to make assumptions about what the giving behavior of the members of the partnership would have been over that period in the absence of this gift (with or without a conventional naming gift).


The Milwaukee Journal Sentinel reports on it here, including a list of other large gifts to business schools in past years.

What Is Falling?

The dollar, that's for sure. Even with the Loonie. A new low against the Euro. Paul Krugman asks if this is the Wile E. Coyote moment. I have a general view about what happens to the economies of large countries.

In almost all cases, the sky is not falling. Prices adjust so that it hangs lower and grayer.

Expect the dollar to decline until the U.S. current account imbalances shrink substantially. Expect some of this decline to happen as major exporting countries become less willing to organize themselves around holding dollars in exchange for their goods. Expect these countries to diversify their new investments and some of their existing ones, but not to dump their dollar holdings. No other country's short-term economic interests are served by devaluing its own asset holdings, and no exporting country's long-term economic interests are served by inviting a nationalistic, political response from the U.S.

Own-to-Rent on the Marketplace Morning Report

Economics correspondent Chris Farrell got the main points of the Own-to-Rent proposal across yesterday on Marketplace Morning Repot and added a bit of his own spice. From the transcript:

You know, the idea is out there. See there's a real problem with bailouts and let's just use the word bailout loosely all right? You don't want to reward speculators and you don't want to reward lenders. You really want them to suffer, you want that pain. They deserve to go to the seventh circle of hell anyway right? Now, but you do want to protect the homeowner that was misled. The benefit of this idea is that it's the most targeted idea I've seen that helps out that person, doesn't throw them out on the street, doesn't force them to go through foreclosure, and at the same time forces the lenders and the speculators to take a financial hit.

And I would add--the proposal does not force the taxpayer, whether directly through a government bailout or indirectly through greater involvement of Fannie Mae or Freddie Mac, to take a financial hit. This is what most makes it appealing to me, of all the different proposed interventions I have seen.

Save the Homeowners, Not the Hedge Funds

From today's Providence Journal, Dean Baker grants my request to co-sign his proposal to help struggling homeowners rather than bailing out hedge funds. Here's our co-authored op-ed:

THE MORTGAGE-MARKET meltdown has gotten big enough that even Congress is taking notice. Members of Congress, especially those running for president, are now racing to propose bills that promise relief to the millions of homeowners who can’t pay their mortgages.

They are right to act. In the run-up to this crisis, there was precious little counsel to families at the margin of homeownership that it could be better economically to not take on the commitment of ownership. There was aggressive marketing of deceptively worded mortgages that were virtually certain to reset to payments that these families could not afford. And the government has for years been abetting this process, pointing to ever-increasing rates of homeownership as a policy success and pushing for the low short-term interest rates that fostered the bubble in prices and the increase in leverage that precipitated the crisis.

In light of this history, it is important that policy be focused on assisting financially strapped homeowners, not lenders that issued deceptive mortgages or investors who foolishly speculated in mortgage-backed debt.

Some of the proposals currently on the table, for example, getting Fannie Mae and Freddie Mac more involved in the subprime- and jumbo-mortgage market, will do more to help the speculators than the homeowners. After all, if private investors are not prepared to hold this debt, why should these government-backed agencies jump in and buy risky mortgages at above-market prices?

There is a simple way to allow troubled homeowners to stay in their homes without also bailing out the mortgage issuers and speculators.

Congress can pass legislation granting current homeowners the right to stay in their homes as long as they like, simply by paying the fair-market rent. In other words, no one gets tossed out on the street, as long as they can pay the rental value of their house. The fair rent would be determined by an independent appraiser — exactly the same way that a lender is supposed to determine the size of a mortgage that can be issued on a home.

Under this plan, homeowners would turn over their property to the mortgage holder. This would generally not be a loss since borrowers currently face crises precisely because they owe more than the value of their house. If the value of the home exceeded their debt, then they wouldn’t have to sign up for the program.

As a renter with secure tenure, the former homeowner would have incentive to do necessary maintenance and keep the home from falling into disrepair. This would prevent the blight that is already hitting neighborhoods where foreclosures have become commonplace.

The mortgage holder would get possession of the house, but they would be stuck having the former homeowner as a tenant. Otherwise the mortgage holder is free to hold or sell the property as they choose. Being stuck with a renter may reduce the resale value of the house, but intelligent investors knew there was risk when they got into the business.

To limit the size of the program and to ensure that it only benefits those who are really in need, there can be a cap placed on the value of homes that qualify. For example, Congress could stipulate that only homes with a market value below the median price for an area are eligible for this plan.

This security-of-housing proposal meets the needs of the homeowners who were victimized by deceptive lending practices and pro-homeownership ideologues. It gives them the right to stay in their home as long as they want. It accomplishes this task in a way that provides minimal opportunities for fraud and should require very little by way of new government bureaucracy.

It also manages to benefit homeowners in crisis without also rescuing the financial institutions that were speculating in mortgages gone bad. This will give the presidential candidates, and other members of Congress, a clear choice between helping distressed homeowners or bailing out financial institutions that should have known better.

More on Own to Rent

Jim Pethokoukis picks up on Dean Baker's proposal in the current U.S. News & World Report. He quotes a phone conversation we had as follows:

Andrew Samwick, former chief economist for Bush's Council of Economic Advisers, admits his first instinct is that the government should do nothing. Yet he admits feeling more than a "pang of sympathy" for people who were misled when taking out subprime mortgages. So if the government does take action, he would prefer a plan like Baker's that "leaves as small a footprint as possible" over one that creates billion-dollar bailout funds or sweeping changes to Fannie Mae and Freddie Mac. Even Andrew Mellon might have approved.

This answers some of the thoughtful comments on the last post. In particular, if the government is going to intervene in some way, I want it done in such as way that it assists borrowers, not lenders. Baker's proposal in fact helps borrowers at the expense of lenders and does not create or expand the government (or government-sponsored) bureaucracy by much. My views of what happened in the floating rate mortgage market are very much influenced by advertising come-ons like this one that I blogged about last year. So I was persuaded fairly easily that some government-mediated remedy might be appropriate.

In the comments on the last post, ed asks a very good question:

Why should we give advantages to foolish buyers not enjoyed by prudent renters?

... or prudent buyers who locked in a higher (but still low) fixed-rate mortgages, ... or prudent buyers who chose a home that they would be able to afford when the ARM reset? These questions will arise any time that the government intervenes on distributional grounds. If these are your concerns, then you will join me in looking for the government intervention on the smallest possible footprint. This is not a policy that I think of as permanent, and it is certainly one that should only be invoked when there is evidence of systemic fraud or abuse.

The comments also point out that the problems of implementation and equity with Baker's proposal rise with the length of the guaranteed tenancy. That's a key parameter to be decided through the public policy process if the proposal moves forward.

Own to Rent

Here are some more details from Dean Baker on how his proposal to ease the burden on subprime borrowers would work.

If the government is going to intervene in the aftermath of this meltdown, I haven't seen a better proposal than this one.

Say No to Bailouts

Paul Krugman tells us to "Say No to Bailouts" in his column today, and he's largely right:

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts.

I don't see the market failure, but I don't disagree with the last paragraph if that assertion is removed. We had financial innovation that lowered the upfront costs of financing real estate transactions and raised the costs in the event of default. That we are now "in the event of default" and seeing the higher transaction costs does not mean we have a market failure. That, by itself, does not warrant the government involvement.

However, in addition to the shift on financing arrangements, we had fraud at various points in this process, and determining the financial penalties in those instances would likely have to be worked out over years in protacted legal battles. Congress can pass legislation to substitute for those battles. I haven't seen a better idea than Dean Baker's, which I discussed in the last post.

The consequence of passing it is that it gives the borrower the upper hand in the workout negotiations--the borrower can stay and pay rent as a substitute for the mortgage, and the holder of the mortgage can hold or sell the property (without evicting the tenant) in light of that. I presume that most dispositions will be in either of two forms. Some borrowers will realize that they really cannot afford the house and find a more affordable one, without being evicted unless they also cannot pay rent. In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender. This avoids the need for the government to get actively involved in the terms of the workouts, placing the cost of disposing the property on the lending community where it belongs.

And what of the Wall Street entities that have taken a financial beating as the bottom dropped out of this market? They get to be the roadkill on the capitalist highway, food for scavengers in the financial market. You wouldn't know it from the headlines dominating the news media today, but there are plenty of financial institutions that have been prudent and maintained their liquidity though this chaos. They are going to get some bargains in the months to come.

Extreme Risk in Financial Markets

Via Tanta at Calculated Risk, here's a post by Dean Baker that I would co-sign if I could. The teaser:

The whining from Wall Street is growing louder. Those brilliant high-flying hedge fund managers are now facing the prospect of financial ruin. It seems that they are holding hundreds of billions of dollars of mortgage debt, some of which is worthless, and much of which is worth considerably less than it was a few weeks ago. Since the hedge funds are heavily leveraged (they borrowed heavily to buy assets), many of them could be wiped out.

Given the gravity of the situation, the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.

Specifically, they want the Federal Reserve Board to bail them out with lower interest rates. They hope that this will buy them the time needed to dump their mortgages on less well-informed investors.

The hedge fund folks say that this is the Fed’s job, that it must step in as the lender of last resort and restore order to the market. That ain’t necessarily so.

He's diagnosed this exactly right and proposes a novel idea at the end of his post about how to protect some of the mortgage borrowers who may lose their homes. Read the whole thing.

Keeping with the theme of betraying conservatism, I should point out that government bailouts of risky or stupid businesses are right near the top of the list. I thought St. Louis Federal Reserve Bank President Bill Poole had it right in his speech last month. A key excerpt:

The Federal Reserve had followed developments in housing and the non-prime mortgage markets very closely this year (Bernanke, 2007a, 2007b, 2007c). A highly visible development is the growing amount of financial stress among some of the millions of households with non-prime mortgages. We know that many non-prime mortgage lenders and brokers have gone out of business or tightened their lending standards this year, reducing the flow of mortgage credit to borrowers unable to access the prime market. Financial markets have dealt harshly, but on the whole appropriately, with banks, hedge funds and certain other investors who were heavily exposed to the riskiest segments of the non-prime securitized mortgage market.

While none of these developments is pleasant for the lenders and financial firms most directly affected, one cannot help being impressed with the even-handedness of it all. Until we receive clear evidence that basically sound financial decisions and arrangements were disrupted by erratic and irrational market forces, I believe we should conclude that this year’s markets punished mostly bad actors and/or poor lending practices. Lenders who made loans to borrowers without documentation, or who did not check borrower documents that proved fraudulent, or who made adjustable-rate loans to borrowers who could not hope to service the debt when rates adjusted up, deserved financial failure. As is often the case, the market’s punishment of unsound financial arrangements has been swift, harsh and without prejudice. While I cannot feel sorry for the lenders who have gone out of business, my attitude is entirely different toward the relatively unsophisticated, but honest, borrowers who have lost their homes through foreclosure. Many are true victims.

Read the whole thing.

In Praise of Kenneth Griffin

Earlier this week, we read that the three top hedge fund managers--James Simons, Kenneth Griffin, and Edward Lampert--each earned more than a billion dollars in compensation last year. In his column today, Paul Krugman has this to say:

Consider a head-to-head comparison. We know what John D. Rockefeller, the richest man in Gilded Age America, made in 1894, because in 1895 he had to pay income taxes. (The next year, the Supreme Court declared the income tax unconstitutional.) His return declared an income of $1.25 million, almost 7,000 times the average per capita income in the United States at the time.

But that makes him a mere piker by modern standards. Last year, according to Institutional Investor’s Alpha magazine, James Simons, a hedge fund manager, took home $1.7 billion, more than 38,000 times the average income. Two other hedge fund managers also made more than $1 billion, and the top 25 combined made $14 billion.

How much is $14 billion? It’s more than it would cost to provide health care for a year to eight million children — the number of children in America who, unlike children in any other advanced country, don’t have health insurance.

The hedge fund billionaires are simply extreme examples of a much bigger phenomenon: every available measure of income concentration shows that we’ve gone back to levels of inequality not seen since the 1920s.

For reasons that will be clear below, I'll focus on the case of Ken Griffin, who earned $1.4 billion. This makes him (1.4/1.7)*(38000/7000) = 4.5 times as high-income relative to the typical person as J.D. Rockefeller according to Krugman's metric. Krugman's use of the term "mere piker" suggests that he thinks these hedge fund managers are even worse in some way than Rockefeller.

Let's continue the comparison. Consider that Rockefeller's Standard Oil had the advantage of being a near-monopoly. Griffin has no such luxury--he's in one of the most fiercely competitive industries you will ever find. He makes his money not by shrinking from competition but by surpassing it. According to some estimates, his firm, Citadel Investments, is responsible for over 3 percent of the average daily trading volume in New York, London, and Tokyo. It takes a very unusual person to build a business that can do that.

I know whereof I speak. I was an acquaintance of Ken's both in high school and in college. He attended a rival high school in the same county, and we competed in math tournaments. He and I entered Harvard the same year, both majored in Economics, and both graduated in three years. But let me not suggest to you that we were similar in too many ways. Most significantly, while I was busy with my studies and my interest in economics inside the classroom, Ken was pursuing his interests in economics outside the classroom. I didn't see him on campus more than a handful of times. This profile gives a good description of his background, how he got his start in finance, and his business strategy.

What emerges is someone who is intensely intelligent--in the sense of being able to integrate knowledge from disparate sources to solve a specific problem--and extremely independent-minded--it's his way or the highway, at least at Citadel. He builds the financial capacity to pick up the pieces where others fail--whether Amaranth or Enron--at a bargain price. He doesn't pull his punches--I don't think anyone who offers the "toxic convert" is shy about being a financial intermediary. He's also not trying to win the "Boss of the Year" award. But these are details. To sum him up in three words, he is successful because he is confident, contrarian, and accurate.

I spend a lot of time around college students. I spend a lot of my energy trying to get them to display those three characteristics. Krugman seems to think that one "Kenneth Griffin" is overvalued at 4.5 "John D. Rockefellers." On the contrary, I think it's a buy.

Investment Advice for Presidential Candidates

The latest New York Times headline about Barack Obama's financial investments has the candidate claiming that they did not present a conflict of interest. From what I can tell, there is no ethical problem here. The problem is that Senator Obama should have a better stockbroker. Or, better yet, he should have no stockbroker.

If I were seeking or holding political office, I would not put my financial assets in a blind trust. I would never want to put myself in a position of having to claim, as Obama is now doing, "At no point did I know what stocks were held. And at no point did I direct how those stocks were invested." This is terrible language for a candidate to have to say. It combines the phrasing of a legal technicality with the shifting of blame to an employee. The speculative investments also present the candidate as taking advantage of opportunities that are not available to ordinary folks. This is not the image that a candidate wants to present.

Compare that with a candidate who does not establish a blind trust--no abdication of responsibility, no suggestion that someone else is working in secrecy on his or her behalf. With no blind trust, the candidate shouldn't hold individual stocks, to avoid any suggestion of favoritism. Instead, the candidate can put all stock investments in a low-cost, broadly based index fund, like this one. Now, the candidate is setting an example that all American savers can follow. The candidate is also not playing favorites among companies. He or she does well when every company listed on a major exchange does well.

That's a much better strategy, particularly since the get-rich-quick element of politics can always come later, on the lecture circuit or the book tour.