financialfeudalism

If only Eliot Spitzer could have kept it in his pants. One of the most eloquent explanations of what transpired.

2009-07-14T17:52:00.000-07:00

Joseph Stiglitz with a cogent analysis!

2009-01-26T15:50:00.000-08:00

Commentary: How to rescue the bank bailout
STORY HIGHLIGHTS
Joseph E. Stiglitz: The bank bailout has failed to restart prudent lending by banks
Stiglitz says banks made reckless loans and were burned as a result
Stiglitz: They borrowed so much money that they couldn't handle a downturn
Economist says it's time to consider government takeovers of weaker banks
Next Article in Politics »

By Joseph E. Stiglitz
Special to CNN

Editor's note: Joseph E. Stiglitz, professor at Columbia University, was awarded the Nobel Memorial Prize in Economic Sciences in 2001 for his work on the economics of information. Stiglitz was chairman of the Council of Economic Advisers during the Clinton administration before joining the World Bank as chief economist.

Economist Joseph E. Stiglitz says the strategy followed by the architects of the bank bailout was flawed.

(CNN) -- America's recession is moving into its second year, with the situation only worsening.

The hope that President Obama will be able to get us out of the mess is tempered by the reality that throwing hundreds of billions of dollars at the banks has failed to restore them to health, or even to resuscitate the flow of lending.

Every day brings further evidence that the losses are greater than had been expected and more and more money will be required.

The question is at last being raised: Perhaps the entire strategy is flawed? Perhaps what is needed is a fundamental rethinking. The Paulson-Bernanke-Geithner strategy was based on the realization that maintaining the flow of credit was essential for the economy. But it was also based on a failure to grasp some of the fundamental changes in our financial sector since the Great Depression, and even in the last two decades.

For a while, there was hope that simply lowering interest rates enough, flooding the economy with money, would suffice; but three quarters of a century ago, Keynes explained why, in a downturn such as this, monetary policy is likely to be ineffective. It is like pushing on a string.

Then there was the hope that if the government stood ready to help the banks with enough money -- and enough was a lot -- confidence would be restored, and with the restoration of confidence, asset prices would increase and lending would be restored.

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Remarkably, Bush administration Treasury Secretary Henry Paulson and company simply didn't understand that the banks had made bad loans and engaged in reckless gambling. There had been a bubble, and the bubble had broken. No amount of talking would change these realities.

It soon became clear that just saying that we were ready to spend the money would not suffice. We actually had to get it into the banks. The question was how. At first, the architects of the bailout argued (with complete and utter confidence) that the best way to do this was buying the toxic assets (those in the financial market didn't like the pejorative term, so they used the term "troubled assets") -- the assets that no one in the private sector would touch with a 10-foot pole.

It should have been obvious that this could not be done in a quick way; it took a few weeks for this crushing reality to dawn on them. Besides, there was a fundamental problem: how to value the assets. And if we valued them correctly, it was clear that there would still be a big hole in banks' balance sheets, impeding their ability to lend.

Then came the idea of equity injection, without strings, so that as we poured money into the banks, they poured out money, to their executives in the form of bonuses, to their shareholders in the form of dividends.

Some of what they had left over they used to buy other banks -- to pursue strategic goals for which they could not have found private finance. The last thing in their mind was to restart lending.

The underlying problem is simple: Even in the heyday of finance, there was a huge gap between private rewards and social returns. The bank managers have taken home huge paychecks, even though, over the past five years, the net profits of many of the banks have (in total) been negative.

And the social returns have even been less -- the financial sector is supposed to allocate capital and manage risk, and it did neither well. Our economy is paying the price for these failures -- to the tune of hundreds of billions of dollars.

But this ever-present problem has now grown worse. In effect, the American taxpayers are the major provider of finance to the banks. In some cases, the value of our equity injection, guarantees, and other forms of assistance dwarf the value of the "private" sector's equity contribution; yet we have no voice in how the banks are run.

This helps us understand the reason why banks have not started to lend again. Put yourself in the position of a bank manager, trying to get through this mess. At this juncture, in spite of the massive government cash injections, he sees his equity dwindling. The banks -- who prided themselves on being risk managers -- finally, and a little too late -- seem to have recognized the risk that they have taken on in the past five years.

Leverage, or borrowing, gives big returns when things are going well, but when things turn sour, it is a recipe for disaster. It was not unusual for investment banks to "leverage" themselves by borrowing amounts equal to 25 or 30 times their equity.

At "just" 25 to 1 leverage, a 4 percent fall in the price of assets wipes out a bank's net worth -- and we have seen far more precipitous falls in asset prices. Putting another $20 billion in a bank with $2 trillion of assets will be wiped out with just a 1 percent fall in asset prices. What's the point?

It seems that some of our government officials have finally gotten around to doing some of this elementary arithmetic. So they have come up with another strategy: We'll "insure" the banks, i.e., take the downside risk off of them.

The problem is similar to that confronting the original "cash for trash" initiative: How do we determine the right price for the insurance? And almost surely, if we charge the right price, these institutions are bankrupt. They will need massive equity injections and insurance.

There is a slight variant version of this, much like the original Paulson proposal: Buy the bad assets, but this time, not on a one by one basis, but in large bundles. Again, the problem is -- how do we value the bundles of toxic waste we take off the banks? The suspicion is that the banks have a simple answer: Don't worry about the details. Just give us a big wad of cash.

This variant adds another twist of the kind of financial alchemy that got the country into the mess. Somehow, there is a notion that by moving the assets around, putting the bad assets in an aggregator bank run by the government, things will get better.

Is the rationale that the government is better at disposing of garbage, while the private sector is better at making loans? The record of our financial system in assessing credit worthiness -- evidenced not just by this bailout, but by the repeated bailouts over the past 25 years -- provides little convincing evidence.

But even were we to do all this -- with uncertain risks to our future national debt -- there is still no assurance of a resumption of lending. For the reality is we are in a recession, and risks are high in a recession. Having been burned once, many bankers are staying away from the fire.

Besides, many of the problems that afflict the financial sector are more pervasive. General Motors and GE both got into the finance business, and both showed that banks had no monopoly on bad risk management.

Many a bank may decide that the better strategy is a conservative one: Hoard one's cash, wait until things settle down, hope that you are among the few surviving banks and then start lending. Of course, if all the banks reason so, the recession will be longer and deeper than it otherwise would be.

What's the alternative? Sweden (and several other countries) have shown that there is an alternative -- the government takes over those banks that cannot assemble enough capital through private sources to survive without government assistance.

It is standard practice to shut down banks failing to meet basic requirements on capital, but we almost certainly have been too gentle in enforcing these requirements. (There has been too little transparency in this and every other aspect of government intervention in the financial system.)

To be sure, shareholders and bondholders will lose out, but their gains under the current regime come at the expense of taxpayers. In the good years, they were rewarded for their risk taking. Ownership cannot be a one-sided bet.

Of course, most of the employees will remain, and even much of the management. What then is the difference? The difference is that now, the incentives of the banks can be aligned better with those of the country. And it is in the national interest that prudent lending be restarted.

There are several other marked advantages. One of the problems today is that the banks potentially owe large amounts to each other (through complicated derivatives). With government owning many of the banks, sorting through those obligations ("netting them out," in the jargon) will be far easier.

Inevitably, American taxpayers are going to pick up much of the tab for the banks' failures. The question facing us is, to what extent do we participate in the upside return?

Eventually, America's economy will recover. Eventually, our financial sector will be functioning -- and profitable -- once again, though hopefully, it will focus its attention more on doing what it is supposed to do. When things turn around, we can once again privatize the now-failed banks, and the returns we get can help write down the massive increase in the national debt that has been brought upon us by our financial markets.

We are moving in unchartered waters. No one can be sure what will work. But long-standing economic principles can help guide us. Incentives matter. The long-run fiscal position of the U.S. matters. And it is important to restart prudent lending as fast as possible.

Most of the ways currently being discussed for squaring this circle fail to do so. There is an alternative. We should begin to consider it.

The opinions expressed in this commentary are solely those of Joseph E. Stiglitz.

www.cnn.com/2009/POLITICS/01/26/stiglitz.finance.crisis/index.html

Concentration of Wealth and The Great Depression, as recounted by Marriner S. Eccles, FDR's Fed Chairman 1934-1948.

2008-12-05T09:34:00.000-08:00

Inequality of wealth and income
Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from November 1934 to February 1948, detailed what he believed caused the Depression in his memoirs, Beckoning Frontiers (New York, Alfred A. Knopf, 1951)[26]:
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. [Emphasis in original.]
Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers' loans, and foreign debt. The stimulation to spend by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
This then, was my reading of what brought on the depression.

Congratulations to President Elect Obama

2008-11-08T18:10:00.000-08:00

President Elect Obama,

I am delighted that you have been elected president of our country. This is the greatest example of tolerance and belief in fairness that I have personally witnessed in America. We all must be overjoyed that the majority of white people in America were able to put their own prejudices aside and elect a black man as President. There are billions of non-white people in the world, and this has given all hope for the future. I would just like to say that our troubles are many. Specifically, you are clearly the candidate who understood the gravity of the economic distress the majority of Americans are suffering from. So I hope and pray that you will approach the rebuilding of America with caution and humility, as you have promised. As someone who will definitely be paying more taxes, I say that I don't mind. BUT!!!!!!!!!!!!!!! I don't want my money going to the oligarchs on Wall Street. Please send my money to people who are suffering and need jobs, food, shelter or health care. Please don't destroy the dollar by massive inflation/debasement. If you need to default on our debt, please do it sooner rather than later so that we may recover. Regarding health care, I believe that all should have access to health care. BUT!!!!! We as a country must really look at where the majority of the costs really are. If anybody is interested in my opinion (truth) let me know.

P.S. Volcker for Secretary of Treasury (NO CLINTONITES/RUBINOMICS BUBBLE HEADS)

A sad but utterly predictable first move. Beginning of the End of Dollar Hegemony!

2008-10-19T12:05:00.000-07:00

ECB's Nowotny Sees Global `Tri-Polar' Currency System Evolving
By Jonathan Tirone

Oct. 19 (Bloomberg) -- European Central Bank council member Ewald Nowotny said a ``tri-polar'' global currency system is developing between Asia, Europe and the U.S. and that he's skeptical the U.S. dollar's centrality can be revived.

``What I see is a system where we have more centers of gravity'' Nowotny said today in an interview with Austrian state broadcaster ORF-TV. ``I see for the future a tri-polar development, and I don't think that there will be fixed exchange rates between these poles.''

The leaders of the U.S., France and the European Commission will ask other world leaders to join in a series of summits on the global financial crisis beginning in the U.S. soon after the Nov. 4 presidential election, President George W. Bush, French President Nicolas Sarkozy and European Commission President Jose Barroso said in a joint statement yesterday.

Nowotny said he was ``skeptical'' when asked whether the Bretton Woods System of monetary policy, set up after World War II and revised in 1971, could be revived to aid global currency stability. The U.S. meeting should aim to strengthen financial regulation, define bank capital ratios and review the role of debt-rating agencies.

European leaders have pressed to convene an emergency meeting of the world's richest nations, known as the Group of Eight, joined by others such as India and China, to overhaul the world's financial regulatory systems. The meetings are to include developed economies as well as developing nations.

`Real Economy'

Bush, 62, has cautioned that any revamping must not restrict the flow of trade and investment or set a path toward protectionism. The G8 nations are Britain, Canada, France, Germany, Italy, Japan, Russia and the United States. The U.S. hasn't committed itself to the sweeping terms of Europe's agenda, White House press secretary Dana Perino said yesterday.

Sarkozy wants the G8 to consider re-anchoring their currencies, the hallmark of the 1944 Bretton Woods agreement that also gave birth to the International Monetary Fund and World Bank.

The current financial crisis, in which European governments have pledged at least 1.3 trillion euros ($1.7 trillion) to guarantee loans and take stakes in lenders, should be ``under control'' by mid-2009, Nowotny said. The economy will suffer longer.

``What comes then, unfortunately in parallel, will be the problems for the real economy,'' Nowotny said. ``The growth rate in 2009 will be significantly below what we have in 2008.''

He predicted gross domestic product growth around 1 percent in Austria next year.

To contact the reporters on this story: Jonathan Tirone in Vienna at jtirone@bloomberg.net

www.bloomberg.com/apps/news?pid=20601087&sid=apjqJKKQvfDc&refer=home

Wall Street Loves to play Brinkmanship!

2008-10-04T18:23:00.001-07:00

Congressman Brad Sherman from California gives a chilling account of how Paulson warned of martial law if the bailout wasn't passed. You can deduce his argument rather easily. "We need money to get credit flowing because the banks will fail. And if the banks fail, there will be massive unemployment which will lead to civil unrest. We will have to call in the army and impose martial law and perhaps even have a dictatorship. Now you wouldn't want that on your tenure????? So give us $700 billion or else!!!!!!!! Also Senator Cantwell from Washington stating her opposition to the TARP.

Wall Street Journal Op Ed by Nobel Prize Winner Edmund S. Phelps

2008-09-30T19:25:00.000-07:00

We Need to Recapitalize the Banks
Let's have cash infusions in return for warrants.

By EDMUND S. PHELPS

When the speculative fever finally broke in America's housing industry and house prices began falling in search of equilibrium levels, banks everywhere suffered defaults and subsequent losses on a range of assets. In short order, the housing contraction morphed into a banking crisis.

David Gothard
Among most economists, it came as a surprise that the banking industry and, indeed, most of the financial sector, was so devoted to houses. We had not realized that the investment and innovation in the country's business sector was largely getting by on rich uncles, a tiny cottage industry of venture capitalists out West, and a few private-equity funds doing alternative energy. And we didn't foresee that a trillion or two of losses in an economy with $40 trillion of financial wealth could bring high anxiety and, two weeks ago, near panic.

The banks' losses might seem poetic justice after their abominable performance. But costly feedback effects on the rest of us are in prospect. Uncertainty over the quantity and valuation of banks' "toxic assets" has meant that many cannot count on loans from each other to meet daily needs, and this illiquidity in the markets has impaired their ability to lend. Among banks that had excessively leveraged their capital through borrowing and other devices, the losses wiped out much or all of their capital, and this near-insolvency has dampened their willingness to lend.

The resulting credit contraction is starting to crimp working capital and investment outlay at small businesses and is having wider effects on business activity through its impact on interest rates, exchange rates and consumer loans. This feedback is causing a fall of employment on top of the direct effect of the housing contraction on employment in construction and finance. The added fall in jobs will in turn add to mortgage defaults.

Will this chain reaction produce a deep slump, like Japan's in the 1990s or, worse, America's in the 1930s? In my view, the claim by Keynesians that the economy can be stabilized around a satisfactory employment level, thanks to economic science, is false. So is the claim by latter-day neoclassicals that such stability is automatic, thanks to the market. Both dogmas fatally miss the point that the normal activity level is driven by structural shifts, which monetary policy and price-level changes usefully accommodate but cannot reverse. The end of the speculative fever and the credit crunch each have structural effects on the real prices of business assets, real wages, employment and unemployment. As I see it, the former has pushed up the normal, or "natural," volume of structural unemployment. The latter (and the excess houses) is pushing the economy into a temporary slump. It will last as long as required for the banks' self-healing and government therapy to pull us out of it and into the neighborhood of our new, postboom normalcy.

I believe that leaving the process of recovery entirely to the healing powers of the banking industry, as libertarians suggest, would be imprudent, even if the banks could manage it. Lacking much government intervention, Japan's recovery took a decade. Sweden's recovery, with state intervention, took hardly any time at all.

Right now our banking industry is barely operational. Whatever the corrective surgery indicated, the priority is to get the system operating again. Delay would be costly and risky.

The most discussed of the proposed programs would address banks' toxic assets by authorizing the Treasury to buy them, issuing debt to finance the purchase. Proponents of this program add that the government's eventual sale of the assets purchased might repay the investment with a profit -- grossing, say, an 8% rate of return while paying 4% interest.

House Republicans and some economists object, saying that the government could attain its goal with a bigger or surer profit by selling the banks "default insurance" on their distressed assets: the premiums paid are hoped to far exceed the default costs. To me, government entry into the default insurance business is little different from government purchasing the assets. It is not clear to me that selling default insurance would be more profitable.

House Democrats want a parallel program that would help defaulting mortgage borrowers to avoid foreclosure -- to help them "stay in their homes." Such a step might set an undesirable precedent in economic policy. If, after investing in my vocational training, I cannot make it in the line of work I chose -- not at the real wage that the market has since established, at any rate -- will I be entitled to help from the government to "stay in my work"? Furthermore, many defaulters are housing speculators not families caught up in an adjustable rate mortgage they did not understand. Finally, the overinvestment in houses does not present the systemic risk of economic breakdown that the overextension of credit does.

However, the program to revive the operation of the banks through purchase of the toxic assets faces a sticky wicket. If the government sets the prices too low, the banks will supply little of their assets; they will prefer to hold them to maturity in order to get the price appreciation for themselves. The Treasury will then need to raise the terms. But that may cause the banks to hold off longer, speculating on still better terms ahead.

If, instead, the Treasury sets its prices too high, its funds will go far enough to buy only a portion of the toxic assets offered in response. Thus, it is not certain that such a program would work to clean out the toxic assets at all quickly. Subnormal operation of the banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It cannot be counted on to increase the equity capital of the banks -- to shore up their solvency. Underpaying for the toxic assets would actually inflict a further loss of capital. Overpaying the banks for their toxic assets could contribute capital, but that may not be politically feasible or attractive.

So it is clear that the main prong of any "rescue" plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

But these steps toward making the system operational again will leave it dysfunctional. We don't want to restore the system as it was. And the risk that the industry would cause another round of wreckage is not the only reason.

What has occurred is not just an old-fashioned banking crisis but also a banking scandal. Most of the big banks were shot through with short-termism, deceptive practices and self-dealing. We must institute basic changes in corporate governance and in management practice to restore responsibility and honesty for the sake of the economy and for the self-respect of the country.

We also need to return investment banking to its roots. There is more to the influence of the financial sector than merely its effects when it goes off the rails. The financial system is not a sort of circulatory system that passively carries fresh saving to the places in the economic body that demand the greatest investing -- as if guided by some "invisible hand." Judgment and vision -- of bankers, fund managers, angel investors and the rest -- matter hugely. So do the distortions, the limits and the license created by the regulatory system and the moral climate. To prosper and advance, the American business sector is going to need a financial system oriented toward business, not "home ownership."

Mr. Phelps, the winner of the 2006 Nobel Prize in economics, directs the Center on Capitalism and Society at Columbia University.

online.wsj.com/article/SB122282719885793047.html

Some Words of Wisdom From Soros

2008-09-30T19:17:00.000-07:00

Recapitalise the banking system
By George Soros
Published: October 1 2008 02:05 | Last updated: October 1 2008 02:05
The emergency legislation currently before Congress was ill-conceived - or more accurately, not conceived at all. As Congress tried to improve what Treasury originally requested, an amalgam plan has emerged that consists of Treasury’s original Troubled Asset Relief Programme (Tarp) and a quite different capital infusion programme in which the government invests and stabilises weakened banks and profits from the economy’s eventual improvement. The capital infusion approach will cost tax payers less in future years, and may even make money for them.

Two weeks ago the Treasury did not have a plan ready - that is why it had to ask for total discretion in spending the money. But the general idea was to bring relief to the banking system by relieving banks of their toxic securities and parking them in a government-owned fund so that they would not be dumped on the market at distressed prices. With the value of their investments stabilised, banks would then be able to raise equity capital.

The idea was fraught with difficulties. The toxic securities in question are not homogenous and in any auction process the sellers are liable to dump the dregs on to the government fund. Moreover, the scheme addresses only one half of the underlying problem - the lack of credit availability. It does very little to enable house owners to meet their mortgage obligations and it does not address the foreclosure problem. With house prices not yet at the bottom, if the government bids up the price of mortgage backed securities, the taxpayers are liable to loose; but if the government does not pay up, the banking system does not experience much relief and cannot attract equity capital from the private sector.

A scheme so heavily favouring Wall Street over Main Street was politically unacceptable. It was tweaked by the Democrats, who hold the upper hand, so that it penalises the financial institutions that seek to take advantage of it. The Republicans did not want to be left behind and imposed a requirement that the tendered securities should be insured against loss at the expense of the tendering institution. The rescue package as it is now constituted is an amalgam of multiple approaches. There is now a real danger that the asset purchase programme will not be fully utilised because of the onerous conditions attached to it.

Different focus
‘Tarp’s adverse consequences could be mitigated by using taxpayers’ funds more effectively. If Tarp invested in preference shares with warrants attached, private investors, including me, would jump at the opportunity’

Nevertheless, a rescue package was desperately needed and, in spite of its shortcomings, it would change the course of events. As late as last Monday, September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers’ money; that is why he allowed Lehman Brothers to fail. Tarp establishes the principle that public funds are needed and if the present programme does not work, other programmes will be instituted. We will have crossed the Rubicon.

Since Tarp was ill-conceived, it is liable to arouse a negative response from America’s creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers’ funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp’s terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury’s cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.

Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.

www.ft.com/cms/s/0/d68e10cc-8f45-11dd-946c-0000779fd18c.html

What Next?

2008-09-27T13:13:00.000-07:00

I must admit that I secretly hoped that John McCain would oppose the bailout, with the Republican Congressional Insurgency giving him the opportunity to be a “Maverick’. I thought he would then call this rubbish the Bush-Obama Wall Street bailout, thus covering his greatest weakness. But alas, it’s obvious after last night’s debates that it was just wishful thinking. In fact, it was like watching American Idol with two contestants singing the same song. So this is where we are. The Congress is receiving phone calls of up to 100 to 1 against the bailout, yet they are about to sign into law perhaps the most unpopular piece of legislation in the history of our Republic. So one has to ask. What will happen after $700 Billion is engulfed by the Disappearing Deep Hole of Derivative Destruction? What will happen after the MOAB (Mother of All Bailouts)?
One has to believe that there will be a temporary increase in liquidity, which will be quickly sucked up by the system. But it has been obvious that every Fed and Treasury intervention has had more ephemeral staying power. So this intervention will help for maybe 3-6 months. Maybe. But what will happen when the sequel comes out? MOAB II, or perhaps the Son of MOAB? Don’t you think Americans will be even more pissed off? They will say, and justifiably so, you told us that this will save the system and now we’re right back to where we were a few months ago, and you are asking for another massive bailout! I am afraid that we are going down the slippery slope of ill-guided intervention. Didn’t Paulson and Bernanke say that there is no housing bubble, then they said that Subprime is contained, then they said that by nationalizing Fannie and Freddie that it puts a floor under the mess? WHAT WILL THEY SAY? There will probably be new actors, buy they will still have to read the same poorly scripted lines.
We are going down the path of self-destruction. Lenin said that there is no surer way to destroy a nation than to debase its currency. There is no surer way to debase the dollar than to continue down this misguided path. We have become so caught up in stock market and real estate losses, that we have taken our eyes of the real prize! Our greatest asset as a nation is our currency. Today, the US Dollar reigns supreme. But one has to ask how much longer will our creditors keep the credit flows open while we debase and inflate our way out of this self-inflicted greed wound. There are already grumblings of a Sino-Russian alliance, one that could put significant pressure on other nations to abolish the dollar standard. Once the dollar standard is usurped, we are TOAST!!!!!!! Expect massive tax increases, spending cuts and a drastic decrease in our standard of living. Yet, the guys on the yachts are smart. They will have diversified into other currencies, homes in other nations, and accounts in safety deposit boxes around the world. Much like the Nazi’s who bought their freedom after WWII, these criminals will save their hides. Caviar for them and feudalism for us. You’ve been warned.

SERFS UP

Full court press.

2008-09-23T10:43:00.000-07:00

Emperor Paulson is testifying in front of the Senate as I write this piece, but I have some preliminary observations. It is obvious that he is using this moment of crisis (or as the Chinese would say moment of opportunity) to push forward on his Wall Street debt reduction plan. He very well knows that neither party wants to be viewed as anti helping America so close to the elections. So he is taking away space and time from Congress, in order that they make a costly (700 billion) turnover. His argument is oddly amusing. He is saying that these "various assets and instruments" are very complicated. So complicated are they that only experts from Goldman and Morgan understand them. Thus, he needs a clean and simple plan to have a resolution. Funny guy! The next amusing area is in the logic behind this bailout. He's saying that Main Street needs to give money to Wall Street so they can turn around and lend it back to Main Street. Well if Main Steet needs the money, why don't they just keep it in the first place. The reason is simple. This is your classic bait and switch routine where we talk about house prices and complex derivatives, but in point of fact are just covering Wall Street's bad bets. I hope the Senate has the courage to stand up to Caesar, but I highly doubt it.

All Hail Emperor Paulson!

2008-09-21T18:16:00.000-07:00

While the MSM lauds his actions, Emperor Paulson is about to impose economic martial law on the citizens of America. Outside the Treasury will read the moniker "Over 1 Trillion Served" (except not by choice)! I believe it is time that we change our Pledge of Allegiance to more accurately reflect the Imperial status of Mr. Paulson:

I pledge allegiance to the flag of the United States of Hank Paulson and to the kleptrocracy for which it has become, one nation, above God, divisible, with debasement and inflation for all.

Wall Street Perestroika

2008-09-21T10:02:00.000-07:00

A Fait a Compli

Having watched the Sunday talk shows, it is obvious that the Wall Street Debt Reduction Plan is a done deal, with only minor detail to be discussed. I am not sure how to feel about it. But probably it is somewhere between bewilderment and incredulousness. Chutzpah, properly defined, is killing your parents and looking for sympathy that you have become an orphan. The one thing that this plan does not lack is chutzpah. The thieves on Wall Street have designed this plan so that they can improve their balance sheet, and in effect cover their losses on bad bets. Paulson will have absolute authority over the plan, and they will be able to buy instruments from foreign banks as well as commercial real estate paper. So the taxpayer has the added benefit of assisting his banker friends abroad and our Donald Trumps at home. This plan reminds me of another ambitious reform program. When Mikhail Gorbachev came to power, he knew that communism was not sustainable, and he believed it could be saved by a few reforms of the system, Perestroika and Glasnost (Rebuilding and Openness). The problem was that communism itself was a flawed system, and no amount of Perestroika could save it. The Soviet Union (and Russia today) had no finished product to sell abroad, and its collectivized farm system was unable to produce enough food for its population. It was completely reliant on oil exports to fund its ability to feed the masses, and when oil prices collapsed, it took out the USSR, despite all the attempts by the cronies to keep it propped up. So, as I look upon the landscape today, I see that Mr. Paulson is attempting a Wall Street Perestroika, so that the system can be saved!?!? However, one needs to ask a fundamental question, i.e. can our economic system, as currently designed, be saved? The parallels are frightening. As the USSR was dependant on oil exports to stay afloat, so to the USA is dependant on capital exports (treasuries/gse/mbs/derivatives etc…) to stay afloat. So just as a collapse of oil prices in the 80’s squeezed the USSR out of business, the last thing that the USA can tolerate is a new “price discovery’ on our capital exports. Because we are completely dependant on external powers to finance our budget and thus run our country is the reason why I believe these extraordinary measures are being undertaken. But just as Perestroika of the USSR failed because it was unsustainable, Wall Street’s Perestroika will probably fail. Adam Smith said that no country that has ever run up a large foreign debt has ever paid it back. I think that when foreigners understand that we do not have the capacity to pay back our debts, and that we are going to have to inflate our way our of our debt, they will pull the plug on the current finance agreements and in effect destroy the dollar’s standing as the world’s reserve currency. This may lead to the collapse of our whole economic system, despite Mr. Paulson’s best efforts to prop up the oligarchs.

Trickle Down Tax Cuts.

2008-09-20T18:27:00.000-07:00

It has become obvious that this ridiculousness has left the realm of economics and is now a political problem. There is no question but that the Bush tax cut, spending increases and decreased regulations, all financed by borrowing, have allowed the Wall Street oligarchs to game the system in their favor and make an inordinate amount of money (who wouldn't want to pay 15% taxes on 100 million dollar bonus?). But we are well past the point where anybody thinks that this is either right or moral. The question is, what's next? What Mr. Paulson suggests is the largest tax cut for the rich in American history. 1 Trillion dollars of debt relief for the Wall Street oligarchs, financed either by tax increases or inflation, is what is on the table for us. I cannot for the life of me understand why the Democratic candidate for the US president, Mr. Obama, is favor of this solution. The Democratic party has always been the party of the working Joe, so how can Mr. Obama support one trillion dollars of debt relief for the Morgan Stanley's of this world. He is such a big critic of trickle down economics (rightly so), yet he is in favor of trickle down debt relief. Can you just imagine that you had one trillion dollars to play around with. You could give back to Wall Street, who created this mess, or you could spend it as your wish. How many factories, roads, power plants, schools, bridges, solar farms, etc.... could you build? How many jobs could you create with a trillion dollars. How many fiscal stimuli could one inject with a trillion dollars? But Mister Paulson believes the best utilization of our fiat currency is to fortify the Wall Street Oligarchs, "so credit could flow through our system!" This is bull shit!!!!! This is a false choice that is being presented to us!!!! I implore any and all who read my little blog to contact your congressman and senator and tell him/her that you do not want your money to go to Wall Street. Do you believe that is fair that the taxes paid by the brave men and women of our armed services, who put their lives on the line for us day in and day our, be sent to people vacationing on their yachts? If there is any debt relief to be had, let it be had by regular working people who were ensorcelled into taking excessive debt by the oligarchs' sales force. I propose that people have direct debt relief by sending any kind of debt that was incurred from 2003-2006 (or so) to a DRC (Debt Reduction Corporation), and thus 1 trillion dollars of debt relief can be had by the American consumer. Thus, they will have excess capital that can be used for spending, saving or investing. Much of this can be taxed by the government, so they will have a return on investment. I am shocked that Democrats have allowed Wall Street to flim flam them into their nonsense. Please, America, let us unite in this effort to end the Wall Street Debt Reduction plan. They don't deserve it!!!

That was short lived.

2008-09-18T18:35:00.000-07:00

It obviously didn't take long for Misters Bernanke and Paulson to resume their bailout ways. I am not familiar enough with AIG to know how calamitous a Chapter 7/11 would have been, but I am sure that there could have been ways to work it out. Drexel and Lehman went belly up, and the world didn't end! Anyway, I have been thinking for a while as to what to post because I believe that at this point, the MSM has caught on to what has truly been happening vis-a-vis Wall Street, so I am not sure that I can add much, except my own little quirky commentary. As I am writing this blog entry, the government is considering the massive use of our money to buy "toxic debt" a-la RTC. I cannot even comprehend how much money all of this is going to cost, nor the consequences of such an action. It seems that at every stage of this crisis, the government has tried to throw good money after bad into some sort of damage control (does anybody remember the MLEC?). However, I cannot escape the feeling that this will not end well. The problems seem to be getting bigger and bigger, and the bailouts keep getting more and more expensive. Our government is now in the insurance, mortgage and securitization business. Barney Frank recommend that it opens up a Real Estate office with lots of new inventory. Far cry from laissez-fare. Everybody is now aware that the real culprits in this crime drama were the Wall Street oligarchs who, as financial mercenaries, have put this country on the precipice of disaster. I would like to offer one piece of advice, should anybody come across this little piece. I believe that it is absolutely necessary to prosecute the oligarchs! I know it may be extremely difficult from a political standpoint, but is so perversely injust that we will have to hand over our savings, while the oligarchs who pilfered this country's vast wealth are on their yachts. I believe that there can be great populist sentiment evoked if we prosecute and fine these criminals, as well as confiscate their wealth. This will end all moral hazard problems. If the federal reserve used special powers to assist in the take over of Bear Stearns, why can't we create a Guantanamo for Wall Street crooks (maybe we can even suspend habeas corpus). The government should have a rendition team ready to go to waterboard these guys into divulging information as to how these crimes were committed. But I digress. It need not go that far. Just take away their money in a grand public way, and use the proceeds to recapitalize the Federal Reserve, instead of printing $40 Billion new dollars.

Lehman/Merrill Day!

2008-09-14T18:38:00.000-07:00

This day will obviously be remembered in the history books, with the full ramification of these event not known for years to come. But I must say that today I am proud that Misters Bernanke and Paulson had the courage to stand up to the oligarchs. Winston Churchill once said that America always does the right thing, after it tries everything else first. I am sure it was an extremely painful decision to inflict the death blow to such a venerable institution as Lehman, but I am also sure it was the right thing to do. The sooner these leveraged, poorly run businesses get taken out, the sooner we can clean out our financial system and get back on solid ground. It's obvious that a combination of greed, leverage and fraud combined to take out some of our great financial institutions, but out of the ashes, new dynamic institutions will arise. This crisis seems far from over, so I hope that our leaders will continue to allow the market to unwind without further subsidy to insolvent institutions. The business of America is business, it is not leverage buy outs and real estate transactions. Hopefully, some of these great minds will turn away from coming up with "business models" and go to work for our struggling manufacturing sector. The sooner we realize that the fraudulent "service economy" cannot be sustained, the sooner we can regain our status. This delevereraging should also serve as a warning about our national debt. We all see how margin call can be a real bitch! We must stop spending, start saving and investing into our manufacturing sector. Green technology and energy independence with other innovations may still save us. The politicians have to stop flim-flamming us by paying for tax cuts with borrowing. We will all have to tighten our belts, and be a little wiser with our money. The sooner we bury these charlatans, the sooner we can get to work to saving our country!

Bill Gross' 2 Billion Dollar Day. Thanks Easy Al for all of your insights!

2008-09-09T18:39:00.000-07:00

Bail-out hands Pimco $1.7bn payday
By Deborah Brewster in New York
Published: September 9 2008 19:49 | Last updated: September 9 2008 19:49
The Bill Gross-managed Pimco Total Return fund reaped a $1.7bn payday following the US government takeover of home loan giants Fannie Mae and Freddie Mac.

While shareholders in Fannie and Freddie suffered deep losses, the world’s biggest bond fund saw its highest ever one-day rise against its benchmark index on Monday, benefiting from the bet made by Mr Gross on mortgage bonds issued by the agencies.

Mr Gross had made a big shift out of US Treasuries and corporate bonds over the past year and into agency bonds, betting that the government would support Fannie and Freddie Mac. By May this year, more than 60 per cent of his $132bn fund was in mortgage debt.

Mortgage-backed bond prices rose after the US government seized control of the agencies.

Mr Gross’s fund, which side-stepped the housing market slide, had risen strongly before Sunday’s government bail-out. In the 12 months to August 1, the fund returned 9.2 per cent, beating all of its peers, according to fund tracker Morningstar.

On Monday, the fund rose by 1.3 per cent, or $1.7bn, its biggest one-day rise ever against the Lehman Aggregate Bond index.

Mr Gross, who co-founded Pimco and has managed the Total Return fund since 1987, was one of the first to call for a bail-out of Fannie and Freddie.

In his latest monthly commentary, he also said that the government needed to use more of its own money to support financial markets, or risk a “financial tsunami”.

Mr Gross’ style is to take a macro-economic view and make tactical changes based on short-term movements in the economy.

The recent success of the Total Return fund has helped Pimco to be the only one of the 25 largest mutual fund managers to lift its assets under management in the year to date, according to Financial Research Corporation data to the end of July.

By contrast, several well-respected equity fund managers are suffering in the wake of the government move, which leaves Fannie and Freddie stock almost worthless. Legg Mason’s Bill Miller, Fidelity, Dodge & Cox and Wellington are among the fund managers that had heavy exposure to Fannie and Freddie – and had lifted that further this year, according to Bloomberg data.

Copyright The Financial Times Limited 2008

What's wrong with the Economy?

2008-09-05T21:07:00.000-07:00

This is too complex a question for me to answer, but any chance I can get to take a swipe at Wall Street, well I can't resist. As the political season heats up, and we get to choose between Burger King and MacDonalds, people around me keep asking questions as to how we got into this giant mess. Which candidate has the best "economic plan". First, let's start with who is to blame. That answer is simple enough. The Wall Street initiated and Federal Reserve enabled "service" (really finance sector) economy, run by the professional crooks and gamblers of Wall Street is what ruined our economy. There, let's get that straight. It wasn't the coal miners or the auto workers or the engineers or the farmers who destroyed us. It was a laundry list of characters including, but not limited to, guys like Rubin, Greenspan, Boskin, Weil and other elite financiers who have done us in. Until people in America understand this fact, it is impossible to move forward with any kind of debate as to how to solve our economic mess. I have yet to hear either candidate state this, probably because they saw what happened to Ron Paul when he touched on some of these issues. Even as I write this, news is coming out of another massive government bailout of Fannie and Freddie. Can't piss of the Chinese?! Anyway, I would like to post the amount that was paid in Wall Street bonuses over the last 20 years or so. This doesn't include the money the Hedgies or Private Equity boys made, or dividends paid out, but they earned it?! What's remarkable is that there has been a 10 fold increase in bonuses over the last 15 years or so. I know of no other profession with such income growth. Maybe before taxpayer funds are confiscated to bail out these institutions that are too big to fail, the wealth of these elites should be sold off to help offset the bill. I mean, if a company dumps toxic waste, they get a fine, why not Wall Street? I know I am just dreaming, but it will be everybody's nightmare. I believe that at this point, nobody really knows where this is heading, but it probably won't have a happy ending.

www.osc.state.ny.us/press/releases/dec06/bonuses1206.pdf

It's not fair, but that's the way it is.

2008-04-05T12:31:00.000-07:00

As this credit bubble continues to unwind, and more facts come to light, it become ever more apparent the immoral and ridiculous nature of the system. One goes through one’s life and is told by respected elders to do the right thing, follow the rules, be fair, don’t lie, don’t cheat, and don’t steal. But, it is in fact the ability to game the system in your favor, to bend the rules, to cheat, lie, steal and deceive that gets you a house in the Hamptons. The rest of us have become de-facto drones who must only sit and watch with bemused amazement at how institutionalized pilfering has become a state sponsored entity. On America’s Most Wanted, they show the foolish bank robber going in with a mask, risking his life, for an average of $2,000. The reality as it turns out is that the real thieves are in the Wall Street Cartel, backed by U.S. taxpayer largesse. How did we get here? Is this really the way our country works? Has it always been so? Perhaps we are just naïve in believing that justice will find it’s way to the canyons of Wall Street. That the U.S. has entered its inevitable decline from glory is almost beyond doubt, the only question is over what time period and who will bear the greatest pain. As the oligarchs have ensconced themselves in a citadel of deceit and power, the rest of us are left exposed to the erosion. I believe that the system has become so corrupt, that change from within is impossible. All our blogging and blathering about how unfair everything is will not change the facts on the ground. There is opportunity cost to all this ranting and raving, and the reward is diminishing quickly. The deck is heavily stacked in the favor of the financiers, one just needs to accept it and move on. Until our whole credit/debt finance system collapses in conflagration, nothing will change. Perhaps it has always been this way.

John Mauldin email.

2008-03-31T19:54:00.000-07:00

How To Fix It
By Michael E. Lewitt

"This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments."

Adam Smith, The Theory of Moral Sentiments (1759)
Twelve Basis Points

One way of measuring how perilously close the U.S. financial system came to melting down in mid-March 2008 is to look at how low the rate on one-month Treasury bills fell at the depths of the crisis. That number is 12 basis points. 0.12%. The three-month Treasury bill rate, which our friend Jim Bianco of the highly respected Bianco Research points out is the "risk-free" rate for many models such as the capital asset pricing model, the arbitrage risk pricing model and the Black-Scholes pricing model, fell to a 50-year low of 56 basis points on Tuesday, March 25. 0.56%. As Mr. Bianco pointed out, these bills were yielding less than Japanese 3-month financial bills for the first time since July 14, 1993.

And it's not as though the Japanese economy is flourishing. In fact, quite the opposite is occurring as Japan continues to struggle with the aftermath of its lost decade (which is stretching into lost decades). Hilary Clinton, who looks increasingly unlikely to lead her party in the upcoming Presidential election, is definitely onto something when she warns that "[w ]e may be drifting into a Japanese-like situation. I don't think we can work our way out of the problems we're in for the broad-based economy through monetary policy alone. Japan tried that and tried and tried that."1 The structural problems ailing the U.S. economy are severe. They derive from bad economic policies and bad political values.

American Capitalism In Need of Repair2

We all know Adam Smith as the author of the bible of capitalism, The Wealth of Nations (1776). But he first wrote what is arguably a far more important book, The Theory of Moral Sentiments, from which the quote that heads this month's newsletter is drawn. America is rushing headlong into the 21st century without a proper understanding of what economic policies and financial tools are going to be required to prosper in a changing world. For more than two decades, the United States economy has favored financial speculation over production. Over the past century, our legal system had developed an increasingly outmoded concept of fiduciary duty that privileges short-term, single-firm interests over the kind of long-term, society-wide interests that could lead to prolonged prosperity. The current meltdown in the financial markets is a symptom of a serious disease that is eating away at the stability of our most important institutions. What we are witnessing might well be the end of American financial hegemony, which is the result of a burgeoning global economy. The current crisis in financial markets gives us an opportunity to evaluate how we can better prepare ourselves to deal with a borderless world.

In spite of claims to the contrary, the American economy has become increasingly unstable in recent decades. This phenomenon picked up momentum in recent years as financial markets focused on trading derivative financial instruments rather than cash stocks and bonds. Paradoxically, the very financial instruments designed to manage risk increase mark volatility. As the distance separating lenders and borrowers as well managers and stockholders increased, debacles such as the Enron and WorldCom frauds earlier this decade and, more recently, the subprime mortgage and structured credit meltdown of today became more common. By effectively reducing all financial instruments and measures of financial value to "one's and zero's" - by digitalizing value - Wall Street removed crucial checks and balances on financial behavior, which ultimately remains a human activity. The growing use of quantitative trading models led to a market dominated by traders directing money into companies about which they know little or nothing. This leveling of all economic values to indistinguishable signs did untold damage to economic actors' ability to distinguish valuable assets from worthless ones.

In addition, unstoppable economic and historical trends such as globalization caused a shift of jobs and factories to geographic locations with lower labor and materials costs, resulting in a transformation of the U.S. economy from one that manufactures goods to one that traffics in intangible items. The result has been a shift from investing in activities that add to the productive capacity of the country to transactions and activities that are merely speculative in nature, i.e., that merely spawn more money but not more physical or capital assets. This shift from a tangible to an intangible economic base was accompanied by a change in the way in which businesses are financed. At the same time as the business base became increasingly intangible, so did the financial base. Equity was replaced by debt, and cash securities were replaced by derivatives. Much of the new financial architecture is now constructed outside the purview of the Federal Reserve and other regulators, allowing economic actors to avoid margin requirements and other limits on leverage that can prevent systemic threats. The new foundations of corporate finance can vaporize in the blink of a trader's eye. These trends have enormous policy consequences for the United States and our future standard of living.

The fiduciary law that governs our business culture reaches back to the 15th century and requires those who are entrusted with managing our largest corporations or pools of money to act in the best interests of their shareholders or clients. But the evolution of fiduciary law has developed into a mode of thinking that privileges short-term, single-company results over long- term, society-wide results. Consequently, fiduciaries are driven by a logic that dictates a focus on the short-term, which can be more accurately predicted than the long-term. But there is something deeper at work in this mindset. Fiduciary thought privileges form over substance, procedure over justice. Decisions that serve a single corporation's shareholders may cause significant harm to a wider array of interests. The entire concept of fiduciary duty must be rethought if capitalism is going to flourish in a borderless, digitalized world. Instead of a narrow focus on the interests of a single firm's shareholders, the fiduciaries of our large business enterprises are going to have to widen their arc of concern to a wider group of constituencies. Without such a broadening of focus, narrow interests will continue to place the entire system in jeopardy because of the networked nature of today's financial markets.

Some Specific Recommendations for Financial Reform

Nano-scopic interest rates are a sign of just how corrupted our financial system has grown from the twin diseases of leverage and greed. The collapse of Bear Stearns was an all-too predictable byproduct of a system that refuses to look itself in the mirror. The bailout of Bear was an obnoxious necessity in view of the fact that the firm was too interconnected as a Wall Street counterparty and prime broker to be permitted to fail. Its collapse would have placed many hedge funds and other financial firms at risk.3 So instead of being able to allow the firm to enter bankruptcy as a just dessert for its failure to properly manage the risks inherent in its business, the Federal Reserve and Treasury Department had to place the interests of the financial system first. The time to ask about moral hazard is not when the system is about the implode - the appropriate time for such questions is much earlier, when the seeds of destruction that lead to the necessity to bail out players that act in ways that threaten long-term systemic stability are being sown. Such questioning, and the requisite action to avoid future problems, requires degrees of forethought and forthrightness for which the power players on Wall Street and in Washington have little tolerance. Even when we skirt complete systemic collapse - and make no mistake about it, we have come as close to such an event as anyone should dare imagine - those with a stake in the game continuing are working behind the scenes to protect their interests.

The Bush Administration, under the intellectual leadership of Treasury Secretary Henry Paulson, has proposed a broad reorganization of financial industry regulation. Unfortunately, this plan merely addresses form over substance and does little or nothing to address the underlying problems that are eating away at the system like a cancer. If reform ultimately follows the path proposed by Mr. Paulson and goes no farther to outlaw the reckless practices that place the system at risk in order to line the pockets of a privileged few, we will have sadly learned nothing from the current crisis. The system is infected by deep, inbred flaws that are rendering it increasingly unstable. Free-market capitalism as practiced on Wall Street and in The City has run amok. If the current crisis, and the recurring crises of the last twenty years, tell us anything, it is that market solutions are insufficient to protect the system from the greed and fear that drive markets. If the deep structural cracks in the system are not addressed and corrected, the markets may not survive the next near-death experience.

This is not a time to mince words. As the poet William Blake wrote, "Opposition is true friendship." At the risk of offending many of our readers, here are HCM's thoughts on how to reform the financial system.

Financial Industry Regulation: There is too little, not too much, financial industry regulation. The problem with our current regulatory regime is that too many of our current regulations serve little or no purpose (for example, the pages of meaningless disclosure in Wall Street research reports that nobody reads and are often longer than the research reports themselves) or are enforced in a capricious and arbitrary manner by unqualified regulators and overzealous prosecutors. This breeds disrespect for the law and resentment among the regulated. As a result, we have a system of laws, not values, a system that privileges form over substance, process over justice. We are never going to have a sound regulatory system until we raise the compensation levels for those who are charged with insuring that millionaires are following the rules.

HCM often hears the argument that too much regulation will force business offshore and render the U.S. financial industry less competitive. Our response to that argument is that institutions and fiduciaries in the end will gravitate to the system with the strongest and wisest regulatory protections. Moreover, we should be pushing the most reckless practices out of our markets and into other markets. We should be creating global competition over best regulatory practices, not worst ones.

Wall Street Compensation: The financial incentive system that governs Wall Street - and by "Wall Street," we mean the investment and commercial banks, private equity firms and hedge funds - requires dramatic rethinking. As compensation is meted out today on Wall Street, too much is paid to too few for doing too little of value for society. Too much capital is allowed to exit investment banks in the form of annual cash compensation. Executive compensation should be calculated based on multiple years of performance and subject to high water marks and claw backs in the event one year's profits from a transaction or a specific activity are lost in later years when that activity turns out to have been fraudulent or flawed. The subprime mortgage business is a case in point. Why should bankers be permitted to retain bonuses earned with respect to the closing of subprime mortgage CDOs that subsequently led to losses for their firms and investors? Compensation should be based on a longer-term view of value-added. Furthermore, regulators should permit firms to maintain reserve accounts and make other arrangements to facilitate a more nuanced compensation structure with adequate disclosure to keep investors fully informed.

Private equity managers and hedge fund managers should not be compensated based on returns attributable to inflation or the market. Their performance fees should be subject to a hurdle rate that is based on annual inflation rates and the applicable asset class performance (equity market performance in the case of private equity firms, for instance) to insure that investors are really paying fees for performance, not for fortuity.

Private Equity: The private equity business has resulted in the overleveraging of American business. One result is that many businesses are short-changing capital expenditures and research and development in order to service debt. Despite the statistics promulgated by self-serving, private equity-financed industry groups, it is irrefutable that companies would have more money to contribute to the productive stock of the economy if they were devoting less money to servicing their enormous debts. We will look back at the private equity boom as a phenomenon that damaged the American economy and impaired America's competitive position in the world.

The private equity boom is the quintessential example of what the economist Hyman Minsky termed "speculative finance" and, in its most extreme form, "Ponzi finance."4 Private equity deals add little or nothing to the productive capacity or capital base of the economy. Instead, they merely create debts that have to be serviced and divert cash to the activity of servicing debt rather than creating jobs or funding new projects or research. In 50 years, it is going to be clear that the U.S. economy has paid a terrible price for this.

Private equity managers' (and hedge fund managers') "carried interests" should be taxed at ordinary tax rates, not at the capital gains rate. Such earnings are nothing other than compensation, not earnings on risk capital.5 The arguments that private equity firms have tried to promote on Capitol Hill that such a taxation regime would reduce risk-taking are completely unsupportable from a factual standpoint. Henry Kravis and Stephen Schwarzman are not going to stop doing deals because they have to pay taxes at the same rate as their chauffeurs. These arguments are also the most cynical kind of politicking that insults the intelligence of every American. If politicians want to be held in even lower regard than they already are, supporting these arguments is a good way to go.

Finally, private equity firms should not be permitted to go public. The discipline of the markets - i.e. 50 percent or more declines in the price of private equity firms' stocks such as The Blackstone Group (BX) and Fortress Investment Group (FIG) - is inadequate to police the abuses of such transactions. These firms are hopelessly and terminally conflicted between their fiduciary obligations to their limited partners and their fiduciary obligations to their shareholders. The fact that investors are willing to ignore the mind-boggling hypocrisy of IPOs of businesses that are built on the premise that public ownership is economically inefficient is a tribute to the insatiable greed that has consumed investors. That greed has not only corrupted investors' moral sentiments, as Adam Smith wrote more than two centuries ago, it has crippled their common sense.

Financial Institution Leverage: Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with 5 of the 6 chambers of the gun loaded. If one adds the off-balance sheet liabilities to this leverage, you might as well fill the 6th chamber with a bullet and pull the trigger. If this continues, the odds of a systemic crisis more severe than the one we are experiencing are near 100%. An absolute leverage limit should be imposed on investment banks and other financial institutions.6 Some will argue that limiting financial institution leverage will render these businesses less profitable and less competitive with non-U.S. companies. HCM's response is - "so what?" Perhaps less profitable investment banks will result in more of America's talented students becoming scientists, engineers, doctors and teachers instead of investment bankers and mortgage traders. What would be so terrible about that?

Off balance sheet entities should be outlawed immediately, plain and simple. If first Enron and now the SIVs haven't taught us the necessary lessons about hidden liabilities, the system probably doesn't deserve to survive. Speaking as someone with extensive knowledge of these off-balance sheet entities, it would not be difficult to render them extinct relatively easily. It would be doing the world a favor.

Tying this issue to the compensation question in the financial industry, if investment banks want to leverage themselves 30 to 1, their executives should be required to retain 97 percent of their compensation in their firms in the form of equity capital. The way it stands now, the ratio between capital retained and cash out is much lower (perhaps 1:1) and effectively creates a "heads-I-win, tails-you-lose" culture. For institutions that play a central role as financial counterparties and lenders, this is an unacceptable risk-sharing arrangement for society to bear. These institutions need to understand that they have responsibilities to the system, not just to their own shareholders and employees. Sure, Jimmy Cayne sold stock once worth $1.2 billion for only $61 million, but he also took out hundreds of millions of dollars in cash compensation over the years. Nobody can argue that his incentives were anything but grossly asymmetric, which may explain his ability to keep his job while demonstrating a much greater understanding of the strategies of the game of bridge than of the balance sheet risks his firm was undertaking.

Hedge Fund Leverage: Allowing unregulated entities such as hedge funds to be leveraged 10 to 1 or 15 to 1 would be laughable if it wasn't so dangerous. Prime brokers continue to be suckers for big names and big clients (and especially for big name clients). As a result, they often extend credit to parties who are not qualified to employ it prudently. HCM has expressed its view on more than one occasion that fixed income strategies that require excessive amounts of leverage do not make sense and have never made sense. We would refer anybody who disagrees with us to the recent collapses of Sowood Capital Management, LP, Peloton Partners LLP and Carlyle Capital Corp. Each of these firms reportedly employed high amounts of leverage (reportedly more than 15x) in their strategies. An absolute leverage limitation should be placed on hedge funds immediately. Since the prime brokers don't seem to want to impose such a limitation, the Federal Reserve should do so with its new powers. If investors can't generate decent returns without employing grotesque amounts of leverage, they should find another profession.

We recently read7 that John Meriwether of Long Term Capital Management infamy is at risk of blowing up a hedge fund that was leveraged 14.9 to 1 as of the end of February (and is reportedly down 28 percent year-to-date). The fund in question, Mr. Meriwether's Relative Value Opportunity Fund, reportedly has earned about 7 percent per annum since inception in 1999 through February 2008 (according to The Wall Street Journal) despite the use of generous amounts of leverage. According to the Journal article, Mr. Meriwether, like many hedge funds, charges a 2 percent management fee and 20 percent performance fee for managing his fund. We really don't mean to pick on Mr. Meriwether. Everybody is entitled to a second chance. But one would hope that an individual whose firm almost cratered the entire financial system in 1998 would have learned from his mistakes. Any way you slice it, 15x leverage is imprudent. It may look prudent compared to the 100x leverage employed at Long Term Capital Management a decade ago, but that is like saying 2 degrees below zero isn't cold because it isn't 30 degrees below zero.

Of course, the real question is why hedge fund investors are still willing to risk their money in such highly leveraged strategies. HCM has been asking that question for years but has yet to hear a satisfactory explanation. But since the market won't impose the type of discipline that is necessary to protect the system from boom and bust cycles, it is time for the regulators to step in.

Quantitative Strategies: Quantitative investing has not only introduced an unhealthy amount of volatility into the markets, but has contributed to a larger trend in the financial markets that divorces the investment process from the concept of fundamental value. HCM would defy the quants to explain in any degree of detail what the companies in their portfolios do. This is another type of investing activity, like private equity, that does little or nothing to provide capital to increase the productive capacity or physical stock of the economy. In fact, quantitative investment strategies are the quintessential "hot money." Enslaved by their computer models, they trade in and out of positions at the blink of an eye. When things go wrong, they blame everybody but themselves. Being a quant means never having to say you're sorry.

At some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results. Until that happens, we will continue to extol the types of investment activity that contribute little to our world. HCM would respectfully propose that a new school of "ethical investing" be adopted that takes into account how particular kinds of investments contribute to the economy. On this basis, quantitative strategies would be eliminated from consideration.

Short Selling: Short selling is an absolutely legitimate way to invest or hedge a portfolio. The SEC made a major error when it repealed the downtick rule last year. The repeal of this rule increased downside volatility exponentially and contributed to the ability of quantitative and other computer-driven selling to push the market lower based on technical rather than fundamental investment considerations. The SEC should reinstitute the downtick rule immediately.
Financial Triage

The magnitude of the unprecedented steps that the Federal Reserve and U.S. Treasury have had to take to bail out the U.S. financial system speaks to the depth of the problems we are facing. We may have left some steps out, but by our account the following is a list of the extraordinary actions that the U.S. central bank has been required to take to address the current crisis.

Since last summer, the Fed has cut interest rates by 300 basis points. The result? Mortgage rates have barely budged, but they are finally starting to move lower. Unfortunately, this comes too late for many homeowners who are losing their homes.

On December 12, 2007, the Federal Reserve created the Term Auction Facility (TAF) whereby the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window. On March 7, 2008, the Federal Reserve increased the size of the TAF to $100 billion and initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. As with the TAF auction sizes, the Fed said it would increase the size of these term repo operations if necessary. No doubt these facilities will need to be increased.

On March 11, 2008, the Federal Reserve created a $200 billion Term Securities Lending Facility (TSLF) whereby primary dealers could borrow Treasury securities for a period of up to 28 days using as collateral federal agency debt, federal agency residential mortgage backed securities (MBS) and non-agency AAA/Aaa-rated private-label residential MBS.

On March 17, 2008, the Federal Reserve opened up the discount window to the investment banks, which are not subject to the same regulatory limitations as the commercial banks that have traditionally had access to the window.

The Federal Reserve made a $29 billion line of credit available to JP Morgan Chase in connection with its takeover of Bear Stearns.

The Office of Federal Housing Enterprise Oversight (OFHEO) announced on March 19 that it would reduce excess capital requirements for Fannie Mae and Freddie Mac by one-third, from 30 percent to 20 percent. This is calculated to permit these two entities to add another $200 billion of mortgages to their existing $1.4 trillion portfolios (on an equity base of less than $70 billion). The two agencies shortly thereafter announced that they were authorized to raise an additional $5-10 billion of equity capital each, which would still leave them grossly leveraged by HCM's count.

The Federal Housing Finance Board announced that it would increase the limit on Federal Home Loan Banks' MBS (mortgage backed securities) investment authority from 300 percent of capital to 600 percent of capital for two years. This is estimated to enable these institutions to purchase another $200 billion of this paper.
While these moves were probably necessary to save the system from complete collapse, it is abundantly clear that these drastic steps are going to have enormous negative long-term effects on the U.S. economy. Among those effects will be higher future inflation and an extension of the high levels of leverage in the system that pushed the economy to the precipice this time. Does anybody really think it's a good idea to have Federal Home Loan Banks buy more MBS paper? Or for Fannie and Freddie to leverage their balance sheets further? All of these actions are going to have to be unwound at some point, which means that the day of reckoning is simply being delayed.8 It is clear that the authorities are engaged in a desperate attempt at economic triage that bodes poorly for the future economic health and stability of the United States. Looked at in this context, it is difficult to argue against those who believe in long-term U.S. dollar weakness. If you want to look at the end of American economic hegemony, just look at the list of desperate actions taken by U.S. financial authorities above. It is a sad commentary on how the greed and short-sighted actions and policies of U.S. politicians and businessmen have inflicted permanent damage on our economy.

There is a way out, but it will not be easy. The way out is to accompany the drastic steps taken by the Federal Reserve and Treasury with a comprehensive regulatory revolution that addresses the flaws embedded in the system. HCM does not use the word "revolution" loosely, but nothing less than a drastic rethinking of our current system accompanies by action to change it is going to be required if we are to strengthen the global economic system for the challenges to come.

Michael E. Lewitt

Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization

2008-03-31T19:52:00.000-07:00

Nouriel Roubini | Mar 31, 2008
Today U.S. Treasury Secretary Hank Paulson presented his proposals for a reform of the system of supervision and regulation of financial markets following the most severe – still ongoing – financial crisis in the U.S. since the Great Depression. And soon the Draghi Commission within the Financial Stability Forum will report its conclusions and proposals for reform of the financial system to the G7 Finance Ministers.

To understand whether the U.S. Treasury proposals make sense one should first analyze what are the problems that an increasingly complex and globalized financial system face and what are the shortcomings of the current system of financial regulation and supervision, in the U.S. and around the world. Only a detailed consideration of such problems and shortcomings can lead to the recognition of the appropriate reforms of the system.So, let us consider in more detail such problems and shortcomings of the financial system and of its regime of regulation and supervision.

They can be summarized in ten points or issues…

First, the system of compensation of bankers and operators in the financial system is flawed as a source of moral hazard in the form of gambling for redemption. The typical agency problems between financial firms’ shareholders and the firms’ managers/bankers/traders are exacerbated by the way the latter are compensated: since a large fraction of such compensation is in the form of bonuses tied to short-term profits and since such bonuses are one-sided (positive in good times and, at most zero, when returns are poor) managers/bankers/traders have a huge incentive to take larger risks than warranted by the goal of shareholders’ value maximization. The potential solutions to this gambling for redemption bias are varied: restricted stock that has to be maintained for a number of years; or a pool of cumulated bonuses that is not cashed out yearly but that can grow or shrink depending on the medium terms returns to particular investments.

But even leaving aside the problem of how to change such compensation in a highly competitive labor market talent in the financial sector, it is not obvious that the suggested solutions would fully work: for example in the case of Bear Stearns about 30% of the firm was owned by its employees and such employees had restricted stock. However this system of compensation did not prevent Bear Stearns from making reckless investment that eventually made it insolvent. Possibly this was the case because the individual compensation was not tied to the individual investment/lending decision. Still, compensation of bankers/traders should be considered as a crucial factor that distorts lending and investment decisions in financial markets.

Second, the current models of securitization (the “originate and distribute” model) has serious flaws as it reduces the incentive for the originator of the claims to monitor the creditworthiness of the borrower. In the securitization food chain for U.S. mortgages every intermediary in the chain was making a fee and eventually transferring the credit risk to those least able to understand it. The mortgage broker, the home appraiser, the bank originating the mortgages and repackaging them into MBSs, the investment bank repackaging the MBSs into CDOs, CDOs of CDOs and even CDO cubed, the credit rating agencies giving their AAA blessing to such toxic instruments: each of these intermediaries was earning income from charging fees for their step of the intermediation process and transferring the credit risk down the line.

One possible solution to this lack of incentive to undertake a proper monitoring of the borrower would be to force the originating bank and the investment bank intermediaries to hold some of the credit risk, for example in the form of their holding some part of the equity tranche in the CDOs or holding some of the MBS that they originate. But it is not obvious that such solutions would fully resolve the moral hazard problems faced by financial intermediaries. In fact, while the securitization process implied a partial transfer of the credit risk from the mortgage originators and the managers of the CDOs to final investors the reality is that banks and other financial institutions maintained a significant exposure to mortgages, MBS and CDOs. Indeed in the US about 47% of all the assets of major banks are real estate related; and the figure for smaller banks is closer to 67%. I.e. the model of “originate and distribute” securitization did not fully transfer the credit risk of mortgages to capital market investors: banks and broker dealers (say Bear Stearns) did keep in a variety of forms a significant fraction of that credit risk. Indeed, if that credit risk had been fully transferred such banks and other financial intermediaries would have not suffered the hundreds of billions of dollars of losses that they have recognized so far and that they will have to recognized in the future.

Thus, excessive risk taking and gambling for redemption did occur in spite of the fact that financial institutions were holding part of the credit risk. So proposing that such institutions hold some of that risk – rather than try to transfer it all – does not seem to be a solution that will resolve fully the problems deriving from the wrong set of financial incentives faced by bankers and the poor risk management by financial institutions. If the fundamental problem is one of the moral hazard deriving from the way that bankers are compensated forcing financial institutions to hold more of the credit risk will not resolve the problem that led in the first place to the poor monitoring of the creditworthiness of the borrowers and to poor underwriting standards.

Third, the regulation and supervision of banks and the lighter – on in some cases such as that of hedge funds non-existent – regulation and supervision of non-bank financial institutions has led to significant regulatory arbitrage: i.e. the transfer of a large fraction of financial intermediation to non-bank financial institutions such as broker dealers, hedge funds, money market funds, SIVs, conduits, etc.

The problems with this financial innovation are twofold: first, some of the institutions in this shadow banking system (or shadow financial system) are systemically important. Two, most of these institutions are at risk of bank-like runs on their liabilities as they borrow in short and liquid ways, they are highly leveraged and they invest in longer and more illiquid ways.

The risk of runs is significantly prevented for banks by the existence of deposit insurance and by the lender of last resort support that the central bank can provide. Publicly provided deposit insurance is generally not warranted for non-bank financial institutions as the protection of small investors/depositors - who don’t have the expertise to monitor the lending/investment decisions of banks - is not generally an issue for such non banks. But as the recent Bear Stearns episode as well as the run on and collapse of other components of the shadow financial system suggest bank-like runs on non-banks can occur and are more likely to occur more often if such institutions do not properly manage their liquidity and credit risks.

While provision of lender of last resort to non-bank institutions that are not systemically important is not warranted such support may be warranted for the few institutions that are systemically important. And indeed the recent Fed actions - $30 billion rescue of Bear Stearns, and two new facilities that allow non-bank primary dealers to access the Fed ‘s discount window and to swap their illiquid MBS products for safe Treasuries – imply that the lender of last resort support of the Fed has been now extended to systemically important non-bank institutions. Thus, the same regulation and supervision that is applied to banks should also be applied to these systemically important financial firms, not just in periods of turmoil (as recommended by Hank Paulson) but on a more permanent basis.

But if these institutions should be regulated like banks because they are systemically important and receive the Fed’s lender of last resort support one cannot have a system where the regulation and supervision of a subset of non-bank financial institutions is different depending on whether the institution is systemically important or not. Otherwise regulatory arbitrage will lead financial intermediation to move from banks and systemically important broker dealers to more lightly regulated smaller broker dealers and other non-bank financial institutions.

Thus, while the safety net of the Fed and other central banks should remain restricted to banks/depository institutions and to – subject to some constructive ambiguity - systemically important non-bank firms, the regulatory and supervisory framework should be similar for banks and non-bank financial institutions: regulatory capital, type of supervision, liquidity ratios, compliance and disclosure standards, etc, should be similar for banks and other financial institutions. Otherwise regulatory arbitrage will shift financial intermediation and risks to other more lightly regulated institutions.

For example, the loophole that allowed SIVs and conduits to operate with little supervision and no capital standard under the pretense that these were off-balance sheet units – while the sponsoring bank was providing large credit enhancements and systematic liquidity lines that made these units de facto on-balance sheet assets and liabilities – was deeply flawed. Unless these and a whole host of other special purpose vehicles are regulated and supervised as if they were on-balance sheet units this type of regulatory arbitrage will lead again to the disaster that SIVs created.

Moreover, a comprehensive supervisory and regulatory regime that covers both banks and non-bank would also allow a better monitoring and assessment of systemic financial risks that at the moment are not properly supervised. Providing both regulators/supervisors as well as investors and the reporting and disclosure of information that allows an assessment of systemic financial risks will be essential.

Poor liquidity risk management and the risk of bank-like runs on non-bank financial institutions has been shown as a severe problem in the shadow financial system: the entire SIV/conduit regime has recently collapsed given the roll-off of their ABCP liabilities; hedge funds and private equity funds collapsed because of risky investments and redemptions or roll-off of short term credits; money market funds whose NAV fell below par had to be rescued to avoid a run on them; Bear Stearns collapsed because of poor credit/investment choices but also because of a sudden run on its liquidity. While banks have are fundamentally maturity-mismatched given their reliance on short-term deposits there is no reason for non-bank financial institutions to run large liquidity/rollover risk especially as they do not have deposit insurance and no access – apart from the systemically important ones - to the central banks’ lender of last resort support.

Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. A firm that makes money only because it borrows very short, has little capital, leverages a lot and lends long and in illiquid ways is reckless in its risk management. It should certainly disclose fully to supervisors and to investors the liquidity and other risks that it is undertaking. But it should also be required to reduce its liquidity risk with a variety of tools provides it with a greater liquidity buffer.

Fourth, most regulatory and supervisory regimes have moved in the direction of emphasizing self-regulation and market discipline rather than rigid regulations. One of the arguments in favor of this market discipline approach is that financial innovation is always one or more steps ahead of regulation; thus, one need to design a regime that does not rely on rigid rules that would be easily avoidable via financial innovation.

This market discipline approach is behind the reliance on “principles” rather than “rigid” rules, the reliance on internal models of risk assessment and management in determining how much capital a firm needs, the reliance on rating agencies assessments of creditworthiness, and a key element of the philosophy behind the Basel II agreement. But this model based on market discipline has been proven vastly flawed given that the way bankers are compensated and the risk-transfer incentives provided by the “originate and distribute” model implies that internal risk managers are effectively ignored in good times when “the music plays and you gotta dance”; similarly the conflicts of interests of rating agencies lead to mis-ratings of new and exotic financial instruments.

Thus, while reliance on principles is useful to deal with financial innovation and regulatory arbitrage a more robust set of rules that go with the grain of principle-based regulation and supervision is necessary. Strict reliance on market discipline has been proven wrong in a world where bankers are improperly compensated, agency problems lead to poor monitoring of lending, a flawed transfer of credit risk to those least able to understand it and manage it, and where regulatory arbitrage is rampant.

Fifth, even before being fully implemented the Basel II agreement has shown its flaws: capital adequacy ratios that pro-cyclical and thus inductive of credit booms in good times and credit busts in bad times; low emphasis on liquidity risk management; excessively low capital ratios given the risks faced by banks; excessive reliance on internal risk management models; excessive importance given to the rating agencies. These are serious shortcomings of the new capital regime for large internationally active banks and depository institutions.

How to reform Basel II given the current severe financial crisis is not an easy task; but the urgency of this reform is undeniable. Particular importance should be given to: measures that would reduce the pro-cyclicality of capital standards that is a source of boom and busts in credit cycles; and to measures to increase – rather than decrease - the overall amount of capital held by financial institutions as recent history suggests that most financial institutions were vastly undercapitalized given the kind of market, liquidity, credit and operational risks that they were facing in an increasingly globalized financial system.

Sixth, by now the conflicts of interest and informational problems that led the rating agencies to rate – or better mis-rate – many MBS and CDO and other ABS products as highly rated are well known and recognized. With a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments it is clear that rating agencies are ripe with conflicts of interests. Add to this the flaws of a system where competition in this rating market is limited given the regulatory barriers to entry and the semi-official role that rating agencies have, in general and in Basel II in particular; the potential biases of a system where rating agencies are paid by issuers rather than the investors; the informational problems of raters that know little about the underlying risks of new complex and exotic instruments.

What are the potential solutions to these conflicts of interest and other problems? Open up competitions in the rating agency business; drop the semi-official role that rating agencies have in Basel II and in the investment decisions of asset managers; forbid activities (such as consulting or modeling) that cause conflicts of interest; drop the reliance on ratings paid by issuers rather than by investors (the free riding problem of having investors pay for ratings can be solved by pooling the investors’ resources in a pool that can be used to collectively purchase the ratings). Certainly rating agencies have lost a lot of their reputation in this ABS ratings fiasco; and only serious and credible reforms – not just cosmetic changes – will be required to restore their credibility in the rating business.

Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to-market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not.

There are two possible situations where mark to market accounting may distort valuations: first, when there are bubbles and the market value may be above fundamental value; second, when bubbles burst and, because of market illiquidity, asset prices are potentially below fundamental value. The latter case has become a concern in the latest episode of market turmoil as mark-to-market accounting may force excessive writedowns and margin calls that may lead to further fire sales of illiquid assets that, in turn, could cause a cascading fall in asset prices well below long term fundamentals. However, mark to market accounting may also create serious distortions during bubbles when its use may lead to excessive leverage as high valuation allow investors to borrow more and leverage more and feed even further the asset bubble. In either case, mark to market accounting leads to pro-cyclical capital bank capital requirement given the way that the Basel II capital accord is designed.

The shortcomings of mark-to-market valuation are known but the main issue is whether one can find an alternative that is not subject to gaming by financial institutions. Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others propose the use of a discounted cash flow (DCF) model where long run fundamentals – cash flows – would have a greater role. However, historical cost does not seem to be an appropriate way to value assets. The use of a DCF model may seem more appealing but it is not without flaws either. How to properly estimate future cash flows? Which discount rate to apply to such cash flows? How to avoid a situation where those using this model to value asset subjectively game the model to achieve the valuations that they want as the value of the asset in a DCF model strongly depend on assumptions about future cash flows and the appropriate discount factor? Possibly mark-to-market may be a better approach when securities are held in a trading portfolio while DCF may be a more appropriate approach when such securities as held as a long term investment, i.e. until maturity. But the risk of a DCF approach is that different firms will value very differently identical assets and that firms will use any approach different from mark-to-market to manipulate their financial results.

The other difficult problem that one has to consider is that any suspension of mark-to-market accounting in periods of volatility would reduce – rather than enhance – investors’ confidence in financial institutions. Part of the recent turmoil and increase in risk aversion can be seen as an investors’ backlash against an opaque and non-transparent financial system where investors cannot properly know what is the size of the losses experienced by financial institutions and who is holding the toxic waste. Mark-to-market accounting at least imposes some discipline and transparency; moving away from it may further reduce the confidence of investors as it would lead to even less transparency.

Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. Thus, the issue remains open of whether there are forms of regulatory forbearance - that are not destructive of confidence - that can be used in periods of turmoil in order to avoid a cascading and destructive fall in asset prices. But certainly solutions should be symmetric, i.e applied both during periods of rising asset prices and bubbles (when market prices are above fundamentals) and when such bubbles go bust (and asset prices may fall below fundamentals). But so far there is no clear and sensible alternative to mark-to-market accounting.

Eighth, the recent financial markets crisis and turmoil has been partly caused by the fact that the – over the last few years – financial markets have become less transparent and more opaque in many different dimensions. The development of news exotic and illiquid financial instruments that are hard to value and price; the development of increasingly complex derivative instruments; the fact that many of these instruments trade over the counter rather than in an exchange; the fact that there is little information and disclosure about such instruments and who is holding them; the fact that many new financial institutions are opaque and with little or no regulation (hedge funds, private equity, SIV and other off-balance sheet special purpose vehicles) have all contributed to a lack of financial market transparency and increased opacity of such markets.

But private financial markets cannot function properly unless there is enough information, reporting and disclosure both to market participants and to relevant regulators and supervisors. How much reporting and disclosure - and to whom - is appropriate is a difficult question. But it is clear that for the last few years financial market have become excessively opaque in ways that are destructive of investors’ confidence. When investors cannot prices appropriately complex new securities, when investors cannot properly assess the overall losses faced by financial institutions and when they cannot know who is holding toxic waste securities risk (that can be priced) turns into generalized uncertainty (that cannot be priced) and the outcome is an excessive increase in risk aversion, lack of trust and confidence in counterparties and a massive seizure of liquidity in financial markets. Greater transparency and information – including the use of fair value accounting (that, in spite of its shortcomings, is still the best way to value assets) – as well as prompt recognition by financial institutions of their exposures and losses are essential to restore the investors’ confidence in financial markets.

Some specific ideas on how to make new complex and exotic financial instruments more liquid and easier to price would be to make such instrument more standardized and have them traded in clearing house-based exchanges rather than over the counter. The benefits of standardization are clear as such standardization would allow to compare securities with similar characteristics and would thus improve their liquidity. Moreover, instruments that are exchange-traded through a clearing house would have much lower counterparty risk, would be subject to appropriate margin requirements and would be appropriately marked-to-market on a daily basis.

Ninth, what are the appropriate institutions of financial regulation and supervision and the system of such regulation and supervision in a world of financial innovation and globalization? There are many alternative models that have different pros and cons.

An increasingly popular model is the one of a unique and centralized financial regulator and supervisor, as in the case of the UK’s FSA where all financial policies – for banks, securities firms, other financial institutions, insurance companies, etc. – are under one umbrella. Another model is the US one where you have more than half a dozen or more of financial regulators and supervisors at the federal level and another layer of them at the state level. While some have argued that the US system because it foster beneficial competition about the best practices among different regulators the shortcoming of the US system, an incoherent set of overlapping regulators and a race to the bottom – rather than to the top – in terms of excessively deregulatory competition, have now become clear. One overall financial regulator may be too little but sixty plus of them is obviously way too many. A streamlining of such institutions and concentration of most regulatory and supervisory activities among a smaller number of institutions is certainly necessary.

Further, whether supervisory and regulatory power over banks – and possibly other systemically important financial institutions – should be kept within the central bank (as in the US) or whether it should be given to another regulator (as in the case of the UK FSA) is a difficult and controversial issue. Some worry that taking such powers away from the central bank – while maintaining its role as the lender of last resort - would reduce the ability of the central bank to oversee financial vulnerabilities in specific institutions and in the overall financial system (systemic risk). But as long as there is a proper exchange of information between the regulator and supervisor of banks and of other financial institutions and the central bank these informational issues can be properly managed. The UK debacle over Northern Rock was caused not by the existence of a single financial authority (the FSA) but rather – in part – by the lack of coordination and proper information exchange between the FSA, the Bank of England and the UK Treasury. Thus, the UK model of a single financial regulator/supervisor is – in principle – superior to a model where such powers are fragmented among many and different institutions. But proper coordination and information exchange is essential to make this system work.

Tenth, and finally, reforms of financial regulation and supervision cannot be done only at the national level as regulatory arbitrage may lead financial intermediation to move to jurisdictions with a lighter – and less appropriate - regulatory approach. Indeed, the recent US debate on reforming capital markets was driven – before the current market turmoil – by the concerns that a tighter regulatory approach in the U.S. (say the Sarbanes-Oxley legislation) was leading to a competitive slippage of New York relative to London in the provision of financial services.

In a world of financial globalization, mobile capital and lack of capital controls capital and financial intermediation may move to more lightly regulated shores. While the idea of a global financial regulator – or a global financial “sheriff” – is for the time being a bit far-fetched a much stronger degree of coordination of financial regulation and supervision policies is necessary to avoid a race to the bottom in financial regulation and supervision and to prevent excessive regulatory arbitrage. Such international coordination of financial policies is currently occurring on a very limited scale and will have to be seriously enhanced over time. Certainly within the Eurozone a system where bank supervision and regulation occurs only at the national level while only the ECB would be able to provide lender of last resort support in the case of a systemic banking crisis or when a major systemically important cross-border institution gets into trouble is an untested model. Over time financial supervision and regulation within the Eurozone will have to move from the national level to a Eurozone-wide level.

Finally, how do the U.S. Secretary Paulson proposals for the reform of the financial system compare with the principles and ideas for optimal financial regulation and supervision discussed above? An appropriate answer requires a detailed discussion that will be provided in the near future in this forum. But in brief summary, such proposals - while representing a step forward – have many shortcomings and they overemphasize the role of self-regulation, market discipline and reliance on principles rather than rules that have miserably failed to deliver an appropriate regulation and supervision of the financial system. Given that we are still in the midst of the worst U.S. financial crisis since the Great Depression, a crisis that has shaken the foundations of modern financial capitalism, the current US Treasury proposals have significant shortcomings that don’t address the core and structural financial risks and vulnerabilities that the current crisis has revealed.

Let the litigation begin!

2008-03-31T19:49:00.000-07:00

Schiffrin Barroway Topaz & Kessler, LLP Files First ERISA Fiduciary Breach Class Action on Behalf of Participants and Beneficiaries of the Bear Stearns Companies, Inc. Employee Stock Ownership Plan Against the Bear Stearns Companies, Inc. and Other Plan Fi

RADNOR, Pa., March 27 /PRNewswire/ -- The following statement was
issued today by the law firm of Schiffrin Barroway Topaz & Kessler, LLP:

Notice is hereby given that the law firm of Schiffrin Barroway Topaz &
Kessler, LLP ("SBTK") has filed the first lawsuit of its kind on behalf of
participants and beneficiaries of The Bear Stearns Companies, Inc. Employee
Stock Ownership Plan (the "Plan"), in the United States District Court for
the Southern District of New York, alleging violations of the Employee
Retirement Income Security Act ("ERISA"), the federal law governing
employee benefit plans. The lawsuit seeks to recover, on behalf of the Plan
and its aggrieved participants, losses in connection with the unprecedented
devaluation of The Bear Stearns Companies, Inc. ("Bear Stearns") common
stock (NYSE: BSC) held by Plan participants between December 14, 2006 and
the present (the "Class Period").

This case epitomizes the danger of concentrating hundreds of millions
of "retirement eggs" in one basket - employer stock - even for employees of
an institution like Bear Stearns. Plaintiff alleges that Bear Stearns, like
too many others, has inflicted long-term harm on its most precious resource
- its workers.

Pursuant to ERISA, the defendants-fiduciaries of the Plan-were
obligated to ensure that the Plan's assets were prudently invested. The
Complaint alleges that the defendants utterly failed to fulfill their
fiduciary duties and, as a result, the Plan's participants have suffered
tremendous losses to their retirement savings.

The Complaint generally alleges that Bear Stearns and certain of its
officers and directors allowed the imprudent investment of the Plan's
assets/participants' retirement savings in Bear Stearns equity throughout
the Class Period, despite the fact that they clearly knew or should have
known that such investment was imprudent due to, among other things, (a)
the Company's failure to disclose material adverse facts about its
financial well- being including its ability to continue as a going concern;
(b) the foreseeable deleterious consequences to the Company resulting from
its substantial entrenchment in the subprime mortgage market; (c) the fact
that, as a consequence of the above, the Company's stock price was
artificially inflated; and (d) the fact that heavy investment of retirement
savings in Company stock would therefore result in significant losses to
the Plan, and consequently, to its participants.

Specifically, Plaintiff's complaint alleges that Bear Stearns stock was
an inherently imprudent Plan investment vehicle because the Company: (1)
was grossly over-exposed to the potential for substantial losses as
conditions in the subprime industry deteriorated; (2) actively concealed
the ominous dangers it faced; (3) failed to take accurate and timely
write-downs for losses resulting from the collapse of the subprime market;
and that the (4) Company's statements about its financial well-being and
future business prospects were lacking in any reasonable basis when made.

As noted above, this case is brought on behalf of the Plan and its
participants. Proposed class actions have also been brought against Bear
Stearns regarding violations of the federal securities laws by the
company's public shareholders.

SBTK specializes in complex class action litigation, representing
investors, employees and consumers in class actions pending in state and
federal courts throughout the United States. SBTK has substantial
experience and success in this specialized area of pension law, with one of
the preeminent and largest legal departments dedicated to ERISA breach of
fiduciary duty class action litigation in the country. The firm has been
named lead or co-lead counsel in numerous directly analogous ERISA class
cases - including successful actions on behalf of ESOP and/or 401(k)
savings plans sponsored by companies such as AOL/Time Warner,
Bristol-Myers, and Polaroid.

If you are a current or former employee of Bear Stearns, or a
subsidiary of Bear Stearns, who held Bear Stearns stock through the Plan
during the Class Period, and you wish to discuss this action or have any
questions concerning this notice or your rights or interests with respect
to these matters, please contact Schiffrin Barroway Topaz & Kessler, LLP
(Edward W. Ciolko, Esq. or Richard A. Maniskas, Esq.) toll free at
1-888-299-7706 or 1-610-667-7706, or via e-mail at info@sbtklaw.com.

For more information about Schiffrin Barroway Topaz & Kessler, please
visit http://www.sbtklaw.com

CONTACT: Schiffrin Barroway Topaz & Kessler, LLP
Edward W. Ciolko, Esq.
Richard A. Maniskas, Esq.
280 King of Prussia Road
Radnor, PA 19087
1-888-299-7706 (toll free) or 1-610-667-7706
Or by e-mail at info@sbtklaw.com

As Jobs Vanish and Prices Rise, Food Stamp Use Nears Record

2008-03-31T19:47:00.000-07:00

(NYT)
By ERIK ECKHOLM
Published: March 31, 2008
Driven by a painful mix of layoffs and rising food and fuel prices, the number of Americans receiving food stamps is projected to reach 28 million in the coming year, the highest level since the aid program began in the 1960s.

Barometer of Tougher Times
The number of recipients, who must have near-poverty incomes to qualify for benefits averaging $100 a month per family member, has fluctuated over the years along with economic conditions, eligibility rules, enlistment drives and natural disasters like Hurricane Katrina, which led to a spike in the South.

But recent rises in many states appear to be resulting mainly from the economic slowdown, officials and experts say, as well as inflation in prices of basic goods that leave more families feeling pinched. Citing expected growth in unemployment, the Congressional Budget Office this month projected a continued increase in the monthly number of recipients in the next fiscal year, starting Oct. 1 — to 28 million, up from 27.8 million in 2008, and 26.5 million in 2007.

The percentage of Americans receiving food stamps was higher after a recession in the 1990s, but actual numbers are expected to be higher this year.

Federal benefit costs are projected to rise to $36 billion in the 2009 fiscal year from $34 billion this year.

“People sign up for food stamps when they lose their jobs, or their wages go down because their hours are cut,” said Stacy Dean, director of food stamp policy at the Center on Budget and Policy Priorities in Washington, who noted that 14 states saw their rolls reach record numbers by last December.

One example is Michigan, where one in eight residents now receives food stamps. “Our caseload has more than doubled since 2000, and we’re at an all-time record level,” said Maureen Sorbet, spokeswoman for the Michigan Department of Human Services.

The climb in food stamp recipients there has been relentless, through economic upturns and downturns, reflecting a steady loss of industrial jobs that has pushed recipient levels to new highs in Ohio and Illinois as well.

“We’ve had poverty here for a good while,” Ms. Sorbet said. Contributing to the rise, she added, Michigan, like many other states, has also worked to make more low-end workers aware of their eligibility, and a switch from coupons to electronic debit cards has reduced the stigma.

Some states have experienced more recent surges. From December 2006 to December 2007, more than 40 states saw recipient numbers rise, and in several — Arizona, Florida, Maryland, Nevada, North Dakota and Rhode Island — the one-year growth was 10 percent or more.

In Rhode Island, the number of recipients climbed by 18 percent over the last two years, to more than 84,000 as of February, or about 8.4 percent of the population. This is the highest total in the last dozen years or more, said Bob McDonough, the state’s administrator of family and adult services, and reflects both a strong enlistment effort and an upward creep in unemployment.

In New York, a program to promote enrollment increased food stamp rolls earlier in the decade, but the current climb in applications appears in part to reflect economic hardship, said Michael Hayes, spokesman for the Office of Temporary and Disability Assistance. The additional 67,000 clients added from July 2007 to January of this year brought total recipients to 1.86 million, about one in 10 New Yorkers.

Nutrition and poverty experts praise food stamps as a vital safety net that helped eliminate the severe malnutrition seen in the country as recently as the 1960s. But they also express concern about what they called the gradual erosion of their value.

Food stamps are an entitlement program, with eligibility guidelines set by Congress and the federal government paying for benefits while states pay most administrative costs.

Eligibility is determined by a complex formula, but basically recipients must have few assets and incomes below 130 percent of the poverty line, or less than $27,560 for a family of four.

As a share of the national population, food stamp use was highest in 1994, after several years of poor economic growth, with an average of 27.5 million recipients per month from a lower total of residents. The numbers plummeted in the late 1990s as the economy grew and legal immigrants and certain others were excluded.

But access by legal immigrants has been partly restored and, in the current decade, the federal and state governments have used advertising and other measures to inform people of their eligibility and have often simplified application procedures.

Because they spend a higher share of their incomes on basic needs like food and fuel, low-income Americans have been hit hard by soaring gasoline and heating costs and jumps in the prices of staples like milk, eggs and bread.

At the same time, average family incomes among the bottom fifth of the population have been stagnant or have declined in recent years at levels around $15,500, said Jared Bernstein, an economist at the Economic Policy Institute in Washington.

The benefit levels, which can amount to many hundreds of dollars for families with several children, are adjusted each June according to the price of a bare-bones “thrifty food plan,” as calculated by the Department of Agriculture. Because food prices have risen by about 5 percent this year, benefit levels will rise similarly in June — months after the increase in costs for consumers.

Advocates worry more about the small but steady decline in real benefits since 1996, when the “standard deduction” for living costs, which is subtracted from family income to determine eligibility and benefit levels, was frozen. If that deduction had continued to rise with inflation, the average mother with two children would be receiving an additional $37 a month, according to the private Center on Budget and Policy Priorities.

Both houses of Congress have passed bills that would index the deduction to the cost of living, but the measures are part of broader agriculture bills that appear unlikely to pass this year because of disagreements with the White House over farm policy.

Another important federal nutrition program known as WIC, for women, infants and children, is struggling with rising prices of milk and cheese, and growing enrollment.

The program, for households with incomes no higher than 185 percent of the federal poverty level, provides healthy food and nutrition counseling to 8.5 million pregnant women, and children through the age of 4. WIC is not an entitlement like food stamps, and for the fiscal year starting in October, Congress may have to approve a large increase over its current budget of $6 billion if states are to avoid waiting lists for needy mothers and babies.

US credit crunch hits education as banks abandon student loans

2008-03-31T19:39:00.000-07:00

How will I finance college?
Suzy Jagger in New York
One of America’s leading banking associations has given warning that the United States faces a growing educational apartheid as some lenders withdraw from student loans amid new evidence that the credit crisis has spread across all types of borrowing.

In the past fortnight, some banks, including HSBC, have pulled out of the $85 billion (£42 billion) a year US student loans market, fuelling anxiety that the turmoil that hit debt markets on Wall Street last summer is spilling over into the wider economy and making credit more difficult to secure for ordinary American households.

In the US, many undergraduates take out a federal guaranteed loan and top up their financial needs with a private loan from lenders such as Bank of America, JPMorgan Chase and Citi-group. In the academic year 2005-06, $17 billion in private student loans was used to finance higher education.

Banks have become reluctant to offer private student loans because worsening credit conditions have meant that they cannot package up the loans and sell them on.

Although the brightest students who win places at America’s rich Ivy League universities will be affected less because of generous bursaries - which do not have to be repaid – less able students applying to other institutions are expected to face difficulty in securing private loans to fund their study. At one end of the field is Harvard University, with $34 billion of endowments, and at the other are many community colleges and low-tier universities with limited resources.

Joe Belew, president of the Consumer Bankers’ Association, said: “Some of the banks are getting out. Part of the reason is that Congress has cut the fees they could charge, making some loans pretty much unprofitable. But part of the reason is that they can’t securitise the debt. The problems they have had with mortgage-backed debt – it’s the same thing at play in student lending.

“We have talked to some of the banks about this. It’s a painful decision to pull out because of the nature of the clientele – everyone wants to be in the business of helping people get ahead, but at the end of the day you still have to deliver value to shareholders. At the moment, it’s a fine line between hanging in there and pulling out. It’s a murky situation.

“If the overall market is contracting, then those students with poor credit scores or without the rich uncle co-signers [loan guarantor] may have real problems funding themselves.”

Last week, Iowa Student Loan said that it would soon stop offering private loans altogether. The group, which made 29,000 student loans last year, said: “This is really a reaction to the economy’s recent situation, the sub-prime market in particular.”

Within the past fortnight, Montana Higher Education Student Assistance Corp said that a lack of appetite for buying debt such as student loans had led to its interest costs to finance such borrowing rising by a tenth, or $3.4 million, since the beginning of February.

Several members of Congress have urged the Bush Administration to stabilise the market after the National Association of Independent Colleges and Universities gave warning that student loans have become far harder and costlier to obtain since the credit crisis.

Last October, as the credit crisis on Wall Street was gathering pace, Washington introduced legislation limiting the returns that banks could extract from student loans.

Concern over funding for students is also spreading to Ivy League institutions. The University of Pennsylvania’s head of financial aid, William Schilling, has just written to banks demanding assurances they will continue to offer student loans.

Speaking to The Times, Dr Schilling said: “We want the banks to tell us whether they will continue to offer [federal] loans and private loans for the next academic year. The key thing is not just whether they will lend at all, but what the terms will be.”

Dr Schilling said that although some of the loans are guaranteed by Washington and are therefore “very low risk”, the market for them “has just gone away”.

Brace for $1 Trillion Writedown of `Yertle the Turtle' Debt

2008-03-31T19:37:00.000-07:00

Review by James Pressley
March 31 (Bloomberg) -- Be it ever so devalued, $1 trillion is a lot of dough.

That's roughly on a par with the Russian economy. More than double the market value of Exxon Mobil Corp. About nine times the combined wealth of Warren Buffett and Bill Gates.

Yet $1 trillion is the amount of defaults and writedowns Americans will likely witness before they emerge at the far side of the bursting credit bubble, estimates Charles R. Morris in his shrewd primer, ``The Trillion Dollar Meltdown.'' That calculation assumes an orderly unwinding, which he doesn't expect.

``The sad truth,'' he writes, ``is that subprime is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008.''

Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps, Morris says. The notional value for those swaps, which are meant to insure bondholders against default, covered about $45 trillion in portfolios as of mid-2007, up from some $1 trillion in 2001, he writes.

Morris can't be dismissed as a crank. A lawyer, former banker and author of 10 other books, he knows a thing or two about the complex instruments that have spread toxic debt throughout the credit system. He once ran a company that made software for creating and analyzing securitized asset pools. Yet he writes with tight clarity and blistering pace.

The financial innovations of the past 25 years have done some good, Morris notes. Collateralized mortgage obligations, invented in 1983, saved homeowners $17 billion a year by the mid-1990s, according to one study.

Slicing and Dicing

CMOs transformed the business by slicing pools of mortgages into different bonds for different risk appetites. Top-tier bonds had the first claim on all cash flows and paid commensurately low yields. The bottom tier was the first to absorb all the losses; it paid yields resembling those on junk bonds.

What began as a good thing, though, soon spawned a bewildering array of new asset classes that spread throughout the financial system, marbling balance sheets with what Morris calls inflated valuations, hidden debt and ``phony triple-A ratings.'' The more the quants fine-tuned the upper tranches of CMOs and other collateralized debt obligations, the more dangerous the bottom slices grew. Bankers began calling it ``toxic waste.''

Guess where the toxins wound up? That's right: Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that ``most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees,'' he writes.

`Utter Thrombosis'

Morris sketches a scenario in which hedge fund counterparty defaults would ripple through default swap markets, triggering writedowns of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer ``an utter thrombosis,'' he says, making the subprime crisis ``look like a walk in the park.''

As bankers and regulators try to prop up the ``Yertle the Turtle-like unstable tower of debt,'' Morris points to two previous episodes of lost market confidence.

The first was the 1970s inflationary trauma that prompted investors to suck money out of the stocks and bonds that finance business. Confidence returned only after Fed chief Paul Volcker slew runaway inflation by ratcheting up interest rates.

The other precedent is the popped 1980s Japanese asset bubble. In that case, politicians and finance executives tried to paper over their troubles. Two decades later, Japan still hasn't recovered, Morris writes.

We should be as bold as Volcker, he suggests: Face the scale of the mess, take a $1 trillion writedown and shore up regulatory measures. His recommendations include forcing loan originators to retain the first losses; requiring prime brokers to stop lending to hedge funds that don't disclose their balance sheets; and bringing the trading of credit derivatives onto exchanges.

What he fears is that the U.S. will instead follow the Japanese precedent, seeking to ``downplay and to conceal. Continuing on that course will be a path to disaster.''

``The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash'' is from PublicAffairs (194 pages, $22.95).

(James Pressley writes for Bloomberg News. The opinions expressed are his own.)

To contact the writer of this review: James Pressley in Brussels at jpressley@bloomberg.net.

NAA Reveals Biggest Ad Revenue Plunge in More Than 50 Years

2008-03-30T16:42:00.001-07:00

Huge Decline in Ads.
By Jennifer Saba

Published: March 28, 2008 12:55 PM ET
NEW YORK The newspaper industry has experienced the worst drop in advertising revenue in more than 50 years.

According to new data released by the Newspaper Association of America, total print advertising revenue in 2007 plunged 9.4% to $42 billion compared to 2006 -- the most severe percent decline since the association started measuring advertising expenditures in 1950.

The drop-off points to an economic slowdown on top of the secular challenges faced by the industry. The second worst decline in advertising revenue occurred in 2001 when it fell 9.0%.

Total advertising revenue in 2007 -- including online revenue -- decreased 7.9% to $45.3 billion compared to the prior year.

There are signs that online revenue is beginning to slow as well. Internet ad revenue in 2007 grew 18.8% to $3.2 billion compared to 2006. In 2006, online ad revenue had soared 31.4% to $2.6 billion. In 2005, it jumped 31.4% to $2 billion.

As newspaper Web sites generate more advertising revenue, the growth rate naturally slows.

The NAA reported that online revenue now represents 7.5% of total newspaper ad revenue in 2007 compared to 5.7% in 2006.

That growth could not stave off the losses in the print however. National print advertising revenue dropped 6.7% to $7 billion last year. Retail slipped 5% to $21 billion. Classified plunged 16.5% to $14.1 billion.

"Even with the near-term challenges posed to print media by a more fragmented information environment and the economic headwinds facing all advertising media, newspapers publishers are continuing to drive strong revenue growth from their increasingly robust Web platforms," John Sturm, president and CEO of the NAA, said in a statement.
*

Not yet time for a bail-out of banks (FT)

2008-03-30T06:21:00.001-07:00

Published: March 28 2008 19:49 | Last updated: March 28 2008 19:49
The “credit crunch” is nearly eight months old, yet shows little sign of easing. It has already forced the US Federal Reserve to slash its benchmark interest rate by 3 percentage points. It has driven central banks to make huge injections of liquidity into markets. Yet this activity has failed to give confidence to markets. So has the time come for a fiscal bail-out? The short answer is: no.

“The heart of the problem is not in the real economy; it is in the financial sector itself,” argued Mervyn King, governor of the Bank of England this week. “It stems from an ‘overhang’ on banks’ balance sheets of assets in which markets have closed ... That has created uncertainty about the strength of banks’ financial positions.”

Inevitably, banks are now unwilling to extend credit. So spreads between official interest rates and the rates at which banks will lend to one another are unusually high. Worse, these spreads have again been rising in recent months.

The many signs of frozen lending are, in turn, creating a lobby for the “something must be done” school. The most plausible “something” is an injection of public money into the mortgage market or, heaven forbid, the financial industry itself.

Such an infusion is to be contemplated only in the direst circumstances. This is not now close to being the case in any affected country. Moreover, the extent of the losses to be tackled will only be known when asset prices stop falling. For this very reason, that point should be reached as soon as possible. Governments should, therefore, avoid trying to support the housing market, but allow it to adjust, instead. Only then will the value of outstanding mortgage-backed securities, and of the institutions that hold them, be known.

So what should be done now? Central banks must use monetary policy to avoid the risk of economic collapse. They should also try to make illiquid securities less so, while leaving credit risk with their holders. Where adequate room for manoeuvre exists, fiscal policy should support monetary policy.

Governments can also help by facilitating renegotiation of mortgages. The principal aim is to avoid unnecessary and costly foreclosures. Finally, regulators should be willing to let institutions operate with somewhat inadequate capital for a while, provided they have clear plans to rectify the situation.

Does this mean that a fiscal bail-out should be ruled out under all circumstances? No. If the financial system were to be so damaged that it proved impossible to sustain aggregate demand, the public sector would have to step in. But it should do so only over the dead bodies of shareholders and management. Those who caused the crisis must not be rescued by taxpayers from the results of their copious follies.

In the meantime, we must understand one point: the hangover from the party will endure a long while.

Paulson's Executive Summary: Liar's Poker

2008-03-29T09:39:00.001-07:00

I. Executive Summary
The mission of the Department of the Treasury (“Treasury”) focuses on promoting economic
growth and stability in the United States. Critical to this mission is a sound and competitive
financial services industry grounded in robust consumer protection and stable and innovative
markets.
Financial institutions play an essential role in the U.S. economy by providing a means for
consumers and businesses to save for the future, to protect and hedge against risks, and to
access funding for consumption or organize capital for new investment opportunities. A
number of different types of financial institutions provide financial services in the United
States: commercial banks and other insured depository institutions, insurers, companies
engaged in securities and futures transactions, finance companies, and specialized companies
established by the government. Together, these institutions and the markets in which they act
underpin economic activity through the intermediation of funds between providers and users
of capital.
This intermediation function is accomplished in a number of ways. For example, insured
depository institutions provide a vehicle to allocate the savings of individuals. Similarly,
securities companies facilitate the transfer of capital among all types of investors and
investment opportunities. Insurers assist in the financial intermediation process by providing
a means for individuals, companies, and other financial institutions to protect assets from
various types of losses. Overall, financial institutions serve a vitally important function in the
U.S. economy by allowing capital to seek out its most productive uses in an efficient matter.
Given the economic significance of the U.S. financial services sector, Treasury considers the
structure of its regulation worthy of examination and reexamination.
Treasury began this current study of regulatory structure after convening a conference on
capital markets competitiveness in March 2007. Conference participants, including current
and former policymakers and industry leaders, noted that while functioning well, the U.S.
regulatory structure is not optimal for promoting a competitive financial services sector
leading the world and supporting continued economic innovation at home and abroad.
Following this conference, Treasury launched a major effort to collect views on how to
improve the financial services regulatory structure.
In this report, Treasury presents a series of “short-term” and “intermediate-term”
recommendations that could immediately improve and reform the U.S. regulatory structure.
The short-term recommendations focus on taking action now to improve regulatory
coordination and oversight in the wake of recent events in the credit and mortgage markets.
The intermediate recommendations focus on eliminating some of the duplication of the U.S.
regulatory system, but more importantly try to modernize the regulatory structure applicable
to certain sectors in the financial services industry (banking, insurance, securities, and
futures) within the current framework.
1
Treasury also presents a conceptual model for an “optimal” regulatory framework. This
structure, an objectives-based regulatory approach, with a distinct regulator focused on one of
three objectives—market stability regulation, safety and soundness regulation associated with
government guarantees, and business conduct regulation—can better react to the pace of
market developments and encourage innovation and entrepreneurialism within a context of
enhanced regulation. This model is intended to begin a discussion about rethinking the
current regulatory structure and its goals. It is not intended to be viewed as altering regulatory
authorities within the current regulatory framework. Treasury views the presentation of a
tangible model for an optimal structure as essential to its mission to promote economic
growth and stability and fully recognizes that this is a first step on a long path to reforming
financial services regulation.
The current regulatory framework for financial institutions is based on a structure that
developed many years ago. The regulatory basis for depository institutions evolved gradually
in response to a series of financial crises and other important social, economic, and political
events: Congress established the national bank charter in 1863 during the Civil War, the
Federal Reserve System in 1913 in response to various episodes of financial instability, and
the federal deposit insurance system and specialized insured depository charters (e.g., thrifts
and credit unions) during the Great Depression. Changes were made to the regulatory system
for insured depository institutions in the intervening years in response to other financial
crises (e.g., the thrift crises of the 1980s) or as enhancements (e.g., the Gramm-Leach-Bliley
Act of 1999 (“GLB Act”)); but, for the most part the underlying structure resembles what
existed in the 1930s. Similarly, the bifurcation between securities and futures regulation, was
largely established over 70 years ago when the two industries were clearly distinct.
In addition to the federal role for financial institution regulation, the tradition of federalism
preserved a role for state authorities in certain markets. This is especially true in the
insurance market, which states have regulated with limited federal involvement for over 135
years. However, state authority over depository institutions and securities companies has
diminished over the years. In some cases there is a cooperative arrangement between federal
and state officials, while in other cases tensions remain as to the level of state authority. In
contrast, futures are regulated solely at the federal level.
Historically, the regulatory structure for financial institutions has served the United States
well. Financial markets in the United States have developed into world class centers of
capital and have led financial innovation. Due to its sheer dominance in the global capital
markets, the U.S. financial services industry for decades has been able to manage the
inefficiencies in its regulatory structure and still maintain its leadership position. Now,
however, maturing foreign financial markets and their ability to provide alternate sources of
capital and financial innovation in a more efficient and modern regulatory system are
pressuring the U.S. financial services industry and its regulatory structure. The United States
can no longer rely on the strength of its historical position to retain its preeminence in the
global markets. Treasury believes it must ensure that the U.S. regulatory structure does not
inhibit the continued growth and stability of the U.S.
2
financial services industry and the economy as a whole. Accordingly, Treasury has
undertaken an analysis to improve this regulatory structure.
Over the past forty years, a number of Administrations have presented important
recommendations for financial services regulatory reforms.
1
Most previous studies have
focused almost exclusively on the regulation of depository institutions as opposed to a
broader scope of financial institutions. These studies served important functions, helping
shape the legislative landscape in the wake of their release. For example, two reports,
Blueprint for Reform: The Report of the Task Group on Regulation of Financial Services
(1984) and Modernizing the Financial System: Recommendations for Safer, More
Competitive Banks (1991), laid the foundation for many of the changes adopted in the GLB
Act.
In addition to these prior studies, similar efforts abroad inform this Treasury report. For
example, more than a decade ago, the United Kingdom conducted an analysis of its financial
services regulatory structure, and as a result made fundamental changes creating a tri-partite
system composed of the central bank (i.e., Bank of England), the finance ministry (i.e., H.M.
Treasury), and the national financial regulatory agency for all financial services (i.e.,
Financial Services Authority). Each institution has well-defined, complementary roles, and
many have judged this structure as having enhanced the competitiveness of the U.K.
economy.
Australia and the Netherlands adopted another regulatory approach, the “Twin Peaks” model,
emphasizing regulation by objective: One financial regulatory agency is responsible for
prudential regulation of relevant financial institutions, and a separate and distinct regulatory
agency is responsible for business conduct and consumer protection issues. These
international efforts reinforce the importance of revisiting the U.S. regulatory structure.
The Need for Review
Market conditions today provide a pertinent backdrop for this report’s release, reinforcing the
direct relationship between strong consumer protection and market stability on the one hand
and capital markets competitiveness on the other and highlighting the need for examining the
U.S. regulatory structure.
Prompting this Treasury report is the recognition that the capital markets and the financial
services industry have evolved significantly over the past decade. These developments, while
providing benefits to both domestic and global economic growth, have also exposed the
financial markets to new challenges.
Globalization of the capital markets is a significant development. Foreign economies are
maturing into market-based economies, contributing to global economic growth and stability
and providing a deep and liquid source of capital outside the United States. Unlike the United
States, these markets often benefit from recently created or newly
1
See Appendix B for background on prior Executive Branch studies.
3
developing regulatory structures, more adaptive to the complexity and increasing pace of
innovation. At the same time, the increasing interconnectedness of the global capital markets
poses new challenges: an event in one jurisdiction may ripple through to other jurisdictions.
In addition, improvements in information technology and information flows have led to
innovative, risk-diversifying, and often sophisticated financial products and trading
strategies. However, the complexity intrinsic to some of these innovations may inhibit
investors and other market participants from properly evaluating their risks. For instance,
securitization allows the holders of the assets being securitized better risk management
opportunities and a new source of capital funding; investors can purchase products with
reduced transactions costs and at targeted risk levels. Yet, market participants may not fully
understand the risks these products pose.
The growing institutionalization of the capital markets has provided markets with liquidity,
pricing efficiency, and risk dispersion and encouraged product innovation and complexity. At
the same time, these institutions can employ significant degrees of leverage and more
correlated trading strategies with the potential for broad market disruptions. Finally, the
convergence of financial services providers and financial products has increased over the past
decade. Financial intermediaries and trading platforms are converging. Financial products
may have insurance, banking, securities, and futures components.
These developments are pressuring the U.S. regulatory structure, exposing regulatory gaps as
well as redundancies, and compelling market participants to do business in other jurisdictions
with more efficient regulation. The U.S. regulatory structure reflects a system, much of it
created over seventy years ago, grappling to keep pace with market evolutions and, facing
increasing difficulties, at times, in preventing and anticipating financial crises.
Largely incompatible with these market developments is the current system of functional
regulation, which maintains separate regulatory agencies across segregated functional lines of
financial services, such as banking, insurance, securities, and futures. A functional approach
to regulation exhibits several inadequacies, the most significant being the fact that no single
regulator possesses all of the information and authority necessary to monitor systemic risk, or
the potential that events associated with financial institutions may trigger broad dislocation or
a series of defaults that affect the financial system so significantly that the real economy is
adversely affected. In addition, the inability of any regulator to take coordinated action
throughout the financial system makes it more difficult to address problems related to
financial market stability.
Second, in the face of increasing convergence of financial services providers and their
products, jurisdictional disputes arise between and among the functional regulators, often
hindering the introduction of new products, slowing innovation, and compelling migration of
financial services and products to more adaptive foreign markets. Examples of recent inter-
agency disputes include: the prolonged process surrounding the
4
development of U.S. Basel II capital rules, the characterization of a financial product as a
security or a futures contract, and the scope of banks’ insurance sales.
Finally, a functional system also results in duplication of certain common activities across
regulators. While some degree of specialization might be important for the regulation of
financial institutions, many aspects of financial regulation and consumer protection
regulation have common themes. For example, although key measures of financial health
have different terminology in banking and insurance—capital and surplus respectively—they
both serve a similar function of ensuring the financial strength and ability of financial
institutions to meet their obligations. Similarly, while there are specific differences across
institutions, the goal of most consumer protection regulation is to ensure consumers receive
adequate information regarding the terms of financial transactions and industry complies with
appropriate sales practices.
Recommendations
Treasury has developed each and every recommendation in this report in the spirit of
promoting market stability and consumer protection. Following is a brief summary of these
recommendations.
Short-Term Recommendations
This section describes recommendations designed to be implemented immediately in the
wake of recent events in the credit and mortgage markets to strengthen and enhance market
stability and business conduct regulation. Treasury views these recommendations as a useful
transition to the intermediate-term recommendations and the proposed optimal regulatory
structure model. However, each recommendation stands on its own merits.
President’s Working Group on Financial Markets
In the aftermath of the 1987 stock market decline an Executive Order established the
President’s Working Group on Financial Markets (“PWG”). The PWG includes the heads of
Treasury, the Federal Reserve, the Securities and Exchange Commission (“SEC”), and the
Commodity Futures Trading Commission (“CFTC”) and is chaired by the Secretary of
Treasury. The PWG was instructed to report on the major issues raised by that stock market
decline and on other recommendations that should be implemented to enhance market
integrity and maintain investor confidence. Since its creation in 1988, the PWG has remained
an effective and useful inter-agency coordinator for financial market regulation and policy
issues.
Treasury recommends the modernization of the current PWG Executive Order in four
different respects to enhance the PWG’s effectiveness as a coordinator of financial regulatory
policy.
5
First, the PWG should continue to serve as an ongoing inter-agency body to promote
coordination and communication for financial policy. But the PWG’s focus should be
broadened to include the entire financial sector, rather than solely financial markets.
Second, the PWG should facilitate better inter-agency coordination and communication in
four distinct areas: mitigating systemic risk to the financial system, enhancing financial
market integrity, promoting consumer and investor protection, and supporting capital markets
efficiency and competitiveness.
Third, the PWG’s membership should be expanded to include the heads of the Office of the
Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”),
and the Office of Thrift Supervision (“OTS”). Similarly, the PWG should have the ability to
engage in consultation efforts, as might be appropriate, with other domestic or international
regulatory and supervisory bodies.
Finally, it should be made clear that the PWG should have the ability to issue reports or other
documents to the President and others, as appropriate, through its role as the coordinator for
financial regulatory policy.
Mortgage Origination
The high levels of delinquencies, defaults, and foreclosures among subprime borrowers in
2007 and 2008 have highlighted gaps in the U.S. oversight system for mortgage origination.
In recent years mortgage brokers and lenders with no federal supervision originated a
substantial portion of all mortgages and over 50 percent of subprime mortgages in the United
States. These mortgage originators are subject to uneven degrees of state level oversight (and
in some cases limited or no oversight).
However, the weaknesses in mortgage origination are not entirely at the state level. Federally
insured depository institutions and their affiliates originated, purchased, or distributed some
problematic subprime loans. There has also been some debate as to whether the OTS, the
Federal Reserve, the Federal Trade Commission (“FTC”), state regulators, or some
combination of all four oversees the affiliates of federally insured depository institutions.
To address gaps in mortgage origination oversight, Treasury’s recommendation has three
components.
First, a new federal commission, the Mortgage Origination Commission (“MOC”), should be
created. The President should appoint a Director for the MOC for a four to six-year term. The
Director would chair a six-person board comprised of the principals (or their designees) of
the Federal Reserve, the OCC, the OTS, the FDIC, the National Credit Union Administration,
and the Conference of State Bank Supervisors. Federal legislation should set forth (or provide
authority to the MOC to develop) uniform minimum licensing qualification standards for
state mortgage market participants. These should include personal conduct and disciplinary
history, minimum educational requirements,
6
testing criteria and procedures, and appropriate license revocation standards. The MOC
would also evaluate, rate, and report on the adequacy of each state’s system for licensing and
regulation of participants in the mortgage origination process. These evaluations would grade
the overall adequacy of a state system by descriptive categories indicative of a system’s
strength or weakness. These evaluations could provide further information regarding whether
mortgages originated in a state should be viewed cautiously before being securitized. The
public nature of these evaluations should provide strong incentives for states to address
weaknesses and strengthen their own systems.
Second, the authority to draft regulations for national mortgage lending laws should continue
to be the sole responsibility of the Federal Reserve. Given its existing role, experience, and
expertise in implementing the Truth in Lending Act (“TILA”) provisions affecting mortgage
transactions, the Federal Reserve should retain the sole authority to write regulations
implementing TILA in this area.
Finally, enforcement authority for federal laws should be clarified and enhanced. For
mortgage originators that are affiliates of depository institutions within a federally regulated
holding company, mortgage lending compliance and enforcement must be clarified. Any
lingering issues concerning the authority of the Federal Reserve (as bank holding company
regulator), the OTS (as thrift holding company regulator), or state supervisory agencies in
conjunction with the holding company regulator to examine and enforce federal mortgage
laws with respect to those affiliates must be addressed. For independent mortgage originators,
the sector of the industry responsible for origination of the majority of subprime loans in
recent years, it is essential that states have clear authority to enforce federal mortgage laws
including the TILA provisions governing mortgage transactions.
Liquidity Provisioning by the Federal Reserve
The disruptions in credit markets in 2007 and 2008 have required the Federal Reserve to
address some of the fundamental issues associated with the discount window and the overall
provision of liquidity to the financial system. The Federal Reserve has considered alternative
ways to provide liquidity to the financial system, including overall liquidity issues associated
with non-depository institutions. The Federal Reserve has used its authority for the first time
since the 1930s to provide access to the discount window to non-depository institutions.
The Federal Reserve’s recent actions reflect the fundamentally different nature of the market
stability function in today’s financial markets compared to those of the past. The Federal
Reserve has balanced the difficult tradeoffs associated with preserving market stability and
considering issues associated with expanding the safety net.
Given the increased importance of non-depository institutions to overall market stability,
Treasury is recommending the consideration of two issues. First, the current temporary
liquidity provisioning process during those rare circumstances when market stability is
threatened should be enhanced to ensure that: the process is calibrated and transparent;
7
appropriate conditions are attached to lending; and information flows to the Federal Reserve
through on-site examination or other means as determined by the Federal Reserve are
adequate. Key to this information flow is a focus on liquidity and funding issues. Second, the
PWG should consider broader regulatory issues associated with providing discount window
access to non-depository institutions.
Intermediate-Term Recommendations
This section describes additional recommendations designed to be implemented in the
intermediate term to increase the efficiency of financial regulation. Some of these
recommendations can be accomplished relatively soon; consensus on others will be difficult
to obtain in the near term.
Thrift Charter
In 1933 Congress established the federal savings association charter (often referred to as the
federal thrift charter) in response to the Great Depression. The federal thrift charter originally
focused on providing a stable source of funding for residential mortgage lending. Over time
federal thrift lending authority has expanded beyond residential mortgages. For example,
Congress broadened federal thrifts’ investment authority in the 1980s and permitted the
inclusion of non-mortgage assets to meet the qualified-thrift lender test in 1996.
In addition, the role of federal thrifts as a dominant source of mortgage funding has
diminished greatly in recent years. The increased residential mortgage activity of
government-sponsored enterprises (“GSEs”) and commercial banks, as well as the general
development of the mortgage-backed securities market, has driven this shift.
Treasury recommends phasing out and transitioning the federal thrift charter to the national
bank charter as the thrift charter is no longer necessary to ensure sufficient residential
mortgage loans are made available to U.S. consumers. With the elimination of the federal
thrift charter the OTS would be closed and its operations would be assumed by the OCC.
This transition should take place over a two-year period.
Federal Supervision of State-Chartered Banks
State-chartered banks with federal deposit insurance are currently subject to both state and
federal supervision. If the state-chartered bank is a member of the Federal Reserve System,
the Federal Reserve administers federal oversight. Otherwise, the FDIC oversees state-
chartered banks.
The direct federal supervision of state-chartered banks should be rationalized. One approach
would be to place all such banking examination responsibilities for state-chartered banks with
federal deposit insurance with the Federal Reserve.
8
Another approach would be to place all such bank examination responsibilities for state-
chartered banks with federal deposit insurance with the FDIC.
Any such shift of supervisory authority for state-chartered banks with federal deposit
insurance from the Federal Reserve to the FDIC or vice versa raises a number of issues
regarding the overall structure of the Federal Reserve System. To further consider this issue,
Treasury recommends a study, one that examines the evolving role of Federal Reserve
Banks, to make a definitive proposal regarding the appropriate federal supervisor of state-
chartered banks.
Payment and Settlement Systems Oversight
Payment and settlement systems are the mechanisms used to transfer funds and financial
instruments between financial institutions and between financial institutions and their
customers. Payment and settlement systems play a fundamental and important role in the
economy by providing a range of mechanisms through which financial institutions can easily
settle transactions. The United States has various payment and settlement systems, including
large-value and retail payment and settlement systems, as well as settlement systems for
securities and other financial instruments.
In the United States major payment and settlement systems are generally not subject to any
uniform, specifically designed, and overarching regulatory system. Moreover, there is no
defined category within financial regulation focused on payment and settlement systems. As
a result, regulation of major payment and settlement systems is idiosyncratic, reflecting
choices made by payment and settlement systems based on options available at some
previous time.
To address the issue of payment and settlement system oversight, a federal charter for
systemically important payment and settlement systems should be created and should
incorporate federal preemption. The Federal Reserve should have primary oversight
responsibilities for such payment and settlement systems, should have discretion to designate
a payment and settlement system as systemically important, and should have a full range of
authority to establish regulatory standards.
Insurance
For over 135 years, states have primarily regulated insurance with little direct federal
involvement. While a state-based regulatory system for insurance may have been appropriate
over some portion of U.S. history, changes in the insurance marketplace have increasingly
put strains on the system.
Much like other financial services, over time the business of providing insurance has moved
to a more national focus even within the state-based regulatory structure. The inherent nature
of a state-based regulatory system makes the process of developing national products
cumbersome and more costly, directly impacting the competitiveness of U.S. insurers.
9
There are a number of potential inefficiencies associated with the state-based insurance
regulatory system. Even with the efforts of the National Association of Insurance
Commissioners (“NAIC”) to foster greater uniformity through the development of model
laws and other coordination efforts, the ultimate authority still rests with individual states.
For insurers operating on a national basis, this means not only being subject to licensing
requirements and regulatory examinations in all states where the insurer operates, but also
operating under different laws in each state.
In addition to a more national focus today, the insurance marketplace operates globally with
many significant foreign participants. A state-based regulatory system creates increasing
tensions in such a global marketplace, both in the ability of U.S.-based firms to compete
abroad and in allowing greater participation of foreign firms in U.S. markets.
To address these issues in the near term, Treasury recommends establishing an optional
federal charter (“OFC”) for insurers within the current structure. An OFC structure should
provide for a system of federal chartering, licensing, regulation, and supervision for insurers,
reinsurers, and insurance producers (i.e., agents and brokers). It would also provide that the
current state-based regulation of insurance would continue for those not electing to be
regulated at the national level. States would not have jurisdiction over those electing to be
federally regulated. However, insurers holding an OFC could still be subject to some
continued compliance with other state laws, such as state tax laws, compulsory coverage for
workers’ compensation and individual auto insurance, as well as the requirements to
participate in state mandatory residual risk mechanisms and guarantee funds.
An OFC would be issued to specify the lines of insurance that each national insurer would be
permitted to sell, solicit, negotiate, and underwrite. For example, an OFC for life insurance
could also include annuities, disability income insurance, long-term care insurance, and
funding agreements. On the other hand, an OFC for property and casualty insurance could
include liability insurance, surety bonds, automobile insurance, homeowners, and other
specified lines of business. However, since the nature of the business of life insurers is very
different from that of property and casualty insurers, no OFC would authorize an insurer to
hold a license as both a life insurer and a property and casualty insurer.
The establishment of an OFC should incorporate a number of fundamental regulatory
concepts. For example, the OFC should ensure safety and soundness, enhance competition in
national and international markets, increase efficiency in a number of ways, including the
elimination of price controls, promote more rapid technological change, encourage product
innovation, reduce regulatory costs, and provide consumer protection.
Treasury also recommends the establishment of the Office of National Insurance (“ONI”)
within Treasury to regulate those engaged in the business of insurance pursuant to an OFC.
The Commissioner of National Insurance would head ONI and would have
10
specified regulatory, supervisory, enforcement, and rehabilitative powers to oversee the
organization, incorporation, operation, regulation, and supervision of national insurers and
national agencies.
While an OFC offers the best opportunity to develop a modern and comprehensive system of
insurance regulation in the short term, Treasury acknowledges that the OFC debate in
Congress is difficult and ongoing. At the same time, Treasury believes that some aspects of
the insurance segment and its regulatory regime require immediate attention. In particular,
Treasury recommends that Congress establish an Office of Insurance Oversight (“OIO”)
within Treasury. The OIO through its insurance oversight would be able to focus
immediately on key areas of federal interest in the insurance sector.
The OIO should be established to accomplish two main purposes. First, the OIO should
exercise newly granted statutory authority to address international regulatory issues, such as
reinsurance collateral. Therefore, the OIO would become the lead regulatory voice in the
promotion of international insurance regulatory policy for the United States (in consultation
with the NAIC), and it would be granted the authority to recognize international regulatory
bodies for specific insurance purposes. The OIO would also have authority to ensure that the
NAIC and state insurance regulators achieved the uniform implementation of the declared
U.S. international insurance policy goals. Second, the OIO would serve as an advisor to the
Secretary of Treasury on major domestic and international policy issues. Once Congress
passes significant insurance regulatory reform, the OIO could be incorporated into the OFC
framework.
Futures and Securities
The realities of the current marketplace have significantly diminished, if not entirely
eliminated, the original reason for the regulatory bifurcation between the futures and
securities markets. These markets were truly distinct in the 1930s at the time of the enactment
of the Commodity Exchange Act and the federal securities laws. This bifurcation operated
effectively until the 1970s when futures trading soon expanded beyond agricultural
commodities to encompass the rise and eventual dominance on non-agricultural
commodities.
Product and market participant convergence, market linkages, and globalization have
rendered regulatory bifurcation of the futures and securities markets untenable, potentially
harmful, and inefficient. To address this issue, the CFTC and the SEC should be merged to
provide unified oversight and regulation of the futures and securities industries.
An oft-cited argument against the merger of the CFTC and the SEC is the potential loss of
the CFTC’s principles-based regulatory philosophy. Treasury would like to preserve the
market benefits achieved in the futures area. Accordingly, Treasury recommends that the
SEC undertake a number of specific actions, within its current regulatory structure and under
its current authority, to modernize the SEC’s regulatory approach to
11
accomplish a more seamless merger of the agencies. These recommendations would reflect
rapidly evolving market dynamics. These steps include the following:

• The SEC should use its exemptive authority to adopt core principles to apply to securities
clearing agencies and exchanges. These core principles should be modeled after the core
principles adopted for futures exchanges and clearing organizations under the
Commodity Futures Modernization Act (“CFMA”). By imbuing the SEC with a
regulatory regime more conducive to the modern marketplace, a merger between the
agencies will proceed more smoothly.

• The SEC should issue a rule to update and streamline the self-regulatory organization
(“SRO”) rulemaking process to recognize the market and product innovations of the past
two decades. The SEC should consider streamlining and expediting the SRO rule
approval process, including a firm time limit for the SEC to publish SRO rule filings and
more clearly defining and expanding the type of rules deemed effective upon filing,
including trading rules and administrative rules. The SEC should also consider
streamlining the approval for any securities products common to the marketplace as the
agency did in a 1998 rulemaking vis-à-vis certain derivatives securities products. An
updated, streamlined, and expedited approval process will allow U.S. securities firms to
remain competitive with the over-the-counter markets and international institutions and
increase product innovation and investor choice.

• The SEC should undertake a general exemptive rulemaking under the Investment Company
Act of 1940 (“Investment Company Act”), consistent with investor protection, to permit
the trading of those products already actively trading in the U.S. or foreign jurisdictions.
Treasury also recommends that the SEC propose to Congress legislation that would
expand the Investment Company Act by permitting registration of a new “global”
investment company.

These steps should help modernize the SEC’s regulation prior to the merger of the CFTC and
the SEC. Legislation merging the CFTC and the SEC should not only call for a structural
merger, but also a process to merge regulatory philosophies and to harmonize securities and
futures regulations and statutes. The merger plan should also address certain key aspects:

• Concurrent with the merger, the new agency should adopt overarching regulatory principles
focusing on investor protection, market integrity, and overall financial system risk
reduction. This will help meld the regulatory philosophies of the agencies. Legislation
calling for a merger should task the PWG with drafting these principles.

• Consistent with structure of the CFMA, all clearing agency and market SROs should be
permitted by statute to self-certify all rulemakings (except those involving corporate
listing and market conduct standards), which then become effective upon filing. The SEC
would retain its right to abrogate the rulemakings at any time. By

12

limiting self-certified SRO rule changes to non-retail investor related rules, investor
protection will be preserved.

• Several differences between futures regulation and federal securities regulation would need
to be harmonized. These include rules involving margin, segregation, insider trading,
insurance coverage for broker-dealer insolvency, customer suitability, short sales, SRO
mergers, implied private rights of action, the SRO rulemaking approval process, and the
agency’s funding mechanism. Due to the complexities and nuances of the differences in
futures and securities regulation, legislation should establish a joint CFTC-SEC staff task
force with equal agency representation with the mandate to harmonize these differences.
In addition, the task force should be charged with recommending the structure of the
merged agency, including its offices and divisions.

Finally, there has also been a continued convergence of the services provided by broker-
dealers and investment advisers within the securities industry. These entities operate under a
statutory regime reflecting the brokerage and investment advisory industries as they existed
decades ago. Accordingly, Treasury recommends statutory changes to harmonize the
regulation and oversight of broker-dealers and investment advisers offering similar services
to retail investors. In that vein, the establishment of a self-regulatory framework for the
investment advisory industry would enhance investor protection and be more cost-effective
than direct SEC regulation. Thus, to effectuate this statutory harmonization, Treasury
recommends that investment advisers be subject to a self-regulatory regime similar to that of
broker-dealers.
Long-Term Optimal Regulatory Structure
While there are many possible options to reform and strengthen the regulation of financial
institutions in the United States, Treasury considered four broad conceptual options in this
review. First, the United States could maintain the current approach of the GLB Act that is
broadly based on functional regulation divided by historical industry segments of banking,
insurance, securities, and futures. Second, the United States could move to a more functional-
based system regulating the activities of financial services firms as opposed to industry
segments. Third, the United States could move to a single regulator for all financial services
as adopted in the United Kingdom. Finally, the United States could move to an objectives-
based regulatory approach focusing on the goals of regulation as adopted in Australia and the
Netherlands.
After evaluating these options, Treasury believes that an objectives-based regulatory
approach would represent the optimal regulatory structure for the future. An objectives-based
approach is designed to focus on the goals of regulation in terms of addressing particular
market failures. Such an evaluation leads to a regulatory structure focusing on three key
goals:

• Market stability regulation to address overall conditions of financial market stability
that could impact the real economy;

13

• Prudential financial regulation to address issues of limited market discipline caused by
government guarantees; and

• Business conduct regulation (linked to consumer protection regulation) to address
standards for business practices.

More closely linking the regulatory objectives of market stability regulation, prudential
financial regulation, and business conduct regulation to regulatory structure greatly improves
regulatory efficiency. In particular, a major advantage of objectives-based regulation is that
regulatory responsibilities are consolidated in areas where natural synergies take place, as
opposed to the current approach of dividing these responsibilities among individual
regulators. For example, a dedicated market stability regulator with the appropriate mandate
and authority can focus broadly on issues that can impact market stability across all types of
financial institutions. Prudential financial regulation housed within one regulatory body can
focus on common elements of risk management across financial institutions. A dedicated
business conduct regulator leads to greater consistency in the treatment of products,
eliminates disputes among regulatory agencies, and reduces gaps in regulation and
supervision.
In comparison to other regulatory structures, an objectives-based approach is better able to
adjust to changes in the financial landscape than a structure like the current U.S. system
focused on industry segments. An objectives-based approach also allows for a clearer focus
on particular goals in comparison to a structure that consolidates all types of regulation in one
regulatory body. Finally, clear regulatory dividing lines by objective also have the most
potential for establishing the greatest levels of market discipline because financial regulation
can be more clearly targeted at the types of institutions for which prudential regulation is
most appropriate.
In the optimal structure three distinct regulators would focus exclusively on financial
institutions: a market stability regulator, a prudential financial regulator, and a business
conduct regulator. The optimal structure also describes the roles of two other key authorities,
the federal insurance guarantor and the corporate finance regulator.
The optimal structure also sets forth a structure rationalizing the chartering of financial
institutions. The optimal structure would establish a federal insured depository institution
(“FIDI”) charter for all depository institutions with federal deposit insurance; a federal
insurance institution (“FII”) charter for insurers offering retail products where some type of
government guarantee is present; and a federal financial services provider (“FFSP”) charter
for all other types of financial services providers. The market stability regulator would have
various authorities over all three types of federally chartered institutions. A new prudential
regulator, the Prudential Financial Regulatory Agency (“PFRA”), would be responsible for
the financial regulation of FIDIs and FIIs. A new business conduct regulator, the Conduct of
Business Regulatory Agency (“CBRA”), would be responsible for business conduct
regulation, including consumer protection issues, across all types of firms, including the three
types of federally chartered institutions. More detail regarding the responsibilities of these
regulators follows.
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Market Stability Regulator – The Federal Reserve
The market stability regulator should be responsible for overall issues of financial market
stability. The Federal Reserve should assume this role in the optimal framework given its
traditional central bank role of promoting overall macroeconomic stability. As is the case
today, important elements of the Federal Reserve’s market stability role would be conducted
through the implementation of monetary policy and the provision of liquidity to the financial
system. In addition, the Federal Reserve should be provided with a different, yet critically
important regulatory role and broad powers focusing on the overall financial system and the
three types of federally chartered institutions (i.e., FIIs, FIDIs, or FFSPs). Finally, the Federal
Reserve should oversee the payment and settlement system.
In terms of its recast regulatory role focusing on systemic risk, the Federal Reserve should
have the responsibility and authority to gather appropriate information, disclose information,
collaborate with the other regulators on rule writing, and take corrective actions when
necessary in the interest of overall financial market stability. This new role would replace its
traditional role as a supervisor of certain banks and all bank holding companies.
Treasury recognizes the need for enhanced regulatory authority to deal with systemic risk.
The Federal Reserve’s responsibilities would be broad, important, and difficult to undertake.
In a dynamic market economy it is impossible to fully eliminate instability through
regulation. At a fundamental level, the root causes of market instability are difficult to
predict, and past history may be a poor predictor of future episodes of instability. However,
the Federal Reserve’s enhanced regulatory authority along with clear regulatory
responsibilities would complement and attempt to focus market discipline to limit systemic
risk.
2

A number of key long-term issues should be considered in establishing this new framework.
First, in order to perform this critical role, the Federal Reserve must have detailed
information about the business operations of PFRA- and CBRA-regulated financial
institutions and their respective holding companies. Such information will be important in
evaluating issues that can have an impact on overall financial market stability.
The other regulators should be required to share all financial reports and examination reports
with the Federal Reserve as requested. Working jointly with PFRA, the Federal
2
Treasury notes that the PWG, the Federal Reserve Bank of New York, and the OCC have previously
stated that market discipline is the most effective tool to limit systemic risk. See Agreement among PWG
and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital (Feb. 2007).
See also PWG, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 24-
25, 30 (Apr. 1999); PWG, OVER-THE-COUNTER DERIVATIVES MARKETS AND THE COMMODITY EXCHANGE
ACT 34-35 (Nov. 1999).
15
Reserve should also have the ability to develop additional information-reporting requirements
on issues important to overall market stability.
The Federal Reserve should also have the authority to develop information-reporting
requirements for FFSPs and for holding companies with federally chartered financial
institution affiliates. In terms of holding company reporting requirements, such reporting
should include a requirement to consolidate financial institutions onto the balance sheet of
the overall holding company and at the segmented level of combined federally chartered
financial institutions. Such information-reporting requirements could also include detailed
reports on overall risk management practices.
As an additional information-gathering tool, the Federal Reserve should also have the
authority to participate in PFRA and CBRA examinations of federally chartered entities, and
to initiate such examinations targeted on practices important to market stability. Targeted
examinations of a PFRA- or CBRA-supervised entity should occur only if the information
the Federal Reserve needs is not available from PFRA or CBRA and should be coordinated
with PFRA and CBRA.
Based on the information-gathering tools described above, the Federal Reserve should
publish broad aggregates or peer group information about financial exposures that are
important to overall market stability. Disseminating such information to the public could
highlight areas of risk exposure that market participants should be monitoring. The Federal
Reserve should also be able to mandate additional public disclosures for federally chartered
financial institutions that are publicly traded or for a publicly traded company controlling
such an institution.
Second, the type of information described above will be vitally important in performing the
market stability role and in better harnessing market forces. However, the Federal Reserve
should also have authority to provide input into the development of regulatory policy and to
undertake corrective actions related to enhancing market stability. With respect to regulatory
policy, PFRA and CBRA should be required to consult with the Federal Reserve prior to
adopting or modifying regulations affecting market stability, including capital requirements
for PFRA-regulated institutions and chartering requirements for CBRA-regulated institutions,
and supervisory guidance regarding areas important to market stability (e.g., liquidity risk
management, contingency funding plans, and counterparty risk management).
With regard to corrective actions, if after analyzing the information described above the
Federal Reserve determines that certain risk exposures pose an overall risk to the financial
system or the broader economy, the Federal Reserve should have authority to require
corrective actions to address current risks or to constrain future risk-taking. For example, the
Federal Reserve could use this corrective action authority to require financial institutions to
limit or more carefully monitor risk exposures to certain asset classes or to certain types of
counterparties or address liquidity and funding issues.
16
The Federal Reserve’s authority to require corrective actions should be limited to instances
where overall financial market stability was threatened. The focus of the market stability
regulator’s corrective actions should wherever possible be broadly based across particular
institutions or across asset classes. Such actions should be coordinated and implemented with
the appropriate regulatory agency to the fullest extent possible. But the Federal Reserve
would have residual authority to enforce compliance with its requirements under this
authority.
Third, the Federal Reserve’s current lender of last resort function should continue through the
discount window. A primary function of the discount window is to serve as a complementary
tool of monetary policy by making short-term credit available to insured depository
institutions to address liquidity issues. The historic focus of Federal Reserve discount
window lending reflects the relative importance of banks as financial intermediaries and a
desire to limit the spread of the federal safety net. However, banks’ somewhat diminished
role and the increased role of other types of financial institutions in overall financial
intermediation may have reduced the effectiveness of this traditional tool in achieving market
stability.
To address the limited effectiveness of discount window lending over time, a distinction
could be made between “normal” discount window lending and “market stability” discount
window lending. Access to normal discount window funding for FIDIs—including
borrowing under the primary, secondary, and seasonal credit programs—could continue to
operate much as it does today. All FIDIs would have access to normal discount window
funding, which would continue to serve as a complementary tool of monetary policy by
providing a mechanism to smooth out short-term volatility in reserves, and providing some
degree of liquidity to FIDIs. Current Federal Reserve discount window policies regarding
collateral, above market pricing, and maturity should remain in place. With such policies in
place, normal discount window funding would likely be used infrequently.
In addition, the Federal Reserve should have the ability to undertake market stability discount
window lending. Such lending would expand the Federal Reserve’s lender of last resort
function to include non-FIDIs. A sufficiently high threshold for invoking market stability
discount window lending (i.e., overall threat to financial system stability) should be
established. Market stability discount window lending should be focused wherever possible
on broad types of institutions as opposed to individual institutions. In addition, market
stability discount window lending would have to be supported by Federal Reserve authority
to collect information from and conduct examinations of borrowing firms in order to protect
the Federal Reserve (and thereby the taxpayer).
Prudential Financial Regulator
The optimal structure should establish a new prudential financial regulator, PFRA. PFRA
should focus on financial institutions with some type of explicit government guarantees
associated with their business operations. Most prominent examples of this type of
government guarantee in the United States would include federal deposit
17
insurance and state-established insurance guarantee funds. Although protecting consumers
and helping to maintain confidence in the financial system, explicit government guarantees
often erode market discipline, creating the potential for moral hazard and a clear need for
prudential regulation. Prudential regulation in this context should be applied to individual
firms, and it should operate like the current regulation of insured depository institutions, with
capital adequacy requirements, investment limits, activity limits, and direct on-site risk
management supervision. PFRA would assume the roles of current federal prudential
regulators, such as the OCC and the OTS.
A number of key long-term issues should be considered in establishing the new prudential
regulatory framework. First, the optimal structure should establish a new FIDI charter. The
FIDI charter would consolidate the national bank, federal savings association, and federal
credit union charters and should be available to all corporate forms, including stock, mutual,
and cooperative ownership structures. A FIDI charter should provide “field” preemption over
state laws to reflect the national nature of financial services. In addition, to obtain federal
deposit insurance a financial institution would have to obtain a FIDI charter. PFRA’s
prudential regulation and oversight should accompany the provision of federal deposit
insurance. The goal of establishing a FIDI charter is to create a level playing field among all
types of depository institutions where competition can take place on an economic basis rather
than on the basis of regulatory differences.
Activity limits should be imposed on FIDIs to serve the traditional prudential function of
limiting risk to the deposit insurance fund. A starting place could be the activities that are
currently permissible for national banks.
PFRA’s regulation regarding affiliates should be based primarily at the individual FIDI level.
Extending PFRA’s direct oversight authority to the holding company should be limited as
long as PFRA has an appropriate set of tools to protect a FIDI from affiliate relationships. At
a minimum, PFRA should be provided the same set of tools that exists today at the individual
bank level to protect a FIDI from potential risks associated with affiliate relationships. In
addition, consideration should be given to strengthen further PFRA’s authority in terms of
limiting transactions with affiliates or requiring financial support from affiliates. PFRA
should be able to monitor and examine the holding company and the FIDI’s affiliates in order
to ensure the effective implementation of these protections. With these added protections in
place, from the perspective of protecting a FIDI, activity restrictions on affiliate relationships
are much less important.
Holding company regulation was designed to protect the assets of the insured depository
institution and to prevent the affiliate structure from threatening the assets of the insured
institution. However, some view holding company supervision as way to protect against
systemic risk. The optimal structure decouples those two regulatory objectives as the blurring
of these objectives is ineffective and confusing. Therefore, PFRA will focus on the original
intent of holding company supervision, protecting the assets of the insured depository
institution; and a new market stability regulator will focus on broader systemic risk issues.
18
Second, to address the inefficiencies in the state-based insurance regulatory system, the
optimal structure should establish a new FII charter. Similar to the FIDI charter, a FII charter
should apply to insurers offering retail products where some type of government guarantee is
present. In terms of a government guarantee, in the long run a uniform and consistent
federally established guarantee structure, the Federal Insurance Guarantee Fund (“FIGF”),
could accompany a system of federal oversight, although the existing state-level guarantee
system could remain in place. PFRA would be responsible for the financial regulation of FIIs
under the same structure as FIDIs.
Finally, some consideration should focus on including GSEs within the traditional prudential
regulatory framework. Given the market misperception that the federal government stands
behind the GSEs’ obligations, one implication of the optimal structure is that PFRA should
not regulate the GSEs. Nonetheless, given that the federal government has charged the GSEs
with a specific mission, some type of prudential regulation would be necessary to ensure that
they can accomplish that mission. To address these challenging issues, in the near term, a
separate regulator should conduct prudential oversight of the GSEs and the market stability
regulator should have the same ability to evaluate the GSEs as it has for other federally
chartered institutions.
Business Conduct Regulator
The optimal structure should establish a new business conduct regulator, CBRA. CBRA
should monitor business conduct regulation across all types of financial firms, including FIIs,
FIDIs, and FFSPs. Business conduct regulation in this context includes key aspects of
consumer protection such as disclosures, business practices, and chartering and licensing of
certain types of financial firms. One agency responsible for all financial products should
bring greater consistency to areas of business conduct regulation where overlapping
requirements currently exist. The business conduct regulator’s chartering and licensing
function should be different than the prudential regulator’s financial oversight
responsibilities. More specifically, the focus of the business conduct regulator should be on
providing appropriate standards for firms to be able to enter the financial services industry
and sell their products and services to customers.
A number of key long-term issues should be considered in establishing the new business
conduct regulatory framework.
First, as part of CBRA’s regulatory function, CBRA would be responsible for the chartering
and licensing of a wide range of financial firms. To implement the chartering function, the
optimal structure should establish a new FFSP charter for all financial services providers that
are not FIDIs or FIIs. The FFSP charter should be flexible enough to incorporate a wide
range of financial services providers, such as broker-dealers, hedge funds, private equity
funds, venture capital funds, and mutual funds. The establishment of a FFSP charter would
result in the creation of appropriate national standards, in terms of financial capacity,
expertise, and other requirements, that must be satisfied to enter the business of providing
financial services. For example, these standards would resemble
19
the net capital requirements for broker-dealers for that type of FFSP charter. In addition to
meeting appropriate financial requirements to obtain a FFSP charter, these firms would also
have to remain in compliance with appropriate standards and provide regular updates on
financial conditions to CBRA, the Federal Reserve, and the public as part of their standard
public disclosures. CBRA would also oversee and regulate the business conduct of FIDIs and
FIIs.
Second, the optimal structure should clearly specify the types of business conduct issues
where CBRA would have oversight authority. In terms of FIDIs’ banking and lending,
CBRA should have oversight responsibilities in three broad categories: disclosure, sales and
marketing practices (including laws and regulations addressing unfair and deceptive
practices), and anti-discrimination laws. Similar to banking and lending, CBRA should have
the authority to regulate FIIs’ insurance business conduct issues associated with disclosures,
business practices, and discrimination. CBRA’s main areas of authority would include
disclosure issues related to policy forms, unfair trade practices, and claims handling
procedures.
In term of business conduct issues for FFSPs, such as securities and futures firms and their
markets, CBRA’s focus would include operational ability, professional conduct, testing and
training, fraud and manipulation, and duties to customers (e.g., best execution and investor
suitability).
Third, CBRA’s responsibilities for business conduct regulation in the optimal structure would
be very broad. CBRA’s responsibilities would take the place of those of the Federal Reserve
and other insured depository institution regulators, state insurance regulators, most aspects of
the SEC’s and the CFTC’s responsibilities, and some aspect of the FTC’s role.
Given the breadth and scope of CBRA’s responsibilities, some aspect of self-regulation
should form an important component of implementation. Given its significance and
effectiveness in the futures and securities industry, the SRO model should be preserved. That
model could be considered for other areas, or the structure could allow for certain
modifications, such as maintaining rule writing authority with CRBA, while relying on an
SRO model for compliance and enforcement.
Finally, the proper role of state authorities should be established in the optimal structure.
CBRA would be responsible for setting national standards for a wide range of business
conduct laws across all types of financial services providers. CBRA’s national standards
would apply to all financial services firms, whether federally or state-chartered. In addition,
field preemption would be provided to FIDIs, FIIs, and FFSPs, preempting state business
conduct laws directly relating to the provision of financial services.
In the optimal structure, states would still retain clear authority to enact laws and take
enforcement actions against state-chartered financial service providers. In considering the
future role of the states vis-à-vis federally chartered institutions, the optimal structure seeks
to acknowledge the existing national market for financial products, while at the
20
same time preserving an appropriate role for state authorities to respond to local conditions.
Two options should be considered to accomplish that goal. First, state authorities could be
given a formalized role in CBRA’s rulemaking process as a means of utilizing their extensive
local experience. Second, states could also play a role in monitoring compliance and
enforcement.
Federal Insurance Guarantee Corporation
The FDIC should be reconstituted as the Federal Insurance Guarantee Corporation (“FIGC”)
to administer not only deposit insurance, but also the FIGF (if one is created and valid
reasons to leave this at the state level exist as discussed in the report). The FIGC should
function primarily as an insurer in the optimal structure. Much as the FDIC operates today,
the FIGC would have the authority to set risk-based premiums, charge ex-post assessments,
act as a receiver for failed FIDIs or FIIs, and maintain some back-up examination authority
over those institutions. The FIGC will not possess any additional direct regulatory authority.
Corporate Finance Regulator
The corporate finance regulator should have responsibility for general issues related to
corporate oversight in public securities markets. These responsibilities should include the
SEC’s current responsibilities over corporate disclosures, corporate governance, accounting
oversight, and other similar issues. As discussed above, CBRA would assume the SEC’s
current business conduct regulatory and enforcement authority over financial institutions.
Conclusion
The United States has the strongest and most liquid capital markets in the world. This
strength is due in no small part to the U.S. financial services industry regulatory structure,
which promotes consumer protection and market stability. However, recent market
developments have pressured this regulatory structure, revealing regulatory gaps and
redundancies. These regulatory inefficiencies may serve to detract from U.S. capital markets
competitiveness.
In order to ensure the United States maintains its preeminence in the global capital markets,
Treasury sets forth the aforementioned recommendations to improve the regulatory structure
governing financial institutions. Treasury has designed a path to move from the current
functional regulatory approach to an objectives-based regulatory regime through a series of
specific recommendations. The short-term recommendations focus on immediate reforms
responding to the current events in the mortgage and credit markets. The intermediate
recommendations focus on modernizing the current regulatory structure within the current
functional system.
21
The short-term and intermediate recommendations will drive the evolution of the U.S.
regulatory structure towards the optimal regulatory framework, an objectives-based regime
directly linking the regulatory objectives of market stability regulation, prudential financial
regulation, and business conduct regulation to the regulatory structure. Such a framework
best promotes consumer protection and stable and innovative markets.
22

High prices spark fresh gold rush in California (FT)

2008-03-29T07:24:00.000-07:00

By Matthew Garrahan in Los Angeles
Published: March 28 2008 20:38 | Last updated: March 28 2008 20:38
It has been almost 160 years since the first California gold rush but, with prices hitting record highs, prospectors are once again flocking to the state’s rivers and deserts in search of the precious metal.

Gold’s ascent – prices crossed the $1,000 an ounce barrier this month and remain well above $900 – has sent sales of mining equipment soaring.

“There’s been a dramatic change . . . our sales have risen four-fold in the last three months,” said Harrigan McGregor, owner of GoldFeverProspecting.com, an equipment retailer in northern California.

“This is the second big California gold rush. We’ve had a lot of phone calls from people who are quitting their jobs and prospecting full-time.”

The growth of prospecting by individuals has been accompanied by a sharp increase in commercial mining activity. Commercial claims, most of which involve gold mining, rocketed to 2,274 in the first quarter of this year, up from 132 in the same period of 2005, the Bureau of Land Management says.

Roger Haskins, senior specialist for mining law at the BLM, said the high price of gold was “obviously driving [mining] activity up tremendously”.

“We have a market imbalance at the moment and there’s more demand than supply,” he added. “Gold sits in a little niche because it’s speculative . . . People buy it as a hedge for the future.”

Membership in the Gold Prospectors Association of America “has tripled in a very short space of time”, said Corey Rudolph, an official of the southern California-based group, which organises events for recreational miners.

The hotspot is a 320km strip known as the Gold Belt, or “Motherlode”, which runs near Highway 49 (named for prospecting “49ers” of the 19th century) and the Sierra Nevada mountains. Mr Rudolph said 5-10 per cent of available gold had been mined. “There’s still a lot of gold out there for the smart guys.”

The market in second-hand gold is also booming, with southern California pawnshops reporting increased trade as people sell unwanted gold items. Depending on the quality, these items can be refined and resold.

However, Mr McGregor said raw gold can fetch even higher prices. “If you find a nugget larger than your pinkie finger, it could sell for up to 30 per cent more than the spot price.”

Fed offers $100 billion more to banks: Why not, it's only money!

2008-03-28T10:11:00.000-07:00

By MARTIN CRUTSINGER, AP Economics Writer
32 minutes ago
WASHINGTON - The Federal Reserve announced Friday it will auction another $100 billion in April to cash-strapped banks as it continues to combat the effects of a credit crisis.

The central bank said it would make $50 billion available at each of two auctions, on April 7 and April 21.

Through the end of March, the Fed has provided $260 billion in short-term loans to commercial banks through the innovative auction process. It also has employed Depression-era provisions to provide money to investment banks.

All the moves have been designed to cope with a serious financial crisis that has roiled U.S. and global markets and caused the near-collapse of Bear Stearns Cos., the nation's fifth largest investment bank.

The Fed has been holding auctions every two seeks since December to provide short-term loans to commercial banks. It started with auctions of $20 billion, then pushed the level to $30 billion, and in early March raised the auction amount to $50 billion as the credit shortage grew more severe.

In announcing the move to $50 billion last month, the Fed said it would continue the auctions for at least the next six months, unless credit conditions show they are no longer needed.

The auctions are just one of a series of unorthodox steps the Fed has taken to battle the current crisis. The biggest of those moves was an announcement that it was allowing investment banks to borrow directly from the Fed. Previously, only commercial banks, which face tighter regulations, had that privilege.

The Fed also said it would make available $30 billion in financing to support the sale of troubled Bear Stearns to JP Morgan Chase & Co., hoping to prevent a bankruptcy that could have rocked Wall Street.

The Fed's auctions have drawn criticism from some that the central bank, and ultimately U.S. taxpayers, could be financing a bailout for big Wall Street firms that had engaged in risky lending practices.

Fed Chairman Ben Bernanke will fact questions about the Fed's recent moves when he testifies on Wednesday before the congressional Joint Economic Committee.

South Korean Pension Fund to Shun US Treasurys! Well if you can't fool your friends, where do you go?

2008-03-27T18:37:00.000-07:00

By Reuters | 27 Mar 2008 | 07:05 PM ET Font size:
South Korea's National Pension Service, the world's fifth-biggest pension fund, said on Thursday it was shying away from U.S. Treasurys because of falling yields and the weakening dollar.
The move by the NPS could signal a big shift by financial institutions away from U.S. government debt into higher-yielding assets, the Financial Times said.

The fund, which expects its assets to rise to 250 trillion won by the end of 2008, holds about 17.4 trillion won (US$17.63 billion) worth of foreign bonds of which U.S. Treasurys account for 94 percent. Those figures would suggest NPS holds about 16.4 trillion won in U.S. Treasurys.

"We sees the attractiveness of U.S. Treasurys falling," NPS spokeswoman, Chi Younghye, said. "The overall size of foreign bonds this year will be similar to last year's. There will be little net increase in our holding of foreign bonds for a while." She said if yields are more attractive later, the NPS would start buying again.

NPS holdings in U.S. Treasurys are a fraction of the $4,500 billion Treasury market, the FT noted.

"It is difficult to buy more U.S. Treasurys because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot," the newspaper quoted Kwag Dae-hwan, the head of global investments at the pension fund, as saying.

Yields on 2-year treasury notes have dropped sharply since the middle of last year as investors have bought the government debt as a safe-haven from the global credit crisis.

The 2-year note yielded more than 5 percent in June, but currently it returns around 1.68 percent. The 10-year Treasury yield has dropped to just under 3.5 percent from about 5.3 percent over the same period.

Mark-to-market (FT)

2008-03-27T13:00:00.000-07:00

Published: March 27 2008 19:46 | Last updated: March 27 2008 19:46
It is an alluring idea: solve the credit crunch at a stroke of the accountant’s pen. But suspending mark-to-market accounting would only hide banks’ losses – which would only add to suspicion about their solvency. The problem is not mark-to-market as such, it is the use of mark-to-market accounting to underpin pro-cyclical bank capital requirements, and it is the capital regime that should be reviewed.

Under traditional historic cost accounting, bonds that a bank bought for $1m would sit on the balance sheet at $1m until the bank sold them, at which point any profit or loss would be recognised. Under mark-to-market accounting – which became widespread in the 1990s – the value of the bonds is constantly adjusted to reflect the price at which they could currently be bought or sold.

Provided there is a market price to mark to, this kind of accounting is far more useful to investors: it tells them what a bank’s assets are worth today, not what they were worth 10 years ago or what they might be worth in normal economic times. It forces banks to confront problems rather than deny them – and given that uncertainty about which banks have suffered losses is an important reason why they will not lend to each other, covering up losses will not solve the credit crunch, but rather make it worse.

The problem, however, is that mark-to-market accounting is not simply a tool to inform investors. It underlies the balance sheet, and so generates the fundamental number with which a bank is regulated: its capital ratio.

The standard Basel requirement is that a bank’s target ratio of capital to risk-weighted assets should be 8 per cent. Under historic cost accounting, falling market prices had no immediate effect on capital adequacy, but under mark-to-market they create losses, which force banks either to raise more funds or to cut back on lending. There should be a thorough review of the Basel II capital regime, which has other features that make banks cut lending as market prices fall.

Mark-to-market is not perfect. The dozens of assumptions used to value assets with no market price – so-called marking to model – must be thoroughly audited if historic cost accounting is not to be preferable. There may also be the perverse result of banks choosing to hold more illiquid assets in future if they conclude that holding liquid bonds risks mark-to-market losses.

Hiding losses would destroy confidence, not create it, so suspending mark-to-market is not the answer to the credit squeeze. But the capital rules that make mark-to-market a problem cannot be changed overnight and, in the meantime, falling bank capital could create a downward spiral of less lending and further falls in asset prices. The banks either need to raise more capital or they must temporarily be allowed to operate with less.

Copyright The Financial Times Limited 2008

Is This the Big One?

2008-03-27T12:35:00.001-07:00

Is This the Big One?

This article is adapted from Jeff Faux's new book, Why We're Liberals: A Political Handbook for Post-Bush America (Viking).
For more than a decade, we Americans have been living on an economic San Andreas fault--a foundation of fracturing competitiveness covered by unsustainable consumer spending with money borrowed from foreigners. A financial earthquake was inevitable. We don't know how high on the recession Richter scale the current crisis will take us, but it increasingly looks like, as they say in San Francisco, "The Big One."

Since the last Big One, the Great Depression of the 1930s, we have had eleven small to medium recessions, lasting an average of ten months. The most severe--two back-to-back downturns that began in 1979--drove price increases and the unemployment rate to double digits.

We're not at those levels yet. But the structural supports underneath our shop-till-we-drop economy are considerably weaker. For starters, we have a historic depression in the housing market. Americans' total mortgage debt now exceeds their home equity, for the first time since 1945. Housing prices have dropped 10 percent since last spring, followed by record foreclosures. Most economists expect them to drop at least another 10 percent, which could leave more than 14 million households--at least 16 percent of the total--better off if they just walked away from their homes. Prices could go even lower.

Until last year, housing prices in most places had risen rapidly since the 1990s. This enabled middle-class homeowners with stagnant wages and maxed-out credit cards to keep spending by refinancing their mortgages. The housing boom also spawned the now infamous subprime mortgage--a scheme devised by Main Street realtors and Wall Street bankers to finance home buying with loans that let the borrower buy in with little money down but carried high interest rates. The expensive payments would be made later by refinancing the mortgage as prices continued to rise. These subprimes were sold to middle-class strivers upgrading to McMansions as well as to the working poor.

The increased demand pushed housing prices further into the stratosphere--until, inevitably, they fell back to earth. When the subprime borrowers could no longer make their payments, foreclosure signs went up, lowering the value of other houses in the neighborhood. The refinancing spigot shut off, retail sales sputtered and by January the economy was shedding jobs.

But it is not the squeeze on homeowners that is giving our central bankers nightmares. It is the blowback of housing deflation on the country's massively overleveraged financial markets, which has seriously constricted the flow of credit--the lifeblood of the world's largest debtor economy.

In a typical deal, subprime mortgages were sold to investment companies, where they were commingled with prime mortgages to back up new securities that could be touted as both safe and high-yielding. This new debt paper was then peddled to investors, who used it as collateral for "margin" loans to buy yet more stocks and bonds. At each change of hands, fees and underwriting charges added to the total claims on the original shaky mortgages. The result was a frenzied bidding up of prices for a bewildering maze of arcane securities that neither buyers nor sellers could accurately value.

Giant Ponzi scheme? Not to worry, responded the Wall Street geniuses. By spreading risks among more people, the miracle of "diversity" was actually turning bad loans into good ones. Anyway, banks were buying insurance policies against default, which in turn were transformed into a set of even murkier securities called "credit default swaps" and marketed to hedge funds, pension managers and in some cases back to the banks that were being insured in the first place. At the end of 2007 the market for these swaps was estimated at $45.5 trillion--roughly twice as large as all US stock markets combined.

This huge pyramid of debt was made possible by thirty years of relentless deregulation of financial markets, culminating in the 1999 repeal of the Glass-Steagall Act, which had prohibited banks from dealing in high-risk securities. In effect, Washington regulators became passive enablers to Wall Street's financial binge drinkers. When they crashed--for example, in the savings-and-loan and junk-bond debacles of the 1980s, the Long-Term Capital Management collapse of 1998 and the Enron and dot-com crashes of the early 2000s--the government cleaned up the mess with taxpayers' money and let them go back to the bar.

So here we go again. When subprime homeowners stopped paying, the prices of the mortgage-backed securities used as collateral fell. Banks demanded that their borrowers pay up or cover their margins. Panicked selling by borrowers further lowered the securities' prices, triggering more margin calls and more defaults. Massive losses piled up at places like Citigroup, Countrywide, Merrill Lynch and Morgan Stanley, and cascaded back into the insurance companies. At the end of February, the huge insurer American International Group reported the largest quarterly loss, $5 billion, since the company started in 1919.

After some delay, the Federal Reserve Board last summer started lowering interest rates on loans to the banks. But in a phrase from the bank crisis of the 1930s, it was like "pushing on a string." The bankers' problem was not that money was too expensive to lend out; it was that they were afraid they wouldn't get their money back. When they did lend, they jacked up the rates to compensate for the higher perceived risks--even to solid customers. The Port Authority of New York and New Jersey suddenly had to borrow money at 20 percent. The State of Pennsylvania couldn't finance its college student loan program. Fannie Mae, the fund created by the federal government to support perfectly sound middle-class housing, struggled to sell its bonds.

In mid-March, after anguished discussions between Federal Reserve officials and Wall Street moguls, the Fed agreed to provide $400 billion in new cash loans to banks and investment firms. Days later came the shock of eighty-five-year-old Bear Stearns going belly up. In an unprecedented deal, the Fed immediately lent JPMorgan Chase the money to buy Bear Stearns, taking suspect mortgage-backed paper as collateral. Bear's stockholders had already taken a hosing when the stock crashed. The big winners were the company's creditors and insurers, who were saved from the consequences of their bad business judgment.

We are now staring into the abyss. The Bear Stearns bailout has created a presumption of a safety net under any major stockbroker, in addition to any major bank. Rumors are that Lehman Brothers and Citigroup may be next. The Fed could handle a Lehman crash. But the collapse of Citigroup, the world's largest bank, would be catastrophic, bankrupting businesses, other banks and consumers and cutting off credit for state and local governments. And it could stretch the Fed to the limit of its resources.

There is a widespread assumption that there is no bottom to the pockets of the Federal Reserve. Not quite. The Fed has a finite amount of actual assets--mostly Treasury obligations backed by the "full faith and credit" of the government, which is a commitment to raise taxes if necessary to pay the debt. These assets total about $800 billion, some $400 billion of which have been obligated to back up loans. If the loans default, the Fed has to sell the Treasury notes in order to settle. If there are enough of these failures, the Fed could exhaust its assets. It would then have to resort to really "printing money"--issuing promissory notes not backed up by anything--or get bailed out by the Treasury, putting taxpayers further in the hole. Long before the Fed is down to the last of its stash of Treasury notes, more skittish domestic and foreign investors will flee the dollar. Interest rates would balloon and prices of oil and other imports would skyrocket. Credit would freeze, investment would plummet and tens of millions of Americans would be out on the street, with neither a job nor a roof over their heads.

Unlikely? Yes, still. Unthinkable? Not anymore. Estimates of Wall Street's losses already run well up to $500 billion. A 20 percent drop in housing prices would translate into a $4 trillion drop in the value of housing assets. A large chunk of that loss would destroy the value that underlies the mortgage-backed securities the Fed has now agreed to guarantee.

But well short of such a worst-case scenario, the country seems headed for major economic damage that will severely test whatever we have left of safety nets. It took five years from the time the recovery began in 1983 for the unemployment rate to return to pre-recession levels. Once we reach the bottom of this trough, it could be a very long time before American consumers, whose spending accounts for some 70 percent of our economy, crawl out of the debt hole and back into the shopping mall. The Japanese have still not recovered from their similar housing/debt crash in the early 1990s.

Virtually everyone who has studied Japan in the 1990s and the United States in the 1930s concludes that in both cases the government acted too late with too little in order to stop the debt dominoes from tumbling through the entire economy.

But the American political system seems as seized up as the credit markets. As the Federal Reserve tries desperately to put an overdosed Wall Street on life support, President Bush remains dizzily detached, periodically repeating his moronic mantra against government intervention in the free market. At a press conference that is impossible to parody, Treasury Secretary Henry Paulson announced the Administration "plan" to safeguard the nation against a future crisis. It boiled down to a hope that the finance industry would do a better job of policing itself and that individual states would see to any new laws that might be needed. In what the New York Times dryly reported were his "most extensive comments to date about the credit and market problems," Paulson, formerly co-chair of the investment firm Goldman Sachs, firmly told reporters that he was not interested in finding "scapegoats." No kidding.

In response to pressure from Democrats, the White House at the end of January did reluctantly agree to a fiscal stimulus. But Bush demanded that it be limited to the only economic policy he understands: tax cuts. Democrats caved, and the government started printing up $160 billion in a one-time rebate to consumers and businesses, which will be sent out in May. Too little, too late, and likely to be spent paying down debt and buying more Chinese imports.

Senate majority leader Harry Reid has proposed a second round of stimulus--this time through public investment, putting people to work rebuilding bridges, schools and other infrastructure. But no one is talking about a level of fiscal injection needed to counterbalance the drop in consumer and business spending.

If we use the 1979-83 experience as a guide, we'd need some $600 billion to $700 billion in deficit spending. But in those days, the United States was still a creditor nation. Thanks to three decades of trade deficits, topped by the costs of the Iraq War, we now depend on foreign lenders, increasingly worried about the value of their US bonds. As Lee Price, chief economist of the House Appropriations Committee, put it, "We need as big a stimulus as our foreign lenders will allow us to get away with."

To give some relief to those at the bottom of this tottering financial edifice, Barney Frank and Chris Dodd, chairs of, respectively, the House Financial Services and Senate Banking committees, are proposing updated versions of a Depression-era housing rescue program. The government would furnish $300-$400 billion to buy up existing home mortgages at prices marked down to reflect the current lower values. The plan could refinance 1-2 million homes. It may not be enough, but it probably represents the outer limit of what is possible in the twilight year of a White House whose economic competence is in the twilight zone.

Given the way Washington works, the Frank/Dodd proposal would need business support. Yet despite the fact that it would bring desperately needed trust back to the system, the capos of the Wall Street mob are unenthusiastic. Being forced to acknowledge losses on their books could toss a few more of them out of their jobs at a time when the supply of golden parachutes may be getting thin. Better to hunker down and whimper for more welfare from the Fed.

Some are already getting direct bailouts from big government. But it's not coming from the US government. Foreign-government-owned "sovereign wealth funds" are now buying sizable equity shares to shore up battered firms. Citigroup, where the Saudis are already the chief stockholder, sold roughly $20 billion of itself to Abu Dhabi, Singapore and Kuwait. The Chinese just bought 10 percent of Morgan Stanley, and Merrill Lynch sold a 9 percent stake to Singapore. With oil above $100 a barrel, more of Wall Street is certain to wind up owned in the Middle East. Some members of Congress still warn that these countries are looking for political influence in America's financial heart, rather than optimizing their rate of return. They are probably right, but the nationalist fires that flared up against Dubai ownership of US ports in 2006 have largely been banked. Beggars can't be choosers.

Another hope is that the Europeans, the Chinese, whoever, will take over our role as the world's consumer of last resort. As the recession slows US imports, countries that have grown fat on exports to us will certainly have to shift more of their growth to their own domestic market. But to expect that the leaders of other nations would put their own economies at risk by running up trade deficits in order to save us Americans from the consequences of our own folly seems stunningly naïve.

So if this is not The Big One, it is likely to be A Big One--and a long one.

We could still get lucky, of course. Republicans facing re-election might persuade Bush to support a big fiscal stimulus and housing rescue. Home prices may miraculously stabilize. Tomorrow, bankers may wake up like Scrooge on Christmas morning and just start lending. The Chinese may start importing American-made cars...

Otto von Bismarck once remarked, "There is a Providence that protects idiots, drunkards, children and the United States of America." Let's hope it's still true.

Accountants KPMG accused of professional negligence

2008-03-27T12:30:00.001-07:00

KPGM helps with accounting fraud!
Andrew Clark in New York
guardian.co.uk, Thursday March 27 2008 Article history
The accounting firm KPMG has been accused of professional negligence and of acquiescing to a "difficult" client as auditor to New Century Financial, an American mortgage company that collapsed under the weight of sub-prime loans.

An independent report commissioned by the US justice department has suggested that creditors could seek compensation from the European-based accountancy group for allowing and even aiding New Century to understate its liabilities.

The report says a KPMG partner, John Donovan, brushed aside concerns about contentious accounting practices in an impatient email because he feared losing New Century as a client. "I am very disappointed we are still discussing this," wrote Donovan. "As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off."

The sudden bankruptcy of New Century last April was among the early signs of the looming credit crunch brought on by defaults in the US home-loans market.

New Century was a big player in sub-prime loans, providing $60bn (£30bn) of mortgages a year. The securities and exchange commission is investigating its demise and it is the subject of class-action lawsuits by shareholders and ex-staff.

The bankruptcy examiner who compiled the report, Michael Missal, found that New Century had a "brazen obsession" with increasing the size of its loan portfolio, quadrupling its new mortgages over four years. There was little consideration over whether customers could afford repayments — instead, the firm's main criteria was whether it could sell on loans.

New Century ran into trouble when investors began to reject its loans on the secondary debt markets, sending them back as so-called "kickouts". It failed to make sufficient provision for these liabilities and, the report finds, KPMG did not exercise proper scrutiny.

"KPMG failed to question or test certain important assumptions in a rigorous manner," says the report. "The KPMG engagement team acquiesced in New Century's departures from prescribed accounting methodologies and often resisted or ignored valid recommendations."

It says KPMG's auditors were intimidated by New Century's financial controller, Dave Kenneally — a KPMG alumnus himself who the report describes as "difficult, condescending and quick tempered". But KPMG rejected the findings. It said: "We strongly disagree with the report's allegations concerning KPMG and we believe that an objective review of the facts and circumstances will affirm our position."

Fed Auctions Billions in Securities

2008-03-27T12:27:00.001-07:00

WASHINGTON (AP) — Big investment houses took the Federal Reserve up on its first-time offer Thursday to let them borrow Treasury securities, the latest effort to ease a painful credit crisis.
The Federal Reserve auctioned $75 billion worth of Treasury securities. Bidders paid an interest rate of 0.330 percent. Demand was high. The Fed received bids of $86.1 billion worth of the securities.
It was the first time the Fed conducted an auction of this kind. The next one will be held April 3.
The program, dubbed the Term Securities Lending Facility, was announced earlier this month by the Fed and is intended as a booster shot for financial institutions and for the troubled mortgage market. The Fed said it would make as much as $200 billion worth of Treasuries available through weekly auctions that started Thursday.
Big Wall Street investment firms could borrow much-in-demand Treasury securities from the Fed and put up more risky investments, including certain shunned mortgage-backed securities as collateral for the 28-day loans.
The new program is designed to make investment houses more inclined to lend to each other. It also is aimed at providing relief to the distressed market for mortgage-linked securities. Questions about their value and dumping of these securities have driven up mortgage rates, aggravating the housing crisis. Since the Fed's announcement of this new program, rates on some mortgages have eased somewhat.
Federal Reserve Governor Randall Kroszner, in a speech Thursday, said curbing shady lending practices that contributed to the housing and credit debacles should help revive the badly shaken confidence of the public and investors.
"Effective consumer protection can help to restore confidence in the mortgage markets and help to preserve the flow of capital to consumers who wish to purchase a home," Kroszner said.
Under fire from Congress for being too lax in its oversight, the Fed has proposed a sweeping rule to protect homeowners from dubious lending practices. Subprime borrowers — those with tarnished credit histories or low incomes — have been hurt the most, although problems have spread to more credit-worthy borrowers.
The Fed has a proposal that would: restrict lenders from penalizing risky borrowers who pay loans off early; require lenders to make sure these borrowers set aside money to pay for taxes and insurance; and bar lenders from making loans without proof of a borrower's income.
It also would prohibit lenders from engaging in a pattern or practice of lending without considering a borrower's ability to repay a home loan from sources other than the home's value. The proposal would curtail misleading ads for many types of mortgages and bolster financial disclosures to borrowers.

The next bailout: Homeowners! Why not.

2008-03-26T18:04:00.000-07:00

Federal government help for Bear Stearns and other Wall Street firms increases the chance that assistance for those facing foreclosure will be approved.
By Chris Isidore, CNNMoney.com senior writer
Last Updated: March 26, 2008: 6:25 PM EDT
NEW YORK (CNNMoney.com) -- The federal government is keeping Bear Stearns out of bankruptcy. Are you next?

Momentum for federal assistance to struggling homeowners, a non-starter with the Republican administration and many members of Congress only a few months ago, has picked up steam in Washington.

The tipping point came March 16, when the Federal Reserve agreed to back up to $30 billion in Bear Stearns (BSC, Fortune 500) losses as part of JPMorgan Chase's (JPM, Fortune 500) fire sale purchase of Bear Stearns. (The Fed cut its guarantee by $1 billion earlier this week when JPMorgan boosted its offer for Bear.)

"I think there's a growing populist feeling that if you're going to bail out Bear Stearns you better bail out individuals," said Greg Valliere, political economist with the Stanford Group, a Washington think tank.

And some consumers clearly are in an uproar about the bailout. According to a Reuters report, about 60 protesters entered the lobby of Bear Stearns's New York headquarters Wednesday and made a fuss about how consumers needed more help from the government than Wall Street investment banks.

The Bear Stearns deal isn't the Fed's only direct exposure to the problems in the financial markets either.

The Fed also announced earlier this month that it would make billions in loans directly to Wall Street firms at the Fed's so-called discount rate, a right previously reserved for commercial banks. In addition, the Fed has said it will now accept troubled mortgage-backed securities as collateral on up to $200 billion in loans to Wall Street.

But some economists think the Fed's moves are only the beginning. Mark Zandi, chief economist with Moody's Economy.com., said he thinks the Fed is telling the presidential administration that more needs to be done to fix the mortgage mess.

Using FHA to help borrowers

Valliere said that the idea gaining the most support is a plan from Senate Banking Chairman Chris Dodd and House Financial Services Chairman Barney Frank. Both are Democrats.

The proposal, likely to be introduced soon after Congress returns from the Easter recess next week, would have the Federal Housing Administration guarantee hundreds of billions of new, lower-cost loans to troubled homeowners. Many borrowers would see their total principal on these new mortgages reduced under this program.

According to an outline of this bill, homeowners could receive $30 billion in mortgage interest subsidies. But it's uncertain just how much this proposal will ultimately cost taxpayers because it depends on what will happen to the housing market going forward.

The bill would also benefit mortgage lenders and investors in many mortgages since it could prevent a wave of foreclosures. While lenders and mortgage holders would receive less than what is currently owed on the loans with the biggest risk of default, they would receive significantly more than they could hope to recover if the loan goes through the foreclosure process and the home is sold at a sharp discount. In other words, something is better than nothing.

With this in mind, some economists believe the Dodd-Frank proposal could cost more than $100 billion. This is obviously a pretty large number and because of this, there is a debate over whether taxpayer money should be used to bail out the relatively small percentage of homeowners that have run into problems paying their mortgages.

Some opposition to bailout

A poll by CNN in December found Americans almost evenly split on the idea of using federal dollars to help out struggling homeowners, with 51% supporting some kind of help and 46% opposed.

The poll also found that 51% believed the borrowers who were in trouble had only themselves to blame, while 46% believed they were victims of bad lending practices. The tide was overwhelmingly against helping out mortgage lenders, with 72% opposed and only 26% supporting.

But that poll was taken before job losses and other signs that the U.S. economy had fallen into recession. Congress has also stepped in since then with at $170 billion economic stimulus package that won wide bipartisan support, while the Federal Reserve has slashed interest rates three times this year to try and get the economy back on track.

On March 17, the day after the Bear Stearns deal was announced, Dodd told reporters he believed there was now "a greater deal of receptivity to this idea" from the Fed and presidential administration than there was before the Bear Stearns bailout.

The support for the mortgage bailout won't be as widespread as it was for the economic stimulus package, nor will it be enacted nearly as quickly as that bill, which went from early discussions to being signed into law in just about a month.

"It's going to be a tougher sell, just because this is messy, complicated. Giving a tax rebate is simple," said Zandi. "But it may be just as important if not more important, to the economy."

Where the administration stands

The idea of mortgage lenders agreeing to cut the amount owed to them has already won support from the Office of Thrift Supervision, the agency which regulates savings and loans firms. Fed Chairman Ben Bernanke also said in a speech earlier this month to community bankers that he is in favor of such a plan.

But neither the OTS nor Bernanke called for the FHA or other federal agency to take a direct role in negotiating new mortgages.

The administration hasn't commented directly on the Dodd-Frank plan. But President Bush said Tuesday that if there needs to be further action taken to help the economy, the administration will take it.

Treasury Secretary Henry Paulson expressed some caution Wednesday over some of the proposals now being floated by Democrats. But he said the administration is interested in finding solutions to help homeowners who can't afford mortgage payments that are resetting higher.

Paulson also suggested the administration is looking for ways to deal with the Democratic-controlled Congress on the issue.

"We will continue to pursue policies that strike the right balance: that do not slow the housing correction, yet also help avoid preventable foreclosures and unnecessary capital market turmoil," he said.

What the presidential candidates think

Sen. Barack Obama is one of the co-sponsors of Dodd's bill, and his rival for the Democratic nomination for president, Sen. Hillary Clinton, said she also supports it.

However, Clinton proposed a step beyond his plan Monday. She suggested having the FHA become a temporary buyer of so-called "underwater mortgages" -- loans where the principal is now more than a home's value.

Clinton has also talked about a new housing stimulus package to provide $30 billion directly to states and local governments to buy foreclosed or distressed properties. The cities and states could then resell the properties to low-income families or convert them into affordable rental housing.

Sen. John McCain, the presumptive Republican presidential nominee, also expressed a willingness to look at Democratic proposals in a speech about the economy Tuesday.

"I will not play election year politics with the housing crisis," he said. "I will evaluate everything in terms of whether it might be harmful or helpful to our effort to deal with the crisis we face now."

McCain cautioned he wasn't ready to sign onto a bailout, though.

"I have always been committed to the principle that it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers," McCain said.

But Zandi, who is an economic advisor to McCain, said he believes McCain will support some kind of assistance to homeowners and borrowers.

"I think he...understands that the problems in the housing market are broad and deep and threaten the broader economy, and that there may be a role for the federal government to stem those losses," said Zandi, who cautioned he was not speaking on behalf of the McCain campaign.

Stanford Group's Valliere also said he doesn't believe McCain will be able to resist the growing tide to support federal help to troubled homeowners.

"You have to respect McCain's intellectual honesty on this but the Frank-Dodd bill is a steamroller that can not be stopped," he said.

Meltzer, "Fed playing with fire"

2008-03-26T16:42:00.000-07:00

Taxpayers May Be Liable From Bear, Mortgage Rescue (Update3)
By Craig Torres and James Tyson

March 26 (Bloomberg) -- Even as the Bush administration insists it won't risk public funds in a bailout, American taxpayers may already be liable for billions of dollars stemming from Federal Reserve and Treasury efforts to quell a financial crisis.

History suggests the Fed may not recover some of the almost $30 billion investment in illiquid mortgage securities it received from Bear Stearns Cos., said Joe Mason, a Drexel University professor who has written on banking crises. Treasury's push to have Fannie Mae and Freddie Mac buy more mortgage bonds reduces the capital the government-chartered companies hold in reserve at a time when foreclosures and defaults are surging. Senators are promising to investigate.

Officials ``are playing with fire,'' said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. ``With good luck, none of these liabilities will come due. We can't expect that good luck, and we haven't had it.''

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson were forced to respond after capital markets seized up and Bear Stearns faced a run by creditors. In an emergency action that jeopardizes the dividend it pays the Treasury, the Fed authorized a $29 billion loan against illiquid mortgage- and asset-backed securities from Bear Stearns that will be held in a Delaware corporation. JPMorgan Chase & Co. contributed $1 billion.

Grassley, Baucus

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, and Charles Grassley of Iowa, the committee's ranking Republican, gave Fed officials and JPMorgan executives a March 28 deadline to describe the assets involved in the transaction.

``Americans are being asked to back a brand-new kind of transaction, to the tune of tens of billions of dollars,'' Baucus said in a statement today. ``It's the Finance Committee's responsibility to pin down just how the government decided to front $30 billion in taxpayer dollars for the Bear Stearns deal, and to monitor the changing terms of the sale.''

The Delaware company will liquidate the assets over 10 years, with JPMorgan absorbing the first $1 billion in losses, with the Fed bearing any that remain. Any such losses would hurt the Fed's balance sheet, and ultimately the taxpayer, because they would reduce the stipend the Fed pays to the Treasury from earnings on its portfolio. The dividend was $29 billion in 2006.

Pushed to Front

``The fact that Treasury and Congress have been unwilling or unable to be proactive and provide a solution that involves putting taxpayer money at risk means that the Fed has had to take more measures itself, also putting taxpayer money at risk,'' said Laurence Meyer, a former Fed governor, and now vice chairman of Macroeconomic Advisers LLC in Washington.

The Treasury is counting on voluntary loan restructurings and $117 billion in tax rebates to support the economy through the worst housing recession in a quarter century.

Treasury spokeswoman Jennifer Zuccarelli referred to remarks Paulson made March 16 that he is ``looking very carefully'' at additional proposals, ``but all the ones I've seen call for much more government intervention.''

A day earlier, President George W. Bush said some of the ``sweeping government solutions'' proposed in Washington ``would make a complicated problem even worse.''

McCain Position

Republican presidential candidate John McCain said in a speech yesterday that ``when we commit taxpayer dollars as assistance, it should be accompanied by reforms'' to ensure ``transparency and accountability.''

The average recovery on failed bank assets is 40 cents on the dollar over a six-year period, according to Drexel's Mason, a former official at the Treasury's Office of the Comptroller of the Currency. Nobody knows if that historical benchmark will hold for the Fed portfolio because the assets haven't been disclosed, they have already been marked down and the Fed has 10 years to recover value.

``Over 10 years, you might eventually get your money back,'' said Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago.

Still, ``that isn't costless to the Fed, it isn't the same as holding Treasuries,'' she said. On some low-documentation loans, ``you are going to be lucky to get 40 percent.''

Paulson reversed Treasury's stand of the previous three years in approving the decision to direct Fannie Mae and Freddie Mac to expand their $1.5 trillion mortgage assets. Previously, Treasury and the Fed had called for cuts in the portfolios held by the government-chartered companies.

Raising Capital

Fannie Mae and Freddie Mac will buffer against more risk by raising ``significant'' capital, Fannie Mae Chief Executive Officer Daniel Mudd and Freddie Mac Chief Executive Officer Richard Syron said at a press conference with James Lockhart, director of the Office of Federal Housing Enterprise Oversight that regulates the two companies.

The companies reported record fourth-quarter losses totaling $6 billion and warned days before announcing the additional purchases that credit losses will rise this year.

Lockhart dismissed the view that taxpayers could be liable for such losses. ``Certainly not,'' he said. The companies ``have the capital, they support their own'' mortgage-backed securities.

Yet the Treasury's authority to buy $2.25 billion in each of the companies' securities has created investor expectations that the firms hold an implicit federal guarantee against losses.

Lenders allow Fannie Mae and Freddie Mac to borrow more cheaply than rival companies because they expect Treasury would provide a bailout before letting them default.

Because Fannie Mae and Freddie Mac own or guarantee about 40 percent of the $11.5 trillion home loan market, the cost of a bailout would be ``in the hundreds of billions of dollars,'' said Andrew Laperriere, managing director at International Strategy & Investment Group in Washington. ``Taxpayers should be increasingly concerned about the contingent liability.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.netJames Tyson in Washington at jtyson@bloomberg.net

Last Updated: March 26, 2008 12:00 EDT

Letter from the senate.

2008-03-26T15:48:00.001-07:00

Senators' Letters on Bear Deal
March 26, 2008 3:52 p.m.
The following is the text of two letters sent from leading senators regarding Bear Stearns-J.P. Morgan deal. The first is from Sen. Christopher Dodd (D., Conn.), chairman of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, inviting key players in the deal to a hearing on April 3rd. The second is a request for information from Senate Finance Committee Chairman Max Baucus (D., Mont.) and the panel's top Republican, Sen. Charles Grassley of Iowa.

Invited Witnesses:

The Honorable Ben Bernanke
Chairman, Federal Reserve Board of Governors

The Honorable Henry M. Paulson
Secretary of the Treasury

The Honorable Christopher Cox
Chairman, U.S. Securities and Exchange Commission

Timothy F. Geithner
President, Federal Reserve Bank of New York

Alan Schwartz
President and CEO, Bear Stearns

James Dimon
Chairman and CEO, JPMorgan Chase

I am writing you to request your appearance before the United States Senate Committee on Banking, Housing, and Urban Affairs next Thursday, April 3rd, at 10:00 a.m. regarding the ongoing crisis in the U.S. credit markets and one of its outgrowths, the merger agreement and subsequent amended agreement regarding JPMorgan Chase's acquisition of Bear Stearns. Ensuring the strength and orderly functioning of our nation's markets is one of this Committee's primary responsibilities. I believe it is important to maintain liquidity, stability, and investor confidence in the markets. In that regard, the unprecedented nature of some recent actions by the Federal Reserve, Department of the Treasury, and others merits a full and public examination by the Committee. In particular, it is important to examine the role of the Federal Reserve Board, the Treasury Department, and the Securities and Exchange Commission in extending a $30 billion public loan to facilitate the merger between JPMorgan Chase and Bear Stearns, and the implications of this loan for taxpayers, investors, and the regulation of entities that receive such taxpayer-backed benefits.

Had the merger between JPMorgan Chase and Bear Stearns been a routine transaction between two private entities, such an event might not merit public examination. But because this transaction has put public funds at risk, Committee review is not only warranted, but necessary. Accordingly, we ask that your testimony address the following issues: What is your understanding of the role of the Federal Reserve, Treasury, and Securities and Exchange Commission in determining the need for this transaction, placing a value on the transaction, structuring the public loan to support the transaction, and in approving the original and updated terms of the transaction?

The Committee also seeks a thorough accounting of the securities assets that the Federal Reserve is guaranteeing with public funds, including a chronology and rationale behind the selection of those assets, and the valuation of those assets. Finally, given the exposure of public funds as a source of financing in support of the JPMorgan Chase-Bear Stearns transaction, we would welcome your views regarding the implications of these actions on the American taxpayer, and what possible changes these actions may or should herald for the Federal Reserve in its role as a lender of last resort and for the regulation of financial institutions.

Sincerely,

Christopher J. Dodd, Chairman

The following is the letter from Sens. Baucus and Grassley.

March 26, 2008

Mr. Alan D. Schwartz

Mr. James Dimon

Mr. Timothy F. Geithner

The Honorable Ben S. Bernanke

The Honorable Henry M. Paulson, Jr.

Gentlemen:

Since its establishment as a permanent committee on December 10, 1816, the Senate Finance Committee's jurisdiction has generally included "bonded debt of the United States."

In carrying out the Finance Committee's oversight responsibilities with respect to the use of bonded debt of the United States, we instructed our staff to review the details of the Bear Stearns-JPMorgan Chase transaction as announced on March 16, 2008, and as may have been or may be in the process of being amended ("the transaction"). We appreciate the briefings provided to our staff by national Federal Reserve staff and Treasury Department staff. We anticipate further staff discussions with the parties to the transaction and Federal officials.

As we take the next steps in our review, we have several preliminary questions and requests of the parties to the Bear Stearns-JPMorgan Chase transaction.

1. Please provide us with a memorandum on the transaction detailing all steps taken to date and steps that remain to be taken. Please include all pertinent dates.

2. Please provide us with a memorandum describing the assets to be secured by the Federal Reserve in relation to the transaction, including, but not limited to the type of assets, face value and book value of the assets, types of mortgages underlying the assets (e.g., adjustable rate, alt-A, subprime, etc.).

3. Please confirm all the parties (including private and government agencies that participated in negotiations) (collectively referred to herein as "Parties") to the transaction.

4. Please provide us with copies of all documents that have been or that the parties intend to file with the U.S. Securities and Exchange Commission or any other regulatory body and any term sheets that relate to the transaction.

5. Please provide us with the names of all the negotiators who represented the Parties to the transaction.

6. Please provide us with the names of all in-house counsel, outside counsel, accountants, employees and any other professionals who represented the Parties to the transaction.

Please respond by close of business on March 28, 2008. The answers and requested materials should be delivered to the committee office and addressed to Russ Sullivan, Staff Director, Democratic Staff, and Kolan Davis, Staff Director, Republican Staff, Senate Finance Committee…. In advance, we express our appreciation for your cooperation and look forward to working with you on this matter.

Sincerely,

Max Baucus, Chairman

Charles E. Grassley, Ranking Member

Paulson Says US Shouldn't Prop Up Housing Prices

2008-03-26T15:41:00.000-07:00

Price controls on derivatives, but not houses!

U.S. Treasury Secretary Henry Paulson said Wednesday policy-makers should not interfere with an "inevitable" drop in housing prices but should work to minimize the impact on the economy.

"A correction was inevitable and the sooner we work through it, with a minimum of disorder, the sooner we will see home values stabilize, more buyers return to the housing market, and
housing will again contribute to economic growth," he said on prepared remarks for delivery to the U.S. Chamber of Commerce.

The U.S. Treasury chief also said no one should conclude that broker-dealers and other big financial firms will get permanent access to new lending facilities made available by the Federal reserve to ease market stresses.

In wide-ranging comments on current conditions in credit and housing markets, Paulson tried to sound a note of reassurance about the future. He said capital markets remain flexible and resilient and that regulators and policy makers were "vigilant" about the risks the economy faces.

He said the Fed's actions in taking a series of moves to boost market liquidity and to offer broader access to its so-called discount window for loans were helpful but exceptional.

"At this time, the Federal Reserve's recent action should be viewed as a precedent only for unusual periods of turmoil," Paulson said. He said policy makers were fully aware that it was a housing downturn that precipitated capital market turmoil and posed the biggest risk to the economy but made clear he felt it had room to run yet and should be allowed to do so.

Amid calls for action to minimize foreclosures, make more affordable mortgages available and reduce fraud, Paulson said it was vital to choose policies that "minimize the impact of -- but do not slow -- the housing correction."

Paulson said that only about 2 percent of U.S. home mortgages were in foreclosure but said that as many as 2 million foreclosure starts might occur this year. In addition, he said that 8.8 million households may now have negative home equity -- meaning their mortgages are higher than the house could be sold for -- and said that will rise.

Still, he said that if homeowners who are "underwater" on their mortgages walk away from them, they are no more than speculators and don't deserve special help.

"Washington can not create any new mortgage program to induce these speculators to continue to own these homes, unless someone else foots the bill," Paulson said.

He noted that a number of lawmakers have proposed initiatives to ease the strain on homeowners and welcomed their ideas but added "most are not yet ready for the starting
gate."

Bear Stearns Sale to JPMorgan to Be Probed by Senate

2008-03-26T15:37:00.001-07:00

By Ryan J. Donmoyer and Alison Vekshin

March 26 (Bloomberg) -- The Senate Banking and Finance committees are probing the government-backed sale of Bear Stearns Cos. to JPMorgan Chase & Co., voicing concerns about the risk posed to taxpayers from federal involvement in the deal.

Senate Banking Committee Chairman Christopher Dodd today asked Bear Stearns Chief Executive Officer Alan Schwartz, JPMorgan CEO Jamie Dimon, Federal Reserve Chairman Ben S. Bernanke, Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox to testify at an April 3 hearing on the issue.

Separately, the Senate Finance Committee asked the company chief executives, Bernanke, New York Fed President Timothy Geithner and Paulson to provide details on how the buyout was negotiated.

``While it is imperative to maintain the orderly structure of our markets, the sale agreement between JPMorgan Chase and Bear Stearns raises serious public-policy questions regarding the role played by'' the three agencies ``as facilitators of this agreement,'' Dodd, a Connecticut Democrat, said in a statement.

The committees' inquiries may herald a broader congressional backlash against the agreement, which Senate Majority Leader Harry Reid of Nevada has described as a ``bailout.''

The Fed, in an emergency action earlier this month, authorized a $29 billion loan against illiquid mortgage-and asset-backed securities from Bear Stearns to help the company avert bankruptcy. JPMorgan contributed $1 billion.

Letters Sent

Finance Committee Chairman Max Baucus, a Montana Democrat, and Iowa Senator Charles Grassley, the panel's top Republican, today sent letters to those involved in the deal.

The senators are trying to determine whether the arrangement sets a precedent ``for federal involvement when other firms overextend themselves'' and ``whether taxpayers will lose money here,'' Grassley said in a statement.

``Americans are being asked to back a brand new kind of transaction, to the tune of tens of billions of dollars,'' Baucus said in a statement. ``With jurisdiction over federal debt, it's the Finance Committee's responsibility to pin down just how the government decided to front $30 billion in taxpayer dollars'' for the deal, Baucus said.

Dodd said he scheduled the hearing to explore the ``policy rationale'' behind the Fed's action, the impact of the original and new sale agreements on investors and the markets, and the implications for U.S. taxpayers and regulation of U.S. financial markets.

`Warning Shot'

``It's some pushback from Congress to send a warning shot to the Fed to not use taxpayer resources to bail out Wall Street,'' said Andy Laperriere, managing director at International Strategy & Investment Group in Washington. ``If there is a significant negative response from Congress, it would deter the Fed from doing this in the future,'' Laperriere said.

Baucus and Grassley said in their letter that they want to know the names of all negotiators and lawyers involved in the transaction as well as all the steps taken, their specific dates and a list of steps yet to be taken.

Baucus and Grassley want a description of the assets to be secured by the Federal Reserve, including their value and the types of mortgages underlying the assets. The senators asked for all copies of documents that will be filed with the U.S. Securities and Exchange Commission.

The senators asked for a response no later than March 28.

Taking On `Risk'

``The question is how much of a risk has the government taken in extending this loan, and that's fully dependent on the value of the collateral,'' said Gilbert Schwartz, a partner at the law firm of Schwartz & Ballen in Washington and a former Fed lawyer.

``The signal is they want more transparency,'' Schwartz said. ``Given the unusual nature of the transaction, it seems to me appropriate that the public find out what happened.''

Finance Committee spokeswoman Carol Guthrie described Baucus and Grassley as ``quite serious'' about the inquiry, saying they were determined to ``look out for taxpayers.'' The panel doesn't have plans to hold hearings ``as yet,'' she said.

Treasury spokeswoman Jennifer Zuccarelli said the department would work with the panel to respond to the request. Federal Reserve spokeswoman Susan Stawick said the central bank has received the letter and will respond to it.

JPMorgan spokesman Joseph Evangelisti declined to comment on the Finance Committee request. Bear Stearns spokesman Russell Sherman didn't return a call and e-mail seeking a comment.

The Bear Stearns arrangement has divided Senate Democratic leaders. While Reid said the transaction is unfair to taxpayers, Senator Charles Schumer of New York, the No. 3 Democratic leader, has praised it, calling the Fed's role ``smart'' and ``totally necessary'' to avert a broader meltdown of financial institutions.

To contact the reporters on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net; Alison Vekshin in Washington at avekshin@bloomberg.net.

The bankruptcy of Bear Stearns would have been a good lesson

2008-03-25T19:34:00.001-07:00

Why not let Bear bust?

The bailout of Bear Stearns seriously blunts market discipline as a force for market stability.

Market discipline is one of the three pillars of the Basel 2 accord and perhaps the most important.

It requires that financial institutions monitor their counterparties and discipline those which they perceive as being badly run or assuming too much risk.

Market discipline is based on the principle that market participants have a better understanding of what is happening than the supervisors.

When the investment bank faced immediate bankruptcy the Federal Reserve stepped in by underwriting $30bn worth of loans secured by some of the worst assets held by Bear Stearns. It also facilitated its sale to JP Morgan Chase at the initial princely sum of $2 a share.

Investment banks are far less regulated than commercial banks in the US. There is an implicit deal between financial institutions and regulators that those who get more Government protection are also more regulated, due to moral hazard, an arrangement that is eminently sensible.

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If the taxpayer is asked to provide insurance, the taxpayer should have a say in how those insured behave.

The Fed has now signalled an unprecedented willingness to underwrite the obligations of a lightly-regulated institution because it is considered too big to fail.

We are told that if Bear Stearns had been allowed to fail, the reverberations would have been felt throughout Wall Street, affecting profitability, possibly triggering another bank failure or even a full-blown crisis.

Unfortunately, the bailout of Bear Stearns means that counterparties and clients of other institutions will continue happily to do business with institutions they suspect are in difficulty, in the safe knowledge that the government will bail them out if things go bad.

Market discipline is going out of the window.

It is interesting to observe that with the Government money in hand, the value of Bear Stearns shares has risen sharply, JP Morgan Chase has already increased its bid to $10, and the eventual takeover price may even be higher.

At the same time the value of the Government backing remains $30 billion. It would have been more sensible if bidding for Bear Stearns reduced the value of the Government aid, rather than increase the takeover price, thus protecting the taxpayers' interests and not the shareholders' interests.

The bailout of Bear Stearns is part of a common trend whereby financial institutions, having assumed too much risk, look towards the government to save them from their own mistakes.

This has happened in every financial crisis, whose eventual cost has depended on politicians' ability to withstand such demands.

A typical banking crisis costs about 10pc of GDP according to a recent World Bank study.

Eight per cent of the costs flow from inappropriate government response, such as open-ended bailouts, and only 2pc from the actual crisis. The eventual costs of the current sub-prime crisis are following this pattern.

There is enormous pressure on the world's central banks to provide liquidity, either by lending to banks, or reducing interest rates.

The justification being offered is that nobody else wants to lend money to the banks except at a very high rate which destabilises the financial system. The fact that the liquidity squeeze is a problem of the banks own making seems to be forgotten.

It is instructive to look beyond the headlines and ask oneself why nobody except the central banks wants to provide liquidity.

The reason is that the banks have made their operations so complicated that only a handful of people understand what is going on, with enormous scope for misrepresenting the value and the risk of assets.

While this complexity has been very profitable in the past, it implies that it is hopelessly beyond the ability of the world's regulators and most counterparties to understand what the banks are up to.

This complexity minimizes both regulatory scrutiny and market discipline. The complexity that used to be a virtue is now a vice.

By bailing out Bear Stearns, the Fed is rewarding bad behaviour.

The shareholders of Bear Stearns may have lost substantial amounts, but the counterparties are left untouched. The stability of the financial system depends on market discipline, and counterparties being wary. The Fed actions make them too comfortable.

The provision of liquidity is a subsidy to the banks at the expense of taxpayers, causing long-term economic damage. The increase of liquidity is inflationary, and increasing inflation in the middle of an economic downturn risks the re-occurrence of the dreadful 1970s' stagflation.

The costs of reducing the 1970s inflation were enormous, much higher than any short-term benefit provided by liquidity injections.

On both sides of the Atlantic there is a debate between those who would like to regulate the financial system further and those want to leave it as it is now.

In recent years the regulators have shown that their understanding of the financial system, and especially in the complex products sold by banks, is very limited.

I doubt the regulators' ability to create an effective system, regulating banks more heavily and increasing financial stability, without stifling innovation or getting unnecessarily in the banks' way.

If the government is both the ultimate guarantor of the banks, and the supervisor of their risk systems why does the government not get to share in the upside? Why don't we simply nationalise the banks?

To avoid such drastic measures, we need to make banks more sensitive to risk. We need more market discipline.

To that end the bankruptcy of Bear Stearns would have been a good lesson.

Fed's bold moves: Band-Aid or breakthrough?

2008-03-23T18:01:00.001-07:00

Band-Aid or Breakthrough?

Faced with the threat of a massive economic meltdown last week, the Federal Reserve rode to the rescue with unprecedented remedies. It didn't just slash interest rates, it offered emergency loans to securities firms, agreed to take mortgage debt as collateral, and brokered a fire sale of collapsing Wall Street giant Bear Stearns.
Now that the Fed has calmed the economy's troubled waters, investors and economists are left wondering whether the fix will prove to be a Band-Aid or a breakthrough.
Even optimists admit the economy seems to be in an early-stage recession with job losses spreading and spending curtailed as the credit crunch tightens. The question now is how deep the downturn will be and how long it will last.
"It's too soon to say whether we've turned a corner on a sustained basis, but this week's developments pulled us back from the edge," said Gary Schlossberg, senior economist at San Francisco's Wells Capital Management. "We're not out of the woods yet by any means. The fact the Fed and the government have shown willingness to move aggressively (helped) calm the markets; it may limit the turbulence going forward."
Many Wall Street experts say they are encouraged by the Fed's drastic actions and by the government's allowing Fannie Mae and Freddie Mac - the government-chartered lending agencies - to raise billions more to channel into buying mortgages. Most important, investors may have recovered some heart. But there are still huge challenges ahead.
Liquidity dries up
Simply put, much of Wall Street has become gun-shy about lending money as the infection has spread from the defaults of risky, subprime loans that lie at the heart of the economic problems. That crisis of confidence brought Bear Stearns to the brink of bankruptcy. It also has hammered consumers applying for mortgages and businesses seeking loans. Precious little liquidity is available.
Even though the Fed has chopped a whopping three percentage points off its key federal funds rate since September, that has not translated into lower rates for mortgages, car loans and other forms of credit.
"If no one is lending, who cares what the rate is?" said Steve Cochrane, senior economist at Moody's Economy.com in West Chester, Pa. "Even a zero or very-low-interest (federal funds) rate means nothing if there's no lending going on. That's part of what forced the Fed's hand to move in these other directions to become the lender of last resort, and to a wider range of financial institutions."
"What you and I care about is the end borrowing rate, the rate we're going to be paying," said James Wilcox, a professor of financial institutions at the Haas School of Business at UC Berkeley. "So far it hasn't gone down because the financial system isn't working right now. That's short-circuiting some of the interest-rate cuts."
Housing at the epicenter
It all comes down to where it started: the housing market. The wounds are no longer confined to subprime mortgages, but have spread to all segments of real estate with buyers and sellers in a virtual stalemate, and prices plummeting. Until that changes, the economy cannot recover.
"The housing market is the epicenter of the crisis today," said John Lonski, chief economist at Moody's Investor Service in New York. "Stabilizing housing and moderating home-price deflation would go far to enhance investor confidence and modify the supply of liquidity. As home prices slump, so does wealth in general. That reduces consumer spending."
But the housing market is nowhere near a correction yet. The most cheerful estimate is that it will bottom out late this year. Some say it could take years to recover.
"There is no sign that prices have leveled off anywhere," Cochrane said. "Home prices have to get down to a point where buyers truly think they're a bargain given the cost of financing and the long-term outlook for price appreciation."
For a textbook correction, the faster housing prices plunge, the faster they'll hit bottom and be ready to turn around. But the faster they fall, the broader the pain - for homeowners forced into foreclosures, for their neighbors as their home values drop, for Wall Street investors as billions of dollars in mortgage-backed securities go up in smoke.
For that reason, some experts think the government should take even more steps to soften the fall.
"The simple idea would be to give home buyers a tax credit," Lonski said. "Say a home buyer would be allowed to subtract 5 or 10 percent of the purchase price of a home from her tax liability. That incentive would boost capital spending."
Meanwhile, the Fed's interest-rate cuts may help stem the foreclosure tide - which in turn could slow home price devaluation. That's because many homeowners get into trouble when their adjustable-rate mortgages reset to unaffordable levels. ARMs are linked to the federal funds rate, so lower rates there translate into more-manageable monthly mortgage payments and potentially fewer foreclosures.
Pop goes the bubble
Not everyone thinks the government should try to cushion the blow.
"To my mind, the best thing that could happen would be for the (housing) bubble to deflate more quickly," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. "Instead they're coming up with crazy schemes to get more money to Fannie Mae and Freddie Mac to expand lending. That will keep (home) prices inflated."
Baker said he felt the Fed overstepped its bounds by opening its discount lending window to securities traders. If (Fed chief Ben) Bernanke can do that, "Can he just lend me money?" Baker joked. "If he can, maybe I'll call him up and get a low-interest loan."
Another naysayer on government intervention is Peter Schiff, president of Euro Pacific Capital, a Darien, Conn., retail brokerage, and author of "Crash Proof: How to Profit From the Coming Economic Collapse," a 2007 book that predicted economic carnage.
"We would not have this mess if the Fed had not brought interest rates down (in the early 2000s) to postpone the pain from the dot-com collapse," Schiff said. "That created a bigger bubble in housing. Now it's trying to find ways to postpone the pain again."
Schiff's view is that the Fed is debasing the dollar's value - and that that will lead directly to rampant inflation.
"We didn't have a severe recession in 2001-2002," he said. "Now we're paying the price in spades."
But other experts say being too laissez-faire carries its own set of harsh consequences.
Christopher Thornberg, founding partner of Beacon Economics, said a mind-set that preceded the Great Depression was: " 'Let's allow a little Darwinian action to cure the industry of its ills.' In the process of that purge, you basically destroyed the U.S. economy."
Help the rich, not the poor?
This week's actions stirred controversy among those who feel the government will do whatever it takes to prop up rich folks on Wall Street, while exerting less effort for poor folks on Main Street - the people losing their homes to foreclosures.
"We've already seen the Nader-ists call this a bailout of the rich," Thornberg said. "We're going to continue to hear that, but I would make the fundamental argument here, bailout or no bailout, you just can't allow a wholesale panic to cripple the banking industry."
Peter Morici, a business professor at the University of Maryland and former chief economist of the U.S. Trade Commission, begged to disagree.
Treasury Secretary "Henry Paulson is running around the country telling people that if they're upside down in their mortgage but can still afford to pay it, then they have an obligation to pay," he said. "But on the other hand, we let these guys in New York walk away with gigantic severance packages while Bernanke lends them money to stay afloat. That's not fair.
"The policies place a heavy burden on those least able to bear it and let the rich bankers off scot-free," Morici continued. "This kind of stuff caused the French Revolution. They should be thankful people don't work on farms anymore because then they would all have access to a pitchfork."
Morici thinks the Fed should have extracted some concessions from Wall Street in exchange for its assistance, such as agreeing to issue simple, easy-to-analyze mortgage-backed bonds rather than the complex instruments whose failures triggered the current crisis.
Bernanke should "take bankers to the woodshed, go up there with a hickory stick and straighten them out," Morici said.
Even Lonski from Moody's, who was bullish on the Fed's actions, cautioned that its results were fragile.
"Whatever we gained in confidence this past week can be lost in a hurry if we have new evidence of a worsening of home sales and home price deflation, and signs of even bigger job losses and further cutbacks in business and consumer spending," he said.
Small business: The contraction is a threat for entrepreneurs. Tips on surviving it. Business, F1
Chronicle staff writer James Temple contributed to this report. E-mail Carolyn Said at csaid@sfchronicle.com.

Roubini: Should Securities Firms be Regulated and Supervised like Banks?

2008-03-23T17:37:00.000-07:00

Nouriel Roubini | Mar 23, 2008
The events of the last few weeks - including the collapse of Bear Stearns and of other highly leveraged, illiquid and insolvent institutions that are members of the shadow financial system – have shown that non bank financial institutions are at risk of liquidity runs in the same way as banks are. The response of the Fed to this bank-like runs on non-bank institutions has been the most radical change in monetary policy and lender of last resort support by the Fed since the Great Depression: such lender of last resort support has been effectively extended to non-bank broker dealers that are among the primary dealers of the Fed. This radical extension of lender of last resort support to some non-banks has taken three forms: first, the $30 billion lending support that Bear Stearns received as part of its bailout/purchase by JPMorgan; second the new $200 billion facility that will allow all primary dealers to swap some of their illiquid assets (especially agency and private label MBS) in exchange for safe US Treasuries (the new TSLF facility); third allowing such primary dealers to access the Fed’s discount window at same terms as commercial banks (the new PDCF facility).

As it is well known destructive bank runs on illiquid but solvent banks can be addressed via bank holidays; but the risk that such bank holidays (freezing of deposits) may lead to runs on other depository institutions has led – historically – to two alternative ways to deal with bank runs: deposit insurance and lender of last resort support by the central banks. Since these forms of support potentially lead to moral hazard – bankers gambling for redemption and making risky loans and not managing properly liquidity risk – optimal policy management of such banking risks implies that these banking/depository institutions - that benefit from deposit insurance and central bank lender of last resort support - are also subject to strict regulation and supervision of their activities; such regulation and supervision is provided in most countries by the central bank but increasingly we see other models (a unified financial services regulator outside the central bank such as the UK’s FSA or regulation/supervision spread among a variety central or local government institutions as in the US).

Now that some non-bank financial institutions that have been deemed as too-systemically-important to be allowed to fail – i.e. Bear Stearns and non-bank primary dealers – have been effectively put under the lender of last resort support umbrella of the Fed the question arises: shouldn’t these non bank institutions be regulated and supervised in the same way as banks are? I.e. be regulated by the Fed and/or have both banks and non-bank securities firms be regulated by a common new institution? Note that currently US securities firms are supervised/regulated by the SEC and have lower capital standards than banks.

These are most complex and difficult questions that I will address in this note…

Let us start addressing these questions with a few general observations. While it may be tempting to subject all securities firms to the same regulation and supervision that banks receive it is important to note that only a few of such securities firms are systemically important and deserve the liquidity support of the Fed in case of a run on their liabilities. Since supervision and regulation on the same terms as banks would also potentially imply providing such securities firms with the same liquidity support that bank receive in the case of a run – a full blanket deposit insurance for all deposits/liabilities, access to the discount window and lender of last resort support by the central bank – it does not make sense to provide to systemically non-important securities firms such safety net as the risks of additional fiscal bailout costs of insolvent securities firms would be serious. Note that currently securities firms do not benefit from deposit insurance (as the token $500k insurance provided by SIPIC to securities firms creditors is meaningless when large creditors of such firms that are exposed to multiples of that $500k as they can withdraw billions or dozens of billions of dollars in a matter of days as it happened in the case of Bear Stearns).

While one can make the conceptual case that both banks and securities firms (and possibly even hedge funds and other members of the shadow financial system) should be subject to a uniform regulatory/supervisory environment (as they are all like banks highly leveraged institutions that borrow short and in liquid ways and lend/invest longer term and in more illiquid ways) it would be a most dangerous step to expand the lender of last resort support of the central bank to most non-bank financial institutions, even to all securities firms.

Securities firms – excluding the few that may be deemed as systemically important - should succeed or fail on their own without any explicit or implicit guarantee that they would receive liquidity support in case that they mismanage their credit, market and liquidity risks. As a rule non-bank financial institutions (with the exception of the few that are systemically important) that are illiquid should fail in case they mismanage their liquidity risk and are unable to find private source of emergency liquidity; and they should certainly fail if they are insolvent. The argument for providing lender of last resort support to non-banks can at most be made for the few institutions that – given their size, interconnectedness with the system and/or role in the payments and clearing system – are systemically important. These systemically important institutions should be regulated and supervised like banks and by the same regulator as the banks.

But since most of the creditors of such securities firms are not small and uninformed retail depositors but rather larger and more sophisticated investors a formal blanket deposit insurance of the type provided to banks should not be provided to such systemically important securities firms even if they were to be regulated like banks. Indeed sound policy suggests that securities firms should manage properly their liquidity and credit risks and that the creditors of such firms should also provide market discipline by having their claims at risk if the firm becomes insolvent: market discipline implies that such creditors should lend to such securities firms at rates that include all the relevant risks that they face. It would be a dangerous development if creditors of securities firms would be fully guaranteed in their claims as an important element of market discipline – unsecured and unguaranteed and subordinated liabilities of securities firms – would be dropped in case we were to provide deposit insurance to these firms on the same terms as banks.

This means that the only safety net that prevents destructive bank-like runs for the shadow financial system should be in the form of lender of last resort support to systemically important securities firms. Even in that case it would be most appropriate that creditors of insolvent – as opposed to illiquid – systemically important securities firms not be bailed out when such firms get in trouble. This is an important and crucial point that is relevant for the Bear Stearns case.

In the Bear Stearns case it has been argued that there was no bailout as the shareholders of Bear have been effectively wiped out. This argument is incorrect in many dimensions. First, since Bear was insolvent shareholders should have been wiped out 100%; the residual value of their equity – however little at $200m - means that they still fully own the firm and that they would benefit from increases in the market value of the firm that may derive from the liquidity support that the Fed provided if the JPMorgan deal does not go through.

Second, the Bear deal came with a huge - $30 billion – liquidity support by the Fed that has two consequences: JPMorgan was subsidized in its purchase of Bear; and creditors of Bears will not experience the losses that they would have incurred if Bear had been forced to close down. This latter point is crucial: since Bear was insolvent closing it down without the Fed loan would have implied that not only shareholders would have been wiped out 100% but also that other creditors of Bear – who lent without properly considering the significant risks that they were undertaking – would have suffered significant losses. Instead the Fed bailout made such creditors of Bear whole, a most disturbing and moral hazard laden outcome.

Third, not only Bear shareholders were not fully wiped out as they would have been if Bear had been allowed to go bankrupt; but all the senior management of Bear has been kept in place – starting with that reckless golf and bridge-AWOL Jimmy Cayne – when a proper solutions would have been to fire them all without any golden parachute or rich severance package.

So the appropriate resolution of the Bear insolvency – that would have minimized moral hazard given the Fed liquidity support - would have been to wipe out shareholders, wipe out senior management and then have Bear taken over by the government – rather than sold with a massive subsidy for JPMorgan - as public funds were being used to avoid the systemic effects of its collapse. Public money should have then be used not to bail out the creditors of Bear but rather to ensure an orderly disposal or sale of its operations including inflicting the appropriate losses on Bear’s creditors.

Instead the Fed and Treasury created the mother of all moral hazards by the way they resolved the Bear collapse: they did not fully wipe out the Bear shareholders; they did not fire any of the senior management; they bailed out the creditors of an insolvent Bear; they subsidized heavily JPMorgan’s purchase of Bear; they provided a $30 billon lifeline that subsidizes Bear shareholders and management, Bear creditors and JPMorgan; and they provided – for the first time since the Great Depression – a new massive lender of last resort support to all non-bank primary dealers in the form of two new lending facilities (the TSLF and the PDCF).

This is not the proper way to approach the serious problem of bank-like runs on insolvent or illiquid non-bank financial institutions and the issue of the appropriate redesign of a supervisory and regulatory system for a world dominated by the shadow financial system.

The reform and redesign of the now obsolete system of U.S. financial regulation and supervision is a most important policy goal. Lets leave for now aside the fact that a system where you have half a dozen or more federal regulators and fifty plus at the state level is a stone-age system that leads to a race to the bottom in terms of lower regulation and supervision. Given that most securities firms look like banks – they borrow short/liquid, they are highly leveraged and they lend/invest in longer terms and illiquid forms – it is appropriate that their regulation and supervision should be at terms similar to those of banking/depository institutions, including especially similar capital adequacy at both types of institutions.

But even if securities firms should be regulated and supervised like banks the safety net system that banks receive – deposit insurance, access to the discount window and lender of last resort support from the central bank – should not be applied in a blanket form to all securities firms. Certainly publicly provided full deposit insurance should not be provided to any securities firm, even to systemically important ones. Let the private sector provide such insurance and/or force securities firms to properly manage their liquidity risk by imposing - via regulation - greater liquidity ratios for securities firms than for banks. The only form of public support that only systemically important securities firms should receive – to avoid destructive liquidity runs – should then be an appropriately designed lender of last resort support from the central bank.

Even such support should be qualified in a number of ways: it should not be certain as some degree of constructive ambiguity would reduce the moral hazard distortions of a too-big-to-fail perception; so which securities firm is too-big or too-systemically important to be allowed to fail should remain ambiguous and the size of the support should also be uncertain. More importantly, such lender of last resort support should not lead to losses for the creditors of such securities firms only if the firm is illiquid and subject to a run on its liquid liabilities. If it turns out that the firm being provided the lender of last resort support by the central bank is insolvent any public liquidity injection should be strictly aimed at avoiding a disorderly wind-down of the firm; i.e. such support should not be provided to bail out either the shareholders or the creditors of the firm; not only the shareholders but also the creditors of the firm should suffer the full consequences of their poor lending and investment decisions. This also means that insolvent securities firms should go under the same receivership process as depository institutions, especially if public funds are provided to allow an orderly rather a disorderly disposal of their assets.

Much more needs to be done to resolve the current systemic financial crisis, the worst since the Great Depression, to fix and reform the modern financial system and its regulation/supervision to reduce the risk of future systemic crises of the sort that we are experiencing today. The above thoughts, suggestions and principles are only a small sub-set of the reform issues that need to be addressed. But since the Fed has suddenly – and without any previous consultation – now changed in the most radical way the previous safety net system for financial institutions that existed since the Great Depression – effectively extending its lender of last resort support to non-bank systemically important securities firms – it is very important that a reform of the system of regulation and supervision of bank and non-bank financial institutions be implemented rapidly and in ways that do not increase a variety of moral hazard distortions.

Securities firm will certainly aggressively resist and lobby against the new proposals to regulate them in the way that banks are (especially since the SEC regulation has been proven toothless and the capital adequacy standards for securities firms are much lower than those for banks). But as the joke goes around these days: “What is the difference between a bank and a hedge fund? The bank is more highly leveraged” the same can be said of securities firms: they are even more leveraged and engaging in risky investment/lending than banks are.

The kind of reckless high leverage, pathetic “risk management”, including massive underestimation of liquidity and credit risk, that occurred among banks, broker dealers and other securities firms and members of the shadow financial system for the last few years has been an unmitigated disaster that has led – with regulators and supervisors being asleep at the wheel – to the worst financial crisis that the US has experienced since the Great Depression, a crisis that may likely lead to the most severe economic recession of the last few decades. It is now time to punish the reckless lenders and investors and let them suffer the financial losses that they deserve – including the bankruptcy of many insolvent firms and financial institutions and the losses of their shareholders and creditors.

But since public resources – first the Fed’s liquidity support and eventually the tax-payers money – will have to be used to sort out this mess and avoid the severe collateral damage of a systemic financial crisis causing an even more severe and protracted economic recession than the one that we cannot any longer avoid, it is important to rapidly take the proper policy actions that minimize such collateral damage at the minimum cost for the taxpayer.

But so far all the actions of the Fed and of the Treasury have been concentrated in helping financial institutions that made reckless investment and lending decisions; whether you call this help a bail out of the financial system or not all the policy actions have so far targeted the support of lenders and investors rather than the suffering mortgage borrowers: Fed Funds sharp easing providing a subsidy to financial firms via a steepening of the yield curve and rising intermediation margins for banks and financial firms; the variety of Fed’s new liquidity facilities for banks and non-banks; the explicit liquidity support of non-banks; the variety of actions allowing the Fed, the FHA and Fannie and Freddie to swap or buy hundreds of billions of mortgages and mortgage backed securities; the massive support that the FHLB system has provided to mortgage lenders. So far not a penny of public money has been spent to directly help the distressed borrowers, the millions of households that are underwater and/or unable to service their mortgages and their debts. It is thus time to start implementing strong and effective policies that will resolve this crisis rather than rely on policies that have so far provided band-aid support only to the financial system.

Times of severe crisis require bold, comprehensive and effective policy action, not the piecemeal and incoherent set of actions that have so far sequentially plugged one crisis hole a day when two larger ones emerge every other day in this bloodbath of a systemic financial crisis.

Bailouts for everybody (FT)

2008-03-22T14:06:00.001-07:00

Central banks float rescue ideas
By Chris Giles and Krishna Guha in London
Published: March 21 2008 22:02 | Last updated: March 21 2008 22:02
Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, the fact that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system.

It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.

The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.

Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments.

One argument among policymakers and bankers has been that new international rules have exacerbated the credit squeeze by requiring assets to be valued at their current record lows rather than at face value.

But a strongly held view at one European central bank is that it is not “mark-to-market” accounting that is to blame for severe weaknesses in banks’ balance sheets but that prices of MBS securities have fallen to levels that imply unrealistically high rates of default.

If public authorities were to buy and hold sufficient mortgage-backed securities – rather than simply lend against them as they have until now – at prices well below face value but above current prices, they would set a floor in the MBS market.

The Fed does not believe that the point has yet been reached when such drastic action is necessary and considers the discussions it has had with its counterparts to represent “blue-sky thinking” rather than the formulation of a definitive policy proposal.

Fed officials are monitoring the impact of the latest barrage of Fed liquidity moves and interest rate cuts. They also believe the US has not exhausted all the options short of wholesale public intervention and further intermediate steps are available to them.

These could include still more aggressive use of the Fed’s own balance sheet to boost liquidity in the markets.

Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.

The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. The UK government has already become heavily involved in buying mortgages since September with the recent nationalisation of Northern Rock, the mortgage lender.

Michael Coogan, the director-general of the UK’s Council of Mortgage Lenders, said this week: “Demand for mortgages remains strong but cannot be fully met from existing funding sources.” He predicted higher prices and reduced lending.

It is not just central banks that think the MBS market prices are too low and imply a unrealistic level of mortgage default. Some US states’ pension funds are investing small sums in the mortgage market.

Robert Gentzel, a spokesman for the Pennsylvania State Employees’ Retirement System, told the AP news agency: “Some of the securities that have dropped in value were really very solid securities.”

Former Cleveland Fed President highly critical of Bernanke Fed

2008-03-17T18:45:00.000-07:00

www.forbes.com/home/opinions/2008/03/16/fed-inflation-rates-oped-cx_rmlh_0317fedinflation.html

Commentary
Memo To The Fed: Stop Those Rate Cuts
Robert P. Murphy and Lee Hoskins 03.17.08, 6:00 AM ET

The markets rallied last Tuesday in response to the Fed's growing assistance to holders of mortgage-backed securities. Yet many onlookers are convinced that an aggressive cut in the federal funds rate at the upcoming March 18 meeting is still necessary to avoid a painful recession. In our view, further loosening at this time would be a mistake, and would also send an alarming signal regarding future monetary policy.

The Fed needs to quit chasing declining GDP growth and instead focus on curbing inflation and anchoring inflation expectations. Recent allusions to the stagflation of the 1970s are appropriate. Gold has been hitting all-time nominal highs, and oil prices have shattered the inflation-adjusted record set in 1980 during the Iranian hostage crisis. The dollar, meanwhile, is trading at all-time lows against the euro.

Consumer price inflation was 4.1% in 2007 (the highest in 17 years) while the producer price index rose 7.4%--the most since 1981. Amid these alarming trends on the inflation side, output has stalled. Real GDP grew at a meager rate of 0.6% in the last quarter of 2007, and the private sector shed 101,000 jobs in February. The beginnings of stagflation are upon us.

In response, the Fed has slashed its target rate 2.25 percentage points since September, and has engaged in all manner of novel auction schemes to bolster liquidity, particularly among those holding the bag on soured mortgages. Yet despite momentary blips upward, the stock market and the overall economy continue to slide. Even as the Fed's actions pushed many short-term interest rates below the inflation rate, fixed mortgage rates have begun rising. As inflation expectations gather steam, the Fed will find itself painted into an ever-shrinking corner.

The explanation for all of this is simple yet sobering.

The Fed has abandoned the one thing it can truly control--the long-run increase in price levels--in a self-defeating attempt to keep the economy growing. A good portion of the housing mess itself is the result of Fed policy: In response to the 2000-2001 recession, chairman Alan Greenspan brought the federal funds rate down to a shocking 1% by June 2003, then held it there for a full year. The rate was then steadily ratcheted back up, reaching 5.25% by June 2006.

These actions first helped inflate the home-price bubble and then helped burst it. Naturally, there are many factors--and perhaps even villains--that helped create the housing bubble, but excessively low interest rates were surely a necessary ingredient.

Regardless of past mistakes, the Fed must now make the best of a bad situation. It must stop chasing the financial markets, and even the broader economy. Creating more dollar bills will not add to the nation's wealth, or make workers more productive.

The alleged trade-off between inflation and unemployment--the Phillips Curve--is no guide for action. Yes, an unexpected injection of new money can temporarily boost real output. But once people come to expect the higher rates of price inflation, the Phillips Curve simply shifts; it takes greater and greater injections to achieve the same stimulus. That is how a country becomes trapped in a stagflation spiral.

The painful and costly recessions of the early 1980s were the result of the inflationary policies of the Fed during the 1970s. In contrast, Fed policies during the 1980s and 1990s focused on curbing inflation and maintaining price stability; this shift in focus produced both low inflation and strong, steady real growth. It would be a terrible mistake to throw out that costly victory in an effort to avoid a recession today--one that's already baked in the cake.

The Fed should commit to long-term price stability, and it needs to back up that commitment with action. Recessions will always be with us, but they will be shallow and short when the Fed keeps inflation low and evenly paced. If the Fed continues cutting rates, we will simply get the worst of both worlds: prolonged recession and excessive inflation.

Robert P. Murphy is a senior fellow in business and economic studies at the Pacific Research Institute. Lee Hoskins is a senior fellow at the Pacific Research Institute and a former Cleveland Federal Reserve president.

Nice chronology of events from CNNMoney.com

2008-03-17T18:40:00.000-07:00

money.cnn.com/2008/03/17/news/economy/gothere/index.htm?postversion=2008031716

How subprime killed Bear Stearns
A problem with risky mortgages has led to a global financial crisis. The bigger issue: Experts don't know when it will end.
EMAIL | PRINT | DIGG | RSS
By Tami Luhby, CNNMoney.com senior writer
Last Updated: March 17, 2008: 4:51 PM EDT

NEW YORK (CNNMoney.com) -- It started last summer when borrowers with weak credit started defaulting on their mortgages. Last night, it brought down an 85-year-old pillar of Wall Street.

How did we get to this point? How did rising foreclosures among subprime borrowers lead to Bear Stearns being scooped up in a fire-sale for two bucks a share?

The answer starts with investment banks: They sold complex securities backed by debt that was a lot riskier than most realized. The realization that the banks had failed to manage this risk sparked widespread concern among investors and other financial firms. Suddenly, investors found they couldn't put a value on much of what the banks were selling. As a result, the lending markets that keep Wall Street humming seized up because people feared they wouldn't get paid back.

"We got to the point where the various parties in the financial system started not to trust each other," said Lawrence White, an economics professor at New York University.

What's worse is that no one knows when it will end.

Every week, it seems, another part of the U.S. financial system falters and the federal government has to come up with a new rescue plan. The Federal Reserve Bank's actions have helped soothe the markets in past crises, but the magnitude of the current meltdown may prove unprecedented, experts said. Today's troubles ensnare not only traditional banks, but investment firms, hedge funds, insurance companies and non-bank lenders.

No place like home

The roots of the current crisis lie in the euphoria of the real estate boom. With housing prices soaring and the economy solid, financial firms dove into the lucrative mortgage market. To meet the insatiable desire for mortgage-backed securities, firms loosened their lending standards and extended credit to people with weaker financial backgrounds.

But the lenders didn't put in place the necessary controls to handle the risk of a downturn in the housing market, said Amiyatosh Purnanandam, assistant professor of finance at the University of Michigan. The financial firms weren't ready to cope with a downturn in the value of the housing market or of these securities.

The signs were there: The rates paid on risky securities, such as junk bonds, moved closer to those of super-safe Treasuries, an indication that investors didn't feel the need to pay a premium to take on more risk.

"Every time we see a big crisis, someone messed up the risk management," Purnanandam said.

A slowdown in home values last year touched off the maelstrom. Subprime homeowners found they could no longer afford their monthly payments, leading to a spike in delinquencies and defaults. Investors panicked because they could no longer value the securities backed by these mortgages.

At first, some thought the problem would be contained within the mortgage industry. But within a few months, it spread like wildfire through the debt market as people lost faith in the investment banks' ability to manage risk in general. Investors are hesitating to put money in securities backed by municipal bonds, student loans, credit cards and even mortgages backed by Freddie Mac and Fannie Mae, which have an implicit government guarantee, for fear they won't be paid back.

"What happened was we figured out the whole scheme wasn't working the right way," said George Tsetsekos, dean of the LeBow College of Business at Drexel University. "It's an issue of confidence in the marketplace over the ability of institutions to receive back the funds that were lent."

Financial firms are also shying away from extending credit to one another, afraid that the collateral backing the loans will lose value.

The banks are saying "I don't want to be involved in any relationship where you owe me money because I don't know if you will be able to honor that obligation," White explained.

Faith in the currency wanes

The dollar is compounding the problem. The dollar's fall against other currencies has made it less attractive for foreign investors to put their money in dollar-denominated U.S. securities. And that is pulling much-needed funding out of the system, Tsetsekos said.

Without liquidity, the global financial markets started breaking down, forcing the Federal Reserve to repeatedly inject cash into the system and take the hard-to-trade mortgage securities as collateral in return.

The crisis reached new heights last Thursday when Bear Stearns suffered a classic run-on-the-bank after questions about the investment bank's finances surfaced. The bank, one of largest underwriters of mortgage-backed bonds, had suffered greatly in the meltdown and didn't have the diversity of revenues that cushioned its rivals.

Clients began withdrawing funds or demanding more collateral from Bear Stearns (BSC, Fortune 500), leading it to turn to the federal government for help. On Friday, JPMorgan Chase (JPM, Fortune 500), along with the Federal Reserve Bank of New York, announced they would step in with funding while the investment bank explored its alternatives.

Two days later, JPMorgan announced that it would buy the venerable Wall Street firm, once known for its high-quality risk management, for a shockingly low $2 a share, a 93% discount from Bear Stearns' closing price on Friday.

The move, however, has not calmed everyone's nerves. Instead, some investors are looking for the next institution to fail, with their sights set on Lehman Brothers (LEH, Fortune 500), whose shares were down 32% in late-afternoon trading Monday.

"Once you see one bank subject to this kind of run, depositors starting worrying maybe the bank across the street may be equally as susceptible," White said. "Clearly that's what the Fed is worried about."

Roubini: Run of Shadow financial sytem.

2008-03-17T05:43:00.001-07:00

A Generalized Run on the Shadow Financial System

Nouriel Roubini | Mar 17, 2008
Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions.

All these institutions look similar to banks because they are highly leveraged and borrow short and in liquid ways and invest or lend long and in illiquid ways. This shadow financial system is, like banks, subject not only to credit and market risk but also to rollover or liquidity risk, i.e. the risk deriving from having a large stock of short term liabilities (relative to liquid assets) that may not roll over if creditors decide to withdraw their credits to these institutions.

Unlike banks this shadow financial system does not have access to the lender of last resort support of the central bank as these are not depository institutions regulated by the central banks. What we are now observing – with the case of Bear Stearns and the recent disaster among SIVs, conduits, run on a number of hedge funds and money market funds is a generalized liquidity run on this shadow financial system.

The response of the Fed to this run has been radical and in the form of the extension of the lender of last resort support to non bank financial institutions. Specifically, the new $200 bn term facility allows primary dealers – many of which are non banks – to swap their toxic mortgage backed securities for US Treasuries; second, the Fed provided emergency support to Bear Stearns and following the purchase of Bear Stearns by JPMorgan, is now providing a $30 bn plus support to JPMorgan to help the rescue of Bear Stearns; finally, now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.

This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent.

The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. This is a most radical action and a signal of how severe the crisis of the banking system and non-bank shadow financial system is. This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages.

What will happen to the dollar if the oil producing nations will de-peg? Law of unintended consequences!

2008-03-16T19:01:00.000-07:00

Gulf Arab States Should Scrap Dollar Currency Pegs, Faber Says
By Arif Sharif

March 16 (Bloomberg) -- Marc Faber, managing director of Marc Faber Ltd. and publisher of the Gloom, Boom & Doom report, said Persian Gulf economies should revalue their currencies after the dollar slumped to record lows.

Saudi Arabia, the United Arab Emirates and three other Gulf states should link their currencies ``to a basket, and not the weakest currency in the world,'' Faber told a Middle East investment conference in Abu Dhabi today. ``They should have de- pegged their currencies a long time ago,'' he said.

Faber, who advised investors to buy gold at the start of its six-year rally, this month said Federal Reserve moves to cut interest rates to avert a U.S. economic slowdown will ``destroy the U.S. dollar.''

The dollar sank below 99 yen, the weakest in 12 years, last week and slumped to a record low versus the euro after JPMorgan Chase & Co. and the Fed bailed out Bear Stearns Cos., as credit market losses widen.

The U.S. currency also plunged to less than one Swiss franc for the first time as traders speculated the Fed will slash interest rates as much as 1 percentage point on March 18 to avert a recession.

Gulf countries are under pressure to revalue their currencies, or drop their dollar pegs, after the U.S. currency fell 10 percent against the euro last year and the Fed started cutting rates. The weaker dollar has made imports from Europe more expensive, stoking record inflation across the region.

``I am a great believer in flexible exchange rates and a strong currency is a sign of a strong economy,'' said Faber, whose Hong Kong-based Marc Faber Ltd. manages $300 million.

The U.A.E. will keep the dirham pegged to the dollar until at least the end of this year, Central Bank Governor Sultan Bin Nasser al-Suwaidi said Jan. 3. There is ``no reason'' to revalue it, he said.

To contact the reporter on this story: Arif Sharif in Dubai at asharif2@bloomberg.net

The laws of unintended consequences!

2008-03-16T18:38:00.001-07:00

What a remarkable 3 days in the market. Breathtaking. JPM acquired BCS in a Fed-Funded stealth bailout, via a $30b dollar non-recourse loan. There are bloggers out there who state that it was actually JPM being bailed out because they held the most counterparty risk at BCS. I have no information on this, but it will be interesting to see how this plays itself out. At this moment, world equity and futures markets have plummeted, the dollar is sinking faster than the Titanic, and Gold is $1020/oz. Hank Paulson made the Sunday talk show rounds today where he continues to say that the strong dollar is in our national interests, and that "in the long term", our economy and capital markets are sound. But it seems like the market participants have caught on to the Fed/Treasury deceit. This is the law of unintended consequences yet again rearing it's ugly head. Trying to soothe shaky credit markets by bailing out the world's 5th largest investment bank may very well backfire on the Fed/Treasury. People might believe in the law of cockroaches, along with the previously aforementioned rule. Printing money to bail out the cronies, Bernanke has gotten into his helicopter and will confiscate our saving by inflation, and redirect these freshly printed bills to the necessary Cronies. This is remarkable. Is this the start of The Great Recession?

How can you say the JP Morgan "bought" Bear if the Fed gave them $30 billion and they spend $236 million? Where are the liabilities?

2008-03-16T16:43:00.000-07:00

J.P. Morgan to Buy Bear Stearns
By DENNIS K. BERMAN, SUSANNE CRAIG and KATE KELLY
March 16, 2008 7:34 p.m.
J.P. Morgan Chase agreed to buy Bear Stearns for $2 a share in a stock-swap transaction, people familiar with the matter say. J.P. Morgan will exchange 0.05473 shares of its common stock per one share of Bear Stearns stock. Both boards have approved the transaction.

Indeed, the Fed is taking the extraordinary step of providing special financing in connection with this transaction. The Fed has agreed to fund up to $30 billion of Bear Stearns' less liquid assets.

The deal values Bear Stearns at just $236 million, based on the number of Bear shares outstanding as of Feb. 16. At the end of Friday, Bear's stock-market value was about $3.54 billion.

People familiar with the discussions said all sides were pushing hard to complete an agreement before financial markets in Asia open for Monday trading. "None of these things is done until they're done," Treasury Department spokeswoman Michele Davis said Sunday afternoon. "But I think everyone's expectation is sometime in the early evening hopefully" the deal will be done.

One stumbling point appeared to be the amount of risk that J.P. Morgan would absorb in any type of transaction. While J.P. Morgan is eager to snap up some of Bear Stearns assets -- such as its prime brokerage business that caters to hedge funds -- Chief Executive Officer James Dimon was reluctant to pursue the deal without certain assurances that would protect his firm's exposure, said people familiar with the matter.

Federal regulators have been trying to prevent Bear's crisis from mushrooming into a systemic threat to the stability of financial markets and other securities firm, for which confidence is essential to their ongoing operations. Unwinding Bear also would be a nightmare because it trades with nearly every firm on Wall Street.

In an interview with George Stephanopoulos on ABC's "This Week," Treasury Secretary Henry Paulson said he has been following the negotiations closely. "I've been on the phone for a couple of days straight, throughout the weekend," he said. "But people are going to need to look and see what -- and I'm not going to project right now what that outcome of that situation is."

On several occasions over the weekend, Mr. Paulson spoke about the Bear negotiations with Federal Reserve Board Chairman Ben Bernanke and New York Fed Bank President Timothy Geithner.

A price substantially below Friday's close could value Bear at just a tiny fraction of the market cap reached at its all-time peak in early 2007. Terms likely will factor in the value of Bear's Madison Avenue headquarters, which could be valued at around $1.2 billion based on going market rates. That could make Bear's banking franchise worth roughly $1 billion -- a pittance for a firm that was regularly making $1 billion to $2 billion in net income during the middle of the decade.

Through the weekend, Bear Stearns bankers were summoned to the company's headquarters on Madison Avenue, where they were told to prepare lists of ongoing deals and business relationships. Representatives from prospective buyers circulated through conference rooms, with J.P. Morgan executives asking questions of Bear's senior people. A separate bidding group, including J.C. Flowers & Co. and Kohlberg Kravis Roberts & Co., also was in the mix, said a person familiar with the discussions.

People briefed on the talks describe them as very fragile, meaning that they could culminate in a deal or very well fall apart. The final price paid could also be in flux.

Bear also has been preparing for the possibility of a bankruptcy filing, with that as the likeliest scenario if an acquisition by J.P. Morgan falls apart, according to a person familiar with the situation. Such a filing might even occur before financial markets in Asia open for Monday trading.

A takeover agreement, which still would require formal approval by the Federal Reserve, also would signal a stunning, crushing end for Bear Stearns. It has been one of Wall Street's best-known firms, surviving swoons that rivals could not. But Bear was savaged the mortgage meltdown.

Whatever the outcome of the ongoing discussions, there is likely to be a tense market opening in the U.S. on Monday, as investors worry that the run-on-the-bank-type retreat by worried Bear customers last week could spread to other firms. On Sunday, Mr. Paulson, the Treasury secretary, said in a TV interview that the government "would do what it takes" to protect the integrity of the financial system.

Any deal would all but wipe out Bear Stearns shareholders, whose shares have not traded below $20 since 1995. The pain would be most acute for Bear's own employees, who were seeped in a culture of firm ownership -- and own about a third of the outstanding shares.

Over the weekend, some Bear employees were hoping a foreign bank would emerge as the winning suitor, since that might mean fewer job cuts than by a domestic buyer. But those prospects dwindled, leaving J.P. Morgan in the prime position to acquire Bear.

Over time, Bear's misfortune could bear fruit for J.P. Morgan. Bear's investment-banking unit -- which underwrites stocks and bonds and advises on mergers -- and its fixed-income and capital-markets trading businesses, have been badly bruised by the credit crunch but still have some value.

Likely even more valuable are Bear's clearing unit, which settles trades and also services and lends to hedge funds, and an investment-advisory business catering to customers having a high net worth. Both of those operations have suffered from withdrawals in recent days.

The likely sale of Bear Stearns is the latest in the cascading mortgage-related blows that began last summer and have resulted in staggering losses and write-downs on Wall Street, the ouster of CEOs and an epidemic of worry that the financial system faces even more turmoil.

On Friday, Bear sought and received emergency funding backed by the federal government. Both the Fed and J.P Morgan stepped in to keep Bear afloat following a severe cash crunch as investors moved to pull assets from the firm.

In stepping in, the Fed was trying to move aggressively to prevent Bear's crisis from spreading to the broader economy. The lifeline gave Bear access to cash for an initial period of 28 days -- but it was widely believed Bear would be sold within days to stop it from going under.

The Fed's unusual intervention was motivated by a concern that a rapid and disorderly failure of Bear would wreak havoc on the markets in which Bear is an intermediary, particularly the huge and important repo market.

Bear risked defaulting on extensive "repo" loans, in which it pledges securities as collateral for overnight loans from money-market funds. If that happened, other securities dealers would see access to repo loans become more restrictive. The pledged securities behind those loans could be dumped in a fire sale, deepening the plunge in securities prices.

As a result, a priority for regulators in any deal for Bear or its parts is to minimize the risk to the financial system. That suggests that regulators want those counterparties furthest removed from Bear itself, for those parties to know immediately where they stand in any deal, and that a buyer have sufficient financial strength to reassure those counterparties.

The Fed's loan facility is for up to 28 days. Other terms haven't been disclosed. The Fed's leverage is unclear, though it does have the power of moral suasion -- or trying to convince many individual parties that acting for the greater good is in their own collective self-interest.

Some talk of contagion in NYT

2008-03-16T14:48:00.001-07:00

www.nytimes.com/2008/03/16/business/16cnd-bear.html?hp

The cash squeeze that brought Bear Stearns to its knees is fanning fears that other investment banks might be vulnerable to the crisis of confidence gripping Wall Street.

Investors are bracing for another volatile week in the markets as bankers and policy makers deal with the fallout from their bid to rescue Bear Stearns.

For now, the prospect of a new wave of consolidation in the beleaguered financial services industry seems remote. That is because would-be acquirers and everyday investors alike have lost faith in the values that Wall Street firms are placing on their own assets.

Of particular concern are the so-called marks placed on mortgage-linked investments like those that undid Bear Stearns, prompting a run on the firm that led the Federal Reserve and JPMorgan Chase to throw Bear Stearns a financial lifeline last week.

James E. Cayne, the chairman of Bear Stearns, mused eight years ago that he might consider selling the 85-year-old bank for a lofty price of four times what it values itself on its books. But now such a notion seems absurd — and not just for Bear Stearns.

The unhappy experience of Bear Stearns proves that it is a lack of confidence, not capital, that ultimately topples even the savviest financial institutions.

“Once you have a run on the bank you are in a death spiral and your assets become worthless,” said David Trone, a brokerage analyst at Fox Pitt Kelton.

In all-day meetings over the weekend, Alan D. Schwartz, the chief executive of Bear Stearns, met with his top executives at the firm’s Madison Avenue headquarters, trying desperately to persuade skeptical potential suitors that the firm was worth buying.

But the market had already passed a harsh judgment on Bear Stearns. On Friday, its stock plunged 47 percent, closing at $30. At that price, its shares were trading at a gaping 62 percent discount to the $80 book value that the firm has reported, reflecting the broad view that the fallout from the credit crisis had permanently devastated Bear Stearns’s core mortgage operations.

In Washington, the Treasury secretary, Henry M. Paulson Jr., signaled strong support for the Fed’s role in supplying a lifeline to Bear Stearns during the crisis negotiations, saying that his priority was to stabilize the financial system and to worry less right now about the problem of avoiding a “moral hazard” by bailing out errant institutions.

“We’re very aware of moral hazard,” Mr. Paulson said in a television interview with George Stephanopoulos on ABC. “But our primary concern right now — my primary concern — is the stability of our financial system, the orderliness of the markets. And that’s where our focus is.”

Indeed, investors are taking a grim view of the prospects for other investment banks like Lehman Brothers and Merrill Lynch. Managers of hedge funds and mutual funds say the problems at Bear confirmed their worst fears about the brokerages — that they have relied too much on leverage and have done a poor job managing the risks they took on during the boom.

The price of insurance on investment banks has surged in the last few days and is exponentially higher than it was last spring. Credit default swaps that offer protection on Bear Stearns debt traded as low as $35 per $10,000 of bonds in May. As of last Friday, the cost was $830.

Shares of investment banks in the Standard & Poor’s 500-stock index are down nearly 28 percent so far this year, and stock futures on Friday showed that a few investors were betting that Bear Stearns stock could lose virtually all of its value in the next few weeks.

“People have started to realize the risks that are there,” said Steven Gross, a principal at Penso Capital Markets, an investment firm in Cedarhurst, N.Y. “The question is have we reached the bottom.

Citigroup, one of the nation’s largest banking companies, is now trading below its book value. Lehman Brothers, at $39, is trading just below the book value it reported at the end of last year. This year, Bear’s stock is down 65 percent and Lehman’s has sunk 40 percent.

With a market value of $3.5 billion as of Friday, Bear Stearns, one of Wall Street’s oldest investment banks, is perhaps worth no more than $2 billion, accounting for the firm’s midtown skyscraper, which is probably worth at least $1 billion.

But the market did not put much faith in the Fed’s bailout of the firm, announced on Friday. Bear Stearns’s hedge fund servicing business and its clearing operations have traditionally been profitable operations, although they have suffered in recent months as investors and lenders have lost confidence. Throughout much of its history, Bear Stearns has masterfully persuaded the market that its business — narrowly focused on mortgage finance — was worth more than it actually was. To some degree this trick has been a testament to the coy gamesmanship of two of its past leaders, Alan Greenberg and Mr. Cayne.

Both men are devout bridge players and Mr. Greenberg is an amateur magician as well, so they are well schooled in the art of not showing their hand.

Mr. Cayne’s hint eight years ago — that he would only sell the firm for four times its book value — was even then a flight of financial fancy. Wall Street investment banks rarely command such a premium to their book value, given the inherent and unpredictable risks of their business.

Nevertheless, Mr. Cayne and Mr. Greenberg were adept at spreading the view that Bear Stearns was constantly being pursued by buyers as varied as European commercial banks and even JPMorgan, although it was never clear that any of these talks reached a serious level.

But Bear Stearns’s quirky culture and the high pay it awarded its senior executives made it a difficult fit for larger, more staid institutions, and it always seemed that Mr. Greenberg and Mr. Cayne were having too much fun running their business to sell it to an outsider.

In the last few days, Mr. Schwartz, a veteran investment banker whose approach to deal making is more pragmatic and results-oriented than his predecessor, raced against the clock to seal a deal that salvages some measure of value for shell shocked Bear Stearns employees, who own over 30 percent of the firm, and its investors.

And while Bear’s peers on Wall Street are not yet in such dire shape, they have surely accepted the reality of leaner times and lower valuations in the months to come.

“Banks and brokerages are a house of cards built on the confidence of clients, creditors and counterparties,” Mr. Trone said. “If you take chunks out of that confidence, things can go awry pretty quickly. It could happen to any one of the brokers.”

Group challenges legality of Fed's Bear Bailout!

2008-03-16T12:25:00.000-07:00

www.reuters.com/article/ousiv/idUSN1630454820080316

By Joanne Morrison

WASHINGTON (Reuters) - A housing and fair lending activist group has challenged the legality of the Federal Reserve's quick approval of financing for Bear Stearns (BSC.N: Quote, Profile, Research) via JPMorgan Chase (JPM.N: Quote, Profile, Research), questioning the Fed's authority to approve the deal because it involves a non-bank institution.

Inner City Press Community on the Move, in a complaint filed with the Fed late Saturday, called the central bank's brokering of the deal "entirely illegal" and anticompetitive, and questioned whether sufficient Fed members had voted for it.

In a first step toward challenging the bailout, Inner City Press questioned the legality of the Fed approving the deal without public notice, on the grounds Bear Stearns "is not a banking holding company and does not own a bank."

The Fed approved financing to Bear Stearns through JPMorgan in an emergency meeting Friday morning.

It was the Fed's first rescue of a broker since the Great Depression and its latest effort to soothe financial markets roiled by fallout from rising mortgage defaults.

But Matthew Lee, executive director of Inner City Press, vowed to take all needed legal actions against the deal.

"The Fed has hit a new low with this, they did nothing to protect consumers from predatory lending and now their response is to bail out one of the most notorious enablers of predatory lending with no benefit to struggling consumers," said Lee.

"This should be taken as far as it can go to finally bring the Federal Reserve to account that they work for the public interest and not only Wall Street, particularly in a time of crisis," he told Reuters on Sunday. The Fed could not immediately be reached for comment.

Inner City Press, a nonprofit group that has challenged the nation's key bank mergers over the past decade in an effort to ensure poorer communities are served fairly, also questioned why only four of the five Fed governors approved the measure.

The Fed approved the deal between JPMorgan and Bear Stearns under Depression-era laws allowing it to do so under "unusual and exigent circumstances." This provision, however, requires an affirmative vote of not less than 5 members of the board.

At present, there are only five members on the board with two vacancies, but only four approved the measure because governor Frederic Mishkin was not present, according to the Federal Reserve.

But current law mandates that no less than five members can vote on the matter and states that members can be contacted through any electronic means, including by telephone and e-mail.

"There has been no showing that, given technology in 2008 (as opposed to the 1930s when this language was enacted), the required attempts to contact Gov. Mishkin were made," Lee wrote in the complaint.

Inner City Press also questioned whether the deal could be finalized without antitrust review.

"Third, to allow this relation between the nation's third largest bank and fifth largest brokerage, without any antitrust review, even with the required votes (which the Fed) did not have, is unlawful," the complaint stated, requesting public hearings on the matter.

The complaint also asks for a probe into Bear Stearns' disclosure of its financial condition, citing an interview the firm's chief executive gave on CNBC television earlier in the week during which no mention of the scope of the firm's financial troubles were made.

More lies, damn lies and Paulson lies. How can anybody believe this man?

2008-03-16T09:34:00.000-07:00

biz.yahoo.com/ap/080316/paulson_credit_crisis.html

Treasury Chief Defends Fed Intervention
Sunday March 16, 11:01 am ET
By Jeannine Aversa, AP Economics Writer
Treasury Secretary Henry Paulson Says Fed Made Right Decision to Help Bear Stearns

WASHINGTON (AP) -- Treasury Secretary Henry Paulson on Sunday defended the Federal Reserve's decision to help rescue Bear Stearns Cos., the teetering Wall Street investment bank. He sidestepped questions about whether other firms are on shaky ground and the possibility of additional interventions of this kind.
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At the same time, Paulson sought to send a calming message that the Bush administration is on top of the turbulent situation. "The government is prepared to do what it takes" to ease turmoil in the financial system and minimize any damage to the national economy, Paulson said during a series of broadcast interviews. The Fed's intervention "was not a difficult decision. It was the right decision."

The Fed, using a Depression-era procedure, raced to Bear Stearns' aid Friday along with JPMorgan Chase & Co. Bear Stearns had made a fortune in mortgage-backed securities but faced a possible collapse after those investments soured. Wall Street nose-dived as fears spread about whether other big firms were in jeopardy.

"When you go through a period like this," Paulson said, "policymakers need to balance various consequences."

Some critics contend that the Fed's move was akin to a government bailout -- something the Bush administration has repeatedly said it is against.

"Well, every situation is different. We have to respond to the circumstances we're facing today," Paulson said. "And my concern is to minimize the impact on the broader economy as we work our way through this situation, and again, the stability of our financial situation."

The financial system, he said, is "more fragile than we would like right now."

Asked whether other financial companies may be in a situation similar to Bear Stearns', Paulson did not directly answer. He did seek to strike a confident tone.

"Well, our financial institutions, our banks and investments banks are very strong," he said. "And I'm convinced that they're going to come out of this situation very strong."

Paulson would not discuss what would have happened if the government didn't extend a financial lifeline to Bear Stearns. "I'm not going to speculate about what ifs," he said.

Economists increasingly believe the spreading fallout from a severe credit crisis has pushed the country into its first recession since 2001. The situation has led to record-high home foreclosures, forced financial companies to take multibillion losses from bad mortgage-linked investments and rocked Wall Street.

"No one is debating the fact that this economy has slowed way down," Paulson said. "We feel it, we know it, the American people know it."

The government's economic relief package, including tax rebates for people and tax breaks for businesses, should help bolster the economy later this year, Paulson said. He was cool to the need for additional economic stimulus, which is being promoted by Democrats in Congress.

Sen. Charles Schumer, D-N.Y., accused President Bush of not doing enough.

"The president is, indeed, behaving like Herbert Hoover. We're in the most serious economic problem we've been in in a very long time, much worse than 2001. The president's hands-off attitude is reminiscent of Herbert Hoover in 1929, in 1930," Schumer said. "There are lots of things that can be done, particularly on housing. Housing has been the bull's eye of this crisis."

Consultations about the Bear Stearns situation continued through the weekend among representatives from the Fed, Treasury Department, financial institutions and others.

President Bush planned to meet on Monday with his advisory panel on financial markets, whose members include Fed Chairman Ben Bernanke and Paulson. The panel on Thursday recommended stricter regulation of mortgage lenders as part of a broad effort to prevent a repeat of a credit crisis threatening to drive the country into recession.

With the value of the dollar plunging, Paulson stuck to the position of past treasury chiefs when he said a strong dollar is in the national interest. The dollar has dropped to a new low against the euro and a fallen sharply against the Japanese yen. That helps sales of U.S. exports to foreign buyers because it makes U.S. goods less expensive. But the drooping dollar increases inflationary pressures.

Paulson appeared on ABC's "This Week," "Fox News Sunday" and "Late Edition" on CNN. Schumer was on Fox.

Nice case for government policy blowback.

2008-03-16T06:13:00.000-07:00

mwcnews.net/content/view/20933/26/

The Government's Chickens Are Back

When a private company screws up, there is no shortage of people demanding more government intrusion in the marketplace. But when the government screws up, they don't call for less government. They call for more.

The economy is slowing down, and the government is at fault. But, if anything, the policymakers and pundits want the government to do more of what got us into trouble in the first place. If a lot of poison is bad, a lot more is somehow good. That's the logic of statism.

Make no mistake: the government is the cause of the slowdown. The trigger was the housing problem -- the surge in mortgage defaults and foreclosures, and the fall in home values. The government has been all over the housing industry for decades. Through various devices the politicians have made it easy for people to buy homes, even those who had poor credit and zero savings.

There was a time when a young couple just starting out would work hard for several years to save up a down payment for a house. But thanks to the policies of Congress and agencies such as FHA, people could realize the "American dream" with almost no effort. One could buy a house with virtually nothing down. Government guarantees kept mortgage rates lower than they would have been. This was considered good social policy, but we should be suspicious when government claims to be helping people. It has no resources that it hasn't first taken from someone else. Any pledge it makes is a pledge of the taxpayers' money.

Next, in the name of social justice, the government pressured lenders through the Community Reinvestment Act to write mortgages for low-income people with bad credit. This is a source of the subprime mess. The loosening of lending standards was also encouraged by the government-created agencies Freddie Mac and Fannie Mae, which buy mortgages from the original lenders, bundle them, and sell securities based on the resulting income stream. The Federal Reserve's long-standing readiness to bail out banks and other lenders that get into trouble was another step toward the government-caused crisis.

The result of this intervention is known as moral hazard. If government places a safety net under lenders and borrowers, it encourages bad loans. Imagine that the losses of a gambler in Las Vegas were underwritten by the government. Would he be as careful as he is when he has to cover his losses himself? If any of this is reminiscent of the savings-and-loan fiasco of the 1980s, it should be. The government's guarantee of deposits freed the S&Ls to make imprudent investments. The consequence of that policy cost the taxpayers a pretty sum.

"The result of this intervention is known as moral hazard. If government places a safety net under lenders and borrowers, it encourages bad loans. Imagine that the losses of a gambler in Las Vegas were underwritten by the government."

The current rash of defaults and foreclosures is a case of chickens coming home to roost. No one should be surprised that a system designed to lower lending standards did just that and has now come to grief. When the government, regardless of intentions, deliberately weakens the need for responsibility, the result will be irresponsibility, and the consequences will inevitably fall on others. That is how government works.
Nor should we be surprised that presidential candidates are making lenders, rather than the politicians, the scapegoats. When banks shied away from lending to people with bad credit and low incomes, they were accused of discriminatory "red-lining." Now, after making such loans under threat of legal penalty, they are accused of predatory lending. I'm no fan of the government-sponsored banking cartel, but why would a bank intentionally write a mortgage for someone it knew couldn't make the payments? Foreclosing on the house is rarely a preferred outcome.

The mortgage mess has now shaken lots of lending institutions to their foundations. They are reluctant to lend to anyone for any reason. So the economic slowdown has spread. But rather than reversing its policies and letting a free market emerge to fix things up, the government is doing more of the same. This week the Fed announced it will lend billions of dollars to banks and accept their shaky mortgages as collateral.

Another bailout. Another round of moral hazard. More chickens will be on their way home.

Fed trying to jawbone people into staying in home that they can't afford. What's wrong with walking away and renting?

2008-03-16T05:59:00.001-07:00

www.boston.com/business/personalfinance/articles/2008/03/16/boston_fed_makes_rare_direct_appeal_to_hard_hit_borrowers/

Boston Fed makes rare direct appeal to hard-hit borrowers
Email|Print|Single Page| Text size – + By Kimberly Blanton
Globe Staff / March 16, 2008
In a rare appeal to Main Street, the head of Federal Reserve Bank of Boston is telling subprime borrowers how to save their homes in an opinion piece distributed to 139 community newspapers across New England.

The 668-word piece, by Eric Rosengren, the president of Boston's Fed, reads less like an opinion piece and more like a public service announcement. The article seeks to prevent some subprime borrowers from entering foreclosure by impressing upon them the urgency of contacting a lender to renegotiate their mortgage with their current loan company, or with one of five lenders participating in a regional mortgage-rescue program.

"The time to act is now," he wrote, even providing toll-free numbers of banks so homeowners can begin the process. The piece, for publication beginning today, was also translated into Spanish and Portuguese, and distributed to those communities' newspapers.

The letter is among numerous efforts by Rosengren, his counterparts at other regional banks around the country, and the Federal Reserve Board to deal with the growing mortgage crisis. The Fed's campaign comes as both federal and state regulators have come under criticism for failing to anticipate lending problems and to take action earlier to prevent them.

"The goal is to reach these borrowers and make them aware from a reliable source that now is the time to think about what their options are," Rosen gren said in an interview. "A natural human tendency is to put off unpleasant tasks. It's encouraging people not to wait any longer - now is a good time."

The subprime crisis continues to snowball, and foreclosures this year are expected to exceed 2007 levels. Subprime mortgages are higher price loans made to borrowers with questionable credit histories. These adjustable-rate loans started with low interest rates but now are resetting, causing monthly payments to balloon beyond what many borrowers can afford and forcing many into foreclosure.

Fed research found about 16 percent of borrowers may be eligible to qualify for a new mortgage and convert their subprime mortgages to other, more affordable loans. Rosengren said it's extremely difficult to reach these borrowers, who often got a loan through an independent broker or loan company that may have gone out of business.

He and other Boston Fed officials also have taken their message to new venues, including local chambers of commerce, the Massachusetts Bar Association, local community groups, and community banks.

The article is targeted to borrowers not yet in foreclosure. It urges those with high-rate loans who may have equity in their homes to seek out help if their payments are too high. It also directs them to the Mortgage Relief Fund, a $125 million fund set up by Bank of America Corp., Citizens Bank, Sovereign Bank, TD Banknorth, and Webster Bank to refinance subprime mortgages.

The opinion piece also says some borrowers may be able to qualify for federally sponsored mortgages, and it directs lenders to be responsive to borrowers who inquire at their branches.

Federal Reserve officials have not, historically, tried to help consumers directly, and many interpret these educational efforts as a last-ditch effort.

"They've taken a beating," said Patrick Newport, an economist for Global Insight, a Lexington economic consulting firm. "They are doing everything they can because this thing is just a mess, and it's getting worse."

He conceded the op-ed piece could make a small difference to individual borrowers, though its impact will be limited. "Most people don't really know who this president of the New England Federal Reserve is," he said.

Thomas Lavelle, the Boston Fed's spokesman, said the opinion piece was sent to small regional papers across New England including the Burlington Free-Press in Vermont, the Springfield Republican, The Lowell Sun, and The Advocate in Stamford, Conn. It was also distributed to dozens of community papers, including The Sun Journal in Lewiston, Maine, the Kennebec Journal in Maine, the Central Maine Morning Sentinel, and The Metro-West Daily News in Framingham.

Sean Leonard, the editorial page editor of The Daily Item of Lynn, said he plans to run the article soon as a complement to his paper's coverage of foreclosures, which hit that community hard. He said he was surprised to receive it and believes it will carry "gravitas," because it's written by a high-level Fed official.

"There's a sharp realization of what's happening, but people caught in the subprime-mortgage crisis - they don't know what to do," he said. The information in the article, he said, "can certainly help."

Kimberly Blanton can be reached at blanton@globe.com.

Oh The Hypocricy!

2008-03-15T12:08:00.000-07:00

www.bloomberg.com/apps/news?pid=20601087&sid=abL7IinDjRZ4&refer=home

Bush Won't Be Forced Into `Bad Decisions' on Economy (Update1)
By Roger Runningen

March 15 (Bloomberg) -- President George W. Bush, under fire from Democrats who say he's doing too little to help homeowners facing foreclosure, said he won't be stampeded into ``bad policy decisions'' that might harm the economy.

``The market now is in the process of correcting itself, and delaying that correction would only prolong the problem,'' he said today in his weekly radio address. ``I believe the government can take sensible, focused action to help responsible homeowners weather this rough patch.''

Bush's remarks echoed a speech yesterday, when he said the economy is going through a ``tough time'' and that the Federal Reserve and the Treasury Department will take ``appropriate steps'' to stabilize the financial system after a bailout of Bear Stearns Cos., the fifth-largest U.S. securities firm.

Bush is scheduled to meet March 17 with his Working Group on Financial Markets, the nation's top financial regulators that include Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson and the heads of the Securities and Exchange Commission and Commodity Futures Trading Commission.

Bush said today he opposes a congressional plan that would give bankruptcy judges powers to reduce mortgage debts by decree, because banks would charge higher interest rates to cover the risk. Another proposal would have the government buy homes and take them off the market, leading to artificially higher prices than justified by the market, he said.

``If we were to pursue some of the sweeping government solutions that we hear about in Washington, we would make a complicated problem even worse -- and end up hurting far more homeowners than we help,'' Bush said.

Democrats' Plans

Some congressional Democrats said yesterday that the administration must do more to bolster the housing market, including backing a plan to let the Federal Housing Administration insure refinanced mortgages after lenders reduce principal to help struggling borrowers.

``The president seems to be on a different economic planet than most Americans,'' Senator Charles Schumer, a New York Democrat, said yesterday after Bush's speech to the Economic Club of New York.

Even U.S. Federal Deposit Insurance Corp. Chairman Sheila Bair, a Bush appointee, said yesterday that policy makers need to pursue ``more aggressive intervention'' in curbing the surge in foreclosures arising from the subprime-mortgage crisis.

Bernanke yesterday called for ``strong oversight'' of mortgage lenders, saying that ``far too much of the lending in recent years was neither responsible nor prudent.''

Foreclosures Rise

The collapse in housing has rippled into credit markets as foreclosures boost inventories of unsold homes, depressing prices and limiting refinancing opportunities for troubled borrowers. U.S. home foreclosure filings jumped 60 percent in February over the previous year, according to RealtyTrac Inc. of Irvine, California.

In his radio address today, Bush said the administration is pushing industry-led programs where lenders and service providers work with qualified borrowers to refinance home loans when they can't make their monthly mortgage payments. Government regulators also have stepped in to ensure that mortgage contracts are more transparent and fair, he said.

The president said Congress must take other steps to ease the home-lending crisis, including revamping operations of Fannie Mae and Freddie Mac, the largest U.S. mortgage-finance providers.

Lawmakers also must streamline the Federal Housing Administration to become more competitive in the mortgage market and permit state housing agencies to issue tax-free bonds to help homeowners refinance their mortgages, Bush said.

Stimulus Package

A $168 billion stimulus package of rebates to 130 million households beginning in May, and tax breaks for business available now, will help boost the economy, Bush and his economic advisers say.

``By taking these steps and avoiding bad policy decisions, we will see our economy strengthen as the year progresses,'' Bush said in his radio address.

To contact the reporter on this story: Roger Runningen in Washington at rrunningen@bloomberg.net

Roubini: Step 9 of Financial Meltdown

2008-03-15T11:30:00.001-07:00

Step 9 of the Financial Meltdown: "one or two large and systemically important broker dealers" will "go belly up"

Nouriel Roubini | Mar 14, 2008
In my February 5th piece on 12 Steps to a Financial Disaster I predicted - as Step 9 of the meltdown - that "one or two large and systemically important broker dealers" will "go belly up" and that other members of the "shadow financial system" - i.e. non-bank financial institutions that look like banks in terms of liquidity/rollover risk - will also go bankrupt. As I put it then:

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can. [bold added]

And today the first one of these large broker dealers - Bear Stearns - in on the verge of bankruptcy. Let us be clear: given its massive exposure to toxic MBS and ABS product Bear Stearns is insolvent; the decision by the NY Fed to try to bail out Bear Stearns would make sense if this firm was only illiquid; the trouble that it is insolvent and thus such attempted bailout is altogether inappropriate. It is true that Bear is a large broker dealer; but its systemic importance is much smaller than that of much larger institutions. The world and financial market can survive if Bear disappears.

So the only possible justification for such Fed action is to engineer an orderly rather than a disorderly shutdown of this institution. But unfortunately the Fed is behaving as if Bear Stearns is illiquid but solvent. That is delusional and the official sector support of an otherwise insolvent institution will end up - like many other recent Fed actions - being paid for by the US tax-payer.

As discussed months ago in this column non-banks institutions don't have access - based on the Federal Reserve Act - to the lender of last resort support of the Fed unless a very special and unusual procedure and vote is taken. So for the first time in decades - possibly since the Great Depression - the Fed had to rely on this exceptional rule to bail out a non-bank financial institution. So what is next? Bailing out hedge funds, bailing out money market funds, bailing out SIVs? When is enough enough? This when the Fed has already committed this week to swap 60% ($ 400 bn) of its balance sheet of Treasuries for mortgage backed securities of dubious quality and value.

And Bear is only the first broker dealer to go belly up. Rumors had been circulating in the market for days that the exposure of Lehman to toxic ABS/MBS securities is as bad as that of Bear: according to Fitch at the beginning of the turmoil Bear Stearns had the highest toxic waste ("residual balance") exposure as percent of adjusted equity on balance sheet; the exposure of Bear was 54.5% while that of Lehman was only marginally smaller at 53.3%; that of Goldman Sachs was only 21%. And guess what? Today Lehman received a $2 billion unsecured credit line from 40 lenders. Here is another massively leveraged broker dealer that mismanaged its liquidity risk, had massive amount of toxic waste on its books and is now in trouble. Again here we have not only a situation of illiquidity but serious credit problems and losses given the reckless exposure of this second broker dealer to toxic investments.

We will leave aside for today the fact that a growing number of members of the "shadow financial system" have gone belly up in the last month alone: the entire SIV scheme is being wound down and brought back on balance sheet; a few hedge funds are now closing shops (for details see the web site The Hedge Fund Impode-O-Meter) ); a few money market funds that had exposure to toxic MBS have experienced runs and had to be bailed out; a highly leveraged private equity bond fund has gone belly up; a major near prime mortgage lender is bankrupt. In all these cases a poisonous combination of liquidity risk and credit risk was exacerbated by reckless leverage.

So the question is: if Bear Stearns screwed up big time - as it did - with huge leverage, reckless investments, lousy risk management and massive underestimation of liquidity risk why should the US taxpayer bail out this firm and its shareholders? First fully wipe out those shareholders, then fire all the senior management and have the government take over such a bankrupt institution before a penny of public money is wasted in bailing it out. Instead now the use of public money to bail out financial institutions is spreading from banking ones to non banking ones. The Fed should at least give a clear and public explanation of why such extremely exceptional - and almost never used - intervention was justified.

Unless public money is used on a very temporary basis to achieve an orderly wind-down or merger of Bear Stearns this is another case where profits are privatized and losses are socialized. By having thrown down the drain the decades old doctrine and rule that the Fed should not lend or bail out non-bank financial institutions the Fed has created an extremely dangerous precedent that seriously aggravates the moral hazard of its lender of last resort support role. If the Fed starts on the slippery slope of providing massive liquidity support to non-bank financial institutions that have recklessly managed their risks it enters into uncharted territory that radically changes its mandate and formal role. Breaking decades-old rules and practices is a radical action that seriously requires a clear public explanation and justification.

Quote, "Mr. Bernanke has become Wall Street's most important and powerful friend." Gee, do you really think that's true?

2008-03-15T10:41:00.000-07:00

nytimes.com/2008/03/16/business/16bernanke.html?pagewanted=1&_r=1&hp
Fed Chief Shifts Path, Inventing Policy in Crisis

By EDMUND L. ANDREWS
Published: March 16, 2008
WASHINGTON — As chairman of the Federal Reserve, Ben S. Bernanke has long argued that a central bank should base its policies as much as possible on consistent principles rather than seat-of-the-pants judgment.

But now, as the meltdown in credit markets threatens major institutions on Wall Street and a recession appears inevitable, Mr. Bernanke is inventing policy on the fly.

“Modern monetary policy-making puts a lot of weight on rules, but there is no rule book for an economic crisis,” said Douglas W. Elmendorf, a senior fellow at the Brookings Institution and a former Fed economist.

On Friday, the Federal Reserve seemed to toss out the rule book altogether when it assumed the role of white knight, temporarily bailing out Bear Stearns, one of Wall Street’s biggest firms, with a short-term loan to help avoid a collapse that might send other dominoes falling.

That move came just days after the Fed announced a $200 billion lending program for investment banks and a $100 billion credit line for banks and thrifts. In a move that would have been unthinkable until recently, the central bank agreed to accept potentially risky mortgage-backed securities as collateral.

On Tuesday, the central bank is expected to reduce short-term interest rates for the sixth time since September. The Fed has already lowered its benchmark federal funds rate to 3 percent from 5.25 percent, and investors are betting that it will cut the rate to just 2.25 percent on Tuesday.

The mounting crisis has forced Mr. Bernanke, a former professor of economics, to discard the sanguine view of the nation’s economic health that he expressed last summer. He has also abandoned his skepticism about the need to calm financial markets and set aside his concerns about the “moral hazard” of bailing out big financial institutions.

In Washington and in New York, Fed officials were expected to work through the weekend, analyzing the books of Bear Stearns and trying to prevent its troubles from setting off a chain reaction of failures among its lenders and trading partners.

It was just 10 months ago that Mr. Bernanke, in discussing his reluctance to regulate the booming market for arcane credit instruments, declared: “Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or financial institution.”

As recently as last summer, Wall Street executives grumbled privately that Mr. Bernanke was too disengaged from the real world, too slow to understand the plight caused by bad mortgages and too hesitant about lowering interest rates.

But Mr. Bernanke has become Wall Street’s most important and most powerful friend. Executives are praising him for his creativity and willingness to act boldly.

Beyond trying to lower borrowing costs by reducing the federal funds rate, the Fed has adopted a widening array of unconventional tools to infuse money into the banking system.

The question now is whether the Fed is already too late and whether it has enough power to stabilize the markets without starting a new round of inflation. With oil and gold prices soaring to new highs and the dollar falling to new lows, investors already appear to be worrying about higher inflation.

Officially, the Fed continues to predict that the United States can narrowly escape a recession. But Mr. Bernanke has made it clear that the economy is in perilous shape, plagued by a continuing plunge in the housing market, rising job losses, rising energy prices and a paralysis in credit markets as banks and financial institutions sell off even high-quality mortgage-related securities at fire-sale prices.

Most private forecasters contend that a recession is already under way, and even the dwindling numbers of optimists warn that growth will be almost stagnant for the first half of this year.

“The self-feeding downturn now in place shows signs of becoming deeply entrenched,” economists at Citigroup wrote Friday, predicting that the Federal Reserve would cut its benchmark federal funds rate a full percentage point on Tuesday to 2 percent. Citigroup itself has already booked huge losses from its holdings of mortgage-backed securities, and it could face additional losses if Bear Stearns were to fail.

The evolution of Ben Bernanke, who took office in February 2006, began in early August, as credit markets were beginning to freeze up in panic over losses from subprime mortgages. The Fed stunned investors by refusing to lower interest rates and even refusing to change its view that rising inflation posed a bigger risk than slowing growth. The Fed’s rigidity aggravated fears, and investors suddenly became reluctant to finance a wide variety of short-term commercial debt, known as asset-backed commercial paper. It is used to finance mortgages, credit card debt, automobile loans and business loans.

With stock markets plunging and credit availability disappearing, the Fed, along with European central banks, began injecting billions of dollars into financial markets through open-market operations — the buying and selling of Treasury securities.

On Aug. 17, 10 days after the Fed refused to lower its key rate, the central bank held an unscheduled emergency meeting and announced that it would cut the rate at which banks could take out short-term loans from its “discount window,” a program normally used by banks in trouble, and it said banks would be able to pledge mortgages as collateral.

It was the Fed’s first step in what quickly became a major course reversal. The central bank signaled that it would probably lower its most important interest rate, the federal funds rate, but the Fed also took its first step toward addressing a cash shortage by lending cash or Treasury securities, backed up by packages of mortgages.

Fed officials say they have not changed their basic principles. Rather, they say, they have changed their view of the economy’s prospects. Throughout the spring, Mr. Bernanke hoped that the economy’s problems would be limited to the housing market and that the financial sector’s problems would be confined to subprime loans.

But by late August, Mr. Bernanke had immersed himself in the structural plumbing of financial markets, from inscrutable mortgage securities like “collateralized debt obligations” to the proliferation of “structured investment vehicles” that permitted investors to borrow at short-term rates to buy long-term debt securities like mortgages.

Mr. Bernanke, working closely with a group of other prominent officials, including Timothy F. Geithner, president of the Federal Reserve Bank of New York, began looking for new tools, beyond interest rates, that the Fed could use to provide relief.

Still, Fed officials found themselves repeatedly startled by the persistence of acute stress in the credit markets. After the Fed lowered the federal funds rate in September and October, the panic appeared to subside as investors lowered the risk premiums they were demanding on debt securities.

But the panic returned in December and again in January. When Fed officials met Dec. 11 and lowered their key rate another quarter-point, the stock market plunged amid widespread disappointment that the central bank had not done more.

Fed officials hastily telegraphed that they were planning other measures and the next morning announced a new lending program called the “Term Auction Facility.”

The program was open to any bank or depository institution, which would be allowed to bid for up to $20 billion in one-month loans. The twist was that banks could pledge mortgage-backed securities as collateral —including securities that could not be traded and had no current market price.

Fed officials expanded the program to $60 billion a month in January and $100 billion a month in March.

Mr. Bernanke did not stop there. On March 7, the Fed said it would infuse an extra $100 billion into the financial system through its open-market operations. And on Tuesday, it created an additional $200 billion lending program that would permit a select list of big investment banks to borrow money and post mortgage-backed securities as collateral.

“They have been very creative in what they’ve been doing,” said Richard Berner, chief economist at Morgan Stanley. “The key issue is whether the traditional tools of monetary policy — lowering the federal funds rate — is enough to address the financial crisis. These tools don’t solve the credit problem, but they do provide liquidity to the market.”

But by Friday morning, it became clear that more tools would be necessary. Bear Stearns, which had been one of the most aggressive financiers of subprime mortgages, was on the brink of collapse largely because of the sinking value of its own assets.

Hoping to avoid the collapse of a major trading firm that might set off a chain reaction at other firms, the Fed officials helped work out a deal under which Bear Stearns would borrow money long enough to keep from defaulting on its obligations and either be restructured or sold to its rivals.

The bailout had officially begun.

Wall Street loves it's Hand Outs

2008-03-15T10:09:00.001-07:00

www.atimes.com/atimes/Global_Economy/JB28Dj03.html

Pain relievers should share the pain
By Julian Delasantellis

Wrongly attributed to New York Tribune publisher Horace Greeley in 1865 (the actual author was Indiana newspaperman John B L Soule in 1851) "Go West, young man, and grow up with the country" defines not only the American expansionary spirit of the latter 19th century, but, to a certain extent, the philosophical ethos that forever has defined American society, from the pilgrims at Plymouth Rock to the present.

Got a problem, be it with your work, your community, your church hierarchy, your family, even your spouse? The solution was always to pack up stakes and strike out towards the frontier, towards the plentiful open space of the boundless West, towards the limitless new dreams guaranteed to be just over the horizon, available to all free men just by virtue of their birthright as Americans.

Until now. Because of the spreading and intensifying effects of the subprime mortgage crisis, almost 9 million American households (by comparison, there were only 4 million slaves in the American South at the beginning of the US Civil War) are now indefinitely tied down as tightly as Russian serfs to their plots of land, as the turbofinance of the 21st century puts into place a breathtakingly oppressive new financial feudalism that, as much as any poor 19th century peasant toiling on the banks of the Volga, limits their options, their mobility, ultimately their very freedom.

Like a cancer metastasizing through the body invading vulnerable organs one by one, the subprime mortgage crisis is now showing up in yet another doleful manifestation of the closing of the American dream. This time, it's the almost 9 million American homeowners who now owe more on their properties than their properties are worth, who are, in mortgage industry jargon, "under water" on their properties.

The American economic and governing elite, those who rule in the name and for the benefit of the people, is certainly springing into action to address the problem. Last week, Countrywide Financial, the now nearly bankrupt Pied Piper of subprime whose golden flute now appears to have led a good portion of the world's financial markets right off a cliff, hosted a posh "eat drink and be merry, for tomorrow we die" ski soiree (actually, it's probably more accurate to say that the atmosphere was along the lines of "eat, drink and be merry, for tomorrow we'll all get fired" after the pending buyout of Countrywide by Bank of America goes through) for what's left of the mortgage origination industry in Vail, Colorado.

And down there on those private islands in the Caribbean, the places where, you know, only the right sort of Gulfstream G550s are allowed to land, America's business and political elite are obviously burning with desire to assist the nation's endangered homeowners.

Hey, boy. Rub some oil on my back.
Much in the same way that longstanding cultural traditions make those who suffer the coming-of-age ceremony that is female genital mutilation welcome this torture, in America, the formal ceremony that accompanies the legal transfer of real estate from seller to buyer, called a closing, is a traditional torture that Americans have come to accept as an inevitable right of passage along the way to the American dream of home ownership.

Usually occurring at the offices of the specialized professional parasites called real estate lawyers, a closing involves bringing buyer and seller together with lawyers and bankers for hours of paper signings that codify into contract the changes in the parties' ownership and status.

For the buyer, who foots the bill for all parties providing the day's entertainment, the closing involves a formal acknowledgement that, although he may be now on record as the legal owner of the property, his continued ownership is always conditional on keeping current on the mortgage financing obtained to acquire the property.

For the seller, the closing involves signing pounds of paper relinquishing his ownership claim in the property, and, in return, receiving a nice big check in payoff. But first, before the seller receives a penny of proceeds from the property, he must make a one-time payoff of the remaining balance of the mortgage; the difference between what the buyer is paying and what the bank takes out is what the seller walks away from the closing with.

With the traditional pattern of American real estate price appreciation, closings are usually fairly pleasant for the sellers - the rising prices means that the mortgages can be paid off with still healthy chunks of cash left over.

Of course, there's not much that the seller can do with his newfound bounty, for, although he may then have a nice big check in his pocket, he also has no place to live.

Unless he wants to reside in a refrigerator box or move out of his local real estate market into a cheaper one, the riches obtained in selling his old property will be eaten up at the purchase closing of his new property. In this, the varying real estate prices and valuations of America's individual, localized real estate markets work very similarly to the floating rate regime of the international foreign exchange markets.

If you own property in a high-value real estate market, say San Francisco or Boston, you can, in much the same way that European tourists were able to travel to New York this last holiday season to snatch up bargains with their strong euros, sell that overvalued property to get a lot more value in areas with less expensive real estate. Fargo, North Dakota currently lists for sale over 250 three-bedroom, two-bath houses under US$200,000 , while Sunnyvale, California, south of San Francisco, lists, of course, none.

Sellers in pain
It's not at all uncommon for the buyer to have to bring money to the closing, either as the down payment, or to pay the 5-10% of the purchase price that are the useless expenses, called "closing costs", that the actors in the system, collecting what economists would call a "monopoly rent", bleed from out of the open veins of the buyers. But, up until recently, it was unheard of for the seller to have to bring money to the closing.

This would be the case if the selling price of the house was not sufficient to pay off the remaining balance on the mortgage. This would happen if, in between the time of the house's purchase and its sale, its value declined below that of the outstanding mortgage. This situation would be more likely if the seller, instead of paying down the mortgage and building equity in the house, continually re-leveraged the property with second and third mortgages and/or home equity loans.

If the value of the home selling price falls short of the mortgage balance by say, $50,000, then that's $50,000 worth of pain to be deposited on the head of the seller. Even though he no longer owns the house, he still has the same mortgage obligation to pay down the debt; if he doesn't, the bank can go to court to have his wages garnished or assets seized in order to collect it. The only real alternative the poor borrower has then is to declare bankruptcy, and in doing so, resign himself to at least seven years of existence in the shadowy, credit restricted American netherworld known as the cash economy.

Obviously, what most homeowners will do in this situation is to not sell the house; they will continue to live in it and make the payments as best as they can, in the hope that someday the house's value will rise enough that they won't have to keep living their lives as indentured servants to it. This, of course, makes their relationship with the house the most central aspect of at least their financial, and frequently their personal, lives. (A couple going through a divorce in this situation may well find that, even after the relationship they have with each other is legally dissolved, the relationship they continue to have with the house and its mortgage keeps the two of them still bonded and living together in unending, doleful personal embrace.)

In contrast to the supposed sclerotic nature of the West European economies, the American economy is said to be "flexible" and amenable to rapid change. In terms of American companies' human relations policies, that means that most companies view their work staff as interchangeable and disposable as tissue paper. For a worker who thus gets laid off but who can't move to an area with better employment prospects because he can't sell his house, the American promise of unlimited freedom and liberty will ring very hollow, as will it for the worker who, for the same reason, can't accept a promotion or a better job in a new city.

Due to the subprime mortgage crisis, almost 9 million American households are currently in the situation described above, being under water on their mortgages.

Not all of these unfortunates are subprime borrowers. With the quickening pace of foreclosures and subsequent foreclosure property auctions, the added supply of homes onto the market is driving down prices. Also, the tightening lending standards in the mortgage finance industry, with prospective buyers who previously qualified for loans now shut out of the market, are thus further suppressing both demand and prices.

In addition, during the go-go real estate boom of the past few years, many prospective homebuyers and home equity borrowers were allowed to borrow right up to the then inflated assessed value of their property, leaving them almost no cushion of safety should, as is the case now , values start to fall.

Last week, different proposals emerged from both government and the banking system as to how to deal with the crisis of the submerged sellers.

Avatars of ideology
The banking industry is proposing a fairly simple solution to this, and most of the other problems arising from out of the subprime crisis. Much like the nationalization of the Northern Rock bank in stodgy old supposedly socialist Great Britain, these avatars of free-market ideology in the finance trade are, essentially, calling for the nationalization of the entire subprime mortgage industry.

Here is the core difference between advocating for capitalism and supporting capitalists. Capitalism is a system that heralds the innate, natural superiority of the market over government; as for the capitalists themselves, they're just fine with as much government support and largesse that they can get their hands on-well; who says no to found money?

Proposals being floated from the financial community are calling for the government to buy up just about every single subprime, and a whole lot of the now endangered Alt-A higher quality mortgages as well. If the government wanted to then show a measure of forbearance or mercy to the borrowers that the private sector is now choosing not to, it then could - it's no skin off my back then, say the lenders.

This approach is evocative of the Great Depression era US Home

Owners' Loan Corporation, set up by president Franklin D Roosevelt and Congress at the start of the New Deal in 1933.

One might find it surprising that these bankers are turning to the example of FDR and the New Deal for their salvation, as, for most of them, their only real connection to that former president and liberal icon is seeing his name alongside obscenities on the walls of the men's room at their country club. Obviously, in deciding between ideology and real money, ideology is being thrown a ball and told to play outside.

If the private financial industry's solution to these problems is to have the government pay to fix them, it shouldn't be all that surprising that government's solution to these problems is, of course, to have the private financial industry pay to solve them.

Floated from out of the US Office of Thrift Supervision (OTS) last week was a new way to deal with the under-water homeowners. In essence, instead of having homeowners either head to bankruptcy court or stay in their houses until they were grey and grizzled, homeowners could get out of this situation by refinancing their mortgage, and having their mortgage holder issue what is called a "negative amortization certificate" for the difference between the remaining mortgage and the home's now lower, assessed value.

"Few details about the plan have been settled" according to the description of the proposal on CNN.com, and that's the problem. Once the "negative amortization certificate" pops out of the printer, it's not at all clear just who then would have what to do with it.

If the homeowner wants to stay in his home, then, for him at least, negative amortization certificates are clear winners. When, a few years ago, most of the subprime borrowers got into their mortgages on their overpriced properties with the low initial "teaser" mortgage rates that the banks dangled in front of their eyes like a worm lure on a fishing line, they were promised that they could always spare themselves the pain of the resets to higher rates and payments by using the house's inevitable increase in market value as the equity required to refinance into more affordable fixed-rate financing.

As home prices fell, the home equity needed to refinance evaporated, so the subprime borrowers were left defenseless against to full gale force pain of the resets, and the subprime crisis commenced.

For these borrowers, negative amortization certificates provide a clear benefit - they get a much lower monthly mortgage payment. At least temporarily, the holders of the mortgage will do worse, for a good part of the value of their ownership in the mortgage has been now converted into the certificate. The plan's originators at OTS say the banks and other holders of the mortgages, since they will save the average $50,000 it costs to foreclose on a delinquent borrower, will be fine and on board with this.

Sure they will.

When things really get hazy is if the homeowner wants to sell the house. Now he can, his mortgage balance has been reduced, so he won't have to face a Freddy Krueger like figure at the closing table demanding tens of thousands of dollars to wake from his nightmare.

What about the negative amortization certificate? Since its creation it has become a sort of semi-secured lien on the property. When the house sells, any difference between the re-financed mortgage amount and the selling price, up to the value of the original mortgage, supposedly goes back to the holder of the certificate, the mortgage holder, after which the certificate then goes out of existence.

No recovery - what then?
But what if the house's selling price does not recover? Who carries that debt, the value of the negative amortization certificate created when the original mortgage was refinanced? The buyer, for all eternity, like a borrowing Original Sin, paying for a financial mistake he made in his 20s all the way to the nursing home? Or does the holder of the negative amortization certificate just eat the loss, laugh it off with a hale and hearty guffaw, "win some, lose some"? Yeah, right.

The real problem underlying all these solutions is, of course, that in media- and image-sodden America, it's more important to look like you're solving a problem than to actually be solving one. Since the subprime crisis slammed into the markets like a planet-killing asteroid in mid-summer, various other well-trumpeted and fanfared solutions have been advanced that promised to solve the troubles.

From Countrywide's September offer to voluntarily re-finance most of the subprime mortgages under its purview (an offer which, like the subprime mortgages themselves, failed upon reading of the fine print) to the US Treasury’s "Hope Now" (see Hope Now - Sorry, wrong number, Asia Times Online, December 12, 2007)and "Project Lifeline" initiatives, the public relations company and media consultant vetted but ultimately pointless and failing efforts by the governing elite to solve the problem grow ever more feverish and frenetic, as the plight of those actually caught up in the crisis grows ever more desperate and dire.

In 1992, Bill Clinton got votes by saying that he "felt your pain" to those Americans suffering the early 1990s' economic woes brought about by the Savings and Loans crisis. Today, it might help if our current elite actually felt and shared in the pain of those caught up in this economic crisis. That they could do by, instead passing all the cost of solving the problem to someone else while still grabbing for all the credit, they actually put some of their own money, some scratch on the table, to feel the same pain of sacrifice that millions of Americans are now being forced to suffer.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

Old World Order

2008-03-15T09:35:00.001-07:00

Today's Fed actions led me to further think about the current state of our economic system. I have gone over in my mind numerous time about one fundamental question. Under what kind of system are we living? Is it Capitalism, Totalitarianism, Fascism, Communism or Socialism? Today's action provides the most direct evidence that our system has devolved back to FINANCIAL FEUDALISM, or FEDALISM as it could be more aptly called today. This remarkable act of bailing out one investment bank so that their derivatives wouldn't have to be marked to market proves the oligarchical nature of our society. The Lords of Wall Street are under the protectarate of the FEDal system. We the fifes must go about our daily lives and hand over increasingly large sums of our hard earned "money" to ensure the "stability of the markets". What bonus should Mr. Schwartz receive from the taxpayers largesse? As the new Sheriff of Nottingham, Ben Bernanke, and his sidekick, Hank Paulson, go about their daily adventures in destruction of our savings by debasing our currency, we the fifes can only look upon these actions with disbelief. This is a supposed to be a democracy, yet all these decision take place behind closed door under dubious circumstances and have unknown future consequences. This has gone far enough. We should demand the immediate resignation of Ben Bernanke and Hank Paulson, and start having some transparency in our markets. These ridiculous anti-Capitalism, anti-competitive, anti-free market, Save our Crony friends at any cost policies MUST STOP! Robin Hood, where are you?