Hey, Bailing!
Posted by aogTuesday, 30 September 2008 at 19:17 TrackBack Ping URL

I am sure you have all been breathless with anticipation concerning my view of the financial system bailout. I would say that, based on what I have read, I would have voted for the bill that was defeated on Monday. However, I certainly understand why many of the GOP did not. Some people think it was immaturity, but I think that Speaker Pelosi’s speech was just the final straw of a long campaign of abuse, blame shifting, and sleazy political maneuvering. The last was the complete lack of effort by Pelosi to get votes from her fellow party members, particularly the committee chairs. If I were a GOP Representative watching the committee chairs vote “no”, I would likely cease to view the effort as a serious one in any way and be very tempted to bow out.

That said, the GOP lived up to its “Stupid Party” reputation by citing Pelosi’ speech as the cause, instead of the whole chain of abuse. Listing them and say stating they would vote for the measure once Pelosi got her own people to do so might have shifted the public perception more toward the GOP. On the other hand, all I have are reports from Old Media, so who knows what the GOP spokesmen actually said.

As noted, I understand the more fundamental objections to the bail out, and how it’s grindingly depressing to have to continually clean up other people’s messes while getting blamed for it. But sometimes that’s what you have to do when you’re responsible (i.e., not a member of the current Democratic Party leadership). The GOP has to take some blame for not making a principled case in the past to lean on in this crisis, with President Bush taking point on that. The Democratic Party may be completely dysfunctional, but the GOP looks good only by comparison.

On the other hand, mindless boosterism of “any deal is OK as long as we get credit” style seems a bit counter productive, leaving one wondering what the point of governing is if you spend your time passing your opponent’s legislation to increase their political power. That would seem to have a bit of a limited run.

Comments — Formatting by Textile
Brad S Wednesday, 01 October 2008 at 10:52

Well, considering that the House GOP got one of its items (suspension of Mark-to-Market) it requested just yesterday, you’d have to say that refusing the “crap sandwiches” makes the other parties more willing to deal with you to get your support. An increase in the FDIC insurance cap was another request, and it looks like the Senate will put that in the bill.

That said, it should be noted that when anti-Bailout folks see their reps vote the way they want them to, and THEN see the consequences of those actions (777 point Dow drop) within seconds, the political winds do tend to make a sudden shift. Even Michelle Malkin is starting to waver on trying for another No vote in the Senate.

pj Wednesday, 01 October 2008 at 11:25

oj’s political intuition seems to be pretty sound, too bad his economics isn’t.

I agree that the major problem is there has been no solid Republican alternative. Bush hired a Treasury Secretary who is pushing Democratic plans and is backing him 100%. The House Republicans have not formulated sound alternatives. McCain intervenes only as long as he can garner political advantage from it. With Republican disunity, and Paulson working with Pelosi, if there’s going to be a bailout it’s going to be a Democrat-friendly one. And the strong financial industry desire for a bailout, affecting stock market movements, and canny Democratic maneuverings have set things up so that if there is no bailout, it looks bad politically for Republicans.

Still, I can hope that a bailout may fail — as time drags on and disaster doesn’t happen, people may realize existing tools are adequate to the problem; and the Democrats may continue to see political advantage in letting a bailout fail and blaming it on Republicans. And maybe by election day the politics will turn around on the Democrats. Something similar happened with the oil price rise, at first it was bad for Bush and Republicans, then as people looked deeper into causes it started to work against Democrats. Something similar might happen with the mortgage crisis.

Annoying Old Guy Wednesday, 01 October 2008 at 12:52


Yes, and they also got the bill changed from ~100 pages to 421 pages, which may not have been a good trade.


There’s lots of not irrational suspicion that Paulson is pushing the investment bank plan, with the fact that it’s also the Democratic Party plan a happy coincidence. I will admit it’s a bit hard to tell the two apart these days.

But in essence, the problem comes down to the political ineptitude of the GOP. That is, not creating a better plan (which would have been, IMHO, quite doable) and not explaining themselves. I understand the cost of not having a deal, but there’s also a cost to having one and it’s not obvious which cost is higher. OJ’s problem with political analysis is that he doesn’t see any cost to going along with a Democratic plan, his analysis is based on that being completely negligible. You can tell he’s getting flustered, though, when he has to resort to deliberately mis-characterizing the opposing view and name calling.

Harry Eagar Wednesday, 01 October 2008 at 13:15

The idea that a handout of $700 billion to Wall St. fat cats is a Democratic move is going to take some persuading on my part.

It sure SOUNDS Republican.

But then, a Republican administration wanting to double a half-a-trillion budget deficit sure SOUNDS Democratic.

But you guys really have to get over the idea that this was not a pure market failure. It could easily have been forestalled. At 0 cost.

Flash: 0 is less than $700 billion, or $2.5 trillion or whatever numbers we are using today.

pj Wednesday, 01 October 2008 at 13:31

AOG - There is no difference between the investment bankers’ bill and the Democrats’ bill. The investment bankers have been deeply in bed with the Democrats since the Internet destroyed their intermediary role and forced them to live off political connections and regulatory advantages (i.e., since c. the mid-90’s, but increasingly so in recent years). The Democrats have been deeply in bed with their big donors for some years now. I don’t know why they value money so highly, but they do.

As for the GOP, they have had two problems which make the failure to come up with a better plan a little understandable: lack of time and lack of ability to coordinate. With Bush now having ceded his presidency, and McCain campaigning and acknowledgedly ignorant about economics, they have lacked a leader to rally them, and the rest have had trouble reaching agreement — especially since there are strong political constraints, they can’t undercut McCain, or seem to be openly repudiating Bush. The other is lack of time. The Treasury plan has been hatched over a period of weeks, this only came to the House Republicans’ attention last week, and they had a steep learning curve to climb.

Of course, if they really believed in the reform initiatives they made in 2003 and 2005, they would have kept following up on them and had plans ready at hand. They dropped the ball big time in not anticipating something like this.

oj thinks the critical thing is to win elections. He is like Karl Rove that way. He is very invested in McCain. It’s unfair of him though to blame the fact that events aren’t going McCain’s way on the House Republicans. Their ability to manipulate the political environment is very limited. Had they passed the bailout, the Democrats would have gone on a publicity blitz accusing McCAin and the Republicans of being in the pocket of Wall Street fat cats, big media would have supported it, and McCain would have dropped an equal amount.

Harry - Why do you think the Wall Street fat cats donate 70%+ to the Democrats?

But it’s to keep suckers like you on board that Nancy Pelosi demands Republican “cover”, not only from Paulson, Bush and McCain but also from the House Republicans, to pass the plan.

Bret Wednesday, 01 October 2008 at 13:38

I understand the cost of not having a deal, but there’s also a cost to having one and it’s not obvious which cost is higher.


Annoying Old Guy Wednesday, 01 October 2008 at 13:55

you guys really have to get over the idea that this was not a pure market failure

Perhaps, but I can guarantee it’s not going to be because of empty harangues like that. And especially not from someone who claims that there exist government actions which are zero cost, a clear demonstration of a severe reality dysfunction.

Robert Duquette Wednesday, 01 October 2008 at 16:26

It couldn’t have been a pure market failure since there was no pure market to fail. In theory a pure market would be self regulating, but I’ve finally given up on the idea that human nature would ever allow a socio/political system in which a pure market would ever be allowed to operate.

There is plenty of blame to go around, but a lot of it falls squarely on the market side. Chasing returns with leverage is purely a market phenomenon. Originating teaser rate loans is a market phenomenon. Inventing convoluted derivative instruments to hide risk is a market phenomenon.

Harry Eagar Wednesday, 01 October 2008 at 18:03

Suckers like me?

You obviously haven’t been reading Restating the Obvious.

Annoying Old Guy Wednesday, 01 October 2008 at 20:29

I tried hitting Restating the Obvious again, and gosh it’s horrible from a user interface point of view. Even my weblog is better. Does Restating the Obvious even have archives?

Harry Eagar Thursday, 02 October 2008 at 00:19

Over on the right rail, there is a list (“View all my blogs”) which brings up the posts in order of appearance.

You don’t have to read through all 200-odd. Going back to “Too big to crash?” on Sept. 7 and reading forward (skip the water bears) tells the tale. (There are some earlier posts, in fact all the way back to March, but the last 20 or so sum up most of it. I still need to find time to write “Unthinking the thinkable” though.)

Yeah, the setup is awkward and self-defeating. However, the man who is paying the piper is calling the tune. If the people in Wheeling ever pull the plug, I can transfer to Blogger. I could do that now, but they’re paying me to do it their way. Capitalism at work.

Harry Eagar Thursday, 02 October 2008 at 00:23

There are people out there on the internets who can restate the obvious even better than I can, and you don’t have to put up with West by-god Virginia interfaces.

I like this from Steve McIntyre at(of all places) Climate Audit: ‘And let’s say that you were doing so in heady pre-crash days when markets were going up and mark-to-market accounting was something that the companies wanted to do.’

If you accuse McI of being a tool of the Dems, you’ll be the first.

pj Thursday, 02 October 2008 at 07:52

Harry - Why not provide a link? All I got is this page: http://www.restatingtheobvious.com/ which has nothing.

Also, you seem to have misunderstood what prompted me to suggest that you were being suckered by the Dems. My point was that Wall Street investment bankers are deeply in bed with the Democrats and have been since the Internet ruined their business model; they now survive on political protection, perhaps not for much longer. Yet, against all evidence, you buy the lefty propaganda line that the Republican Party, which is the party of the middle class, is a tool of Wall Street.

Annoying Old Guy Thursday, 02 October 2008 at 09:24

Mr. Eagar;

I found the list, but I must say that I have no idea what point you think McIntyre’s quote makes. Was there more of it that got dropped? Normally when one sets up a hypothetical like that, a proposition follows.

Harry Eagar Thursday, 02 October 2008 at 12:36

It was just a restatement of the obvious, though, as often happens, people tend to forget the obvious when convenient. Draw your own conclusions. (It was part of a satire on AGW fearmongers, just an aside on Wall St. behavior. McIntyre used to prepare mining prospectuses.)

I dunno, pj. Isn’t Paulson a Republican? Isn’t Bush a Republican?

Who introduced the $700B raid on the Treasury for the benefit of Wall St.?

Annoying Old Guy Thursday, 02 October 2008 at 13:22

A restatement of the obvious? I disagree. Instead, let’s say you were doing so as a reporter for the Maui News. Deny that! Or is it too obvious?

Harry Eagar Thursday, 02 October 2008 at 13:45

I don’t remember any complaints about marking-to-market in the good ol’ days. I’ve been meaning to post a piece of the renaissance of ‘greed’ in the financial vocabulary.

‘Sfunny. When all the geniuses were talking about ‘maximizing profit potential’ and ‘unlocking shareholder value,’ nobody was saying, ‘It’s greed, it’s just pure greed.’

That’s a direct quote from a governor. A Republican governor. Two weeks ago.

I dunno. Seems obvious to me.

pj Thursday, 02 October 2008 at 14:23

Paulson is a moderate-to-liberal Republican with a record of donating both to Democrats and liberal Republicans — Arlen Specter was his biggest recipient. His wife is a liberal Democrat who makes the great bulk of the family’s political donations, and gives exclusively to Democrats. Paulson’s firm Goldman Sachs has long been a Democratic shop. He is friends with Nancy Pelosi. He was hired by Bush, along with along with the anti-Israel Gates at Defense, in 2006 as a McCain-supported concession to the Democrats to install a Pelosi-approved “bipartisan” cabinet. So, yes, Paulson is a Republican, but Bush in 2006 ceded domestic policy to the Democrats in exchange for continued funding for the war, just like his father did earlier.

So, if this $700 bn raid on the Treasury for the benefit of Wall Street is a bipartisan policy, as it looks to be, it’s the result of Democrats rolling over conservative Republicans.

Annoying Old Guy Thursday, 02 October 2008 at 14:33

I don’t remember any complaints about marking-to-market in the good ol’ days.

You should try to be more widely read, then. I certainly remember vigorous arguments about precisely that subject when the regulation was introduced. It did die down once the regulation was in place, but it was hardly uncontroversial back in the good ol’ days.

And let’s say that you were doing so in heady pre-crash days when markets were going up and mark-to-market accounting was something that the companies wanted to do.

May I take it that you’ve given up on either explaining that McIntyre quote or denying my counter-quote?

Harry Eagar Thursday, 02 October 2008 at 18:50

McI wasn’t presenting this as a hypothetical into markets, but as a hypothetical into climate reconstructions. So there was no further speculation by him about marking-to-market.

My point was simply that other people besides me restate the obvious when those all about them would just as soon not.

The ‘explanation’ is that, like the joys of ‘unlocking shareholder value,’ after you have to live with the consequences of your behavior, sometimes what seemed so clever at the time looks remarkably stupid.

I am searching my memory for, say, Robert Rubin standing up in front of a bunch of analysts and saying, ‘Our goal is maximum greed short of prison’ or something like that. It’s true, I live on a remote island, and maybe people on Wall St. were saying that. In fact, I have always believed that is what they meant whatever they did say, but as a lapsed Catholic, I no longer believe in deathbed conversations. You got to hell for your body of work, not your last day in the market.

As so many are finding out.

Annoying Old Guy Thursday, 02 October 2008 at 21:01

I am searching my memory for, say, Robert Rubin standing up in front of a bunch of analysts and saying, ‘Our goal is maximum greed short of prison’ or something like that.

I am willing to go with the assumption that Rubin never said anything like that. And so …?

Like the McIntyre quote, it seems like an introductory sentence to something, but what that something might be, I have no idea. I must presume that, since you’re on about “restating the obvious”, the something is something obvious. But apparently I live in too alternate a reality to know.

Harry Eagar Thursday, 02 October 2008 at 23:07

It is obvious that:

Things we were told that were good, say, one year ago, turned out not to be good. Rather than admitting they were wrong, the tellers of these tales are trying to redefine words. ‘Unlocking shareholder value,’ once good, is now ‘greed,’ a bad thing.

Yet, obviously, the two are indistinguishable.

Watch the pea.

It is also obvious that the Community Reinvestment Act and Sarbanes-Oxley did not have a writ that ran to, say, Iceland. So CRA ans S-O cannot explain anything about what happened.

Watch the pea.

Bret Friday, 03 October 2008 at 00:13

harry wrote: “So CRA ans S-O cannot explain anything about what happened.

You’ve given reasons that CRA and S-O do not explain EVERYTHING about what happened. However, you’re a long ways off from the much harder task of showing that they do not have ANYTHING to do with what happened. Good luck with that!

Annoying Old Guy Friday, 03 October 2008 at 08:00

Mr. Eagar has the Sarbanes-Oxley point backwards. It was a massive mound of regulation that, we were told, would prevent financial abuse like this. Even Mr. Eagar admits it had no effect. So what was the point? What was the benefit of S-O? It seems a good riposte to those who say “regulation!” is the solution.

However, I will admit that Mr. Eagar is usually far more specific about the shape of regulation than most.

Ali Choudhury Friday, 03 October 2008 at 13:30

Sarbox was designed to boost internal control oversight, not to prevent bad business decisions.

pj Friday, 03 October 2008 at 13:46

Harry - Did you notice after the bailout bill got signed which party was glum and which party was jubilant? The Democrats looked like they just sold a $10 car for $5000.

Harry Eagar Friday, 03 October 2008 at 15:14

The Republicans I hang out with jubilant, too.

I have said, many times, what sort of regulations I believe would have forestalled this problem. Sarbanes-Oxley was not my idea. It was, if you will recall, supposed to deal with fake accounting statements.

Nothing whatever to do with lending, moral hazard circuit-breakers or anything that led to the current freeze-up.

If you’ll recall, the biz failures that inspired S-O, although large, did not even cause a blip in growth.

Reasonable oversight of financial markets has not ever and will not ever prevent recessions, just as it has not ever and will not ever prevent booms. It might, although this would be hard to prove directly, lower the peak of booms.

In fact, since I believe in raises the bottom of busts, logically it ought to lower the peak of booms.

This would be a good thing, if true.

Anyhow, it is so obvious as not to need restating that it was not government interference that required brokers to invent things like interest strips of bundles of alt-A mortgages, and certainly it was not government that induced buyers of secondary paper to put up cash for these monstrosities.

David Cohen Friday, 03 October 2008 at 15:32

First of all, “mark to market” is short-hand for the accounting rule that certain assets must be valued on the books at the lower of cost or market, as opposed to the traditional rule that assets are valued at cost. So, when assets were going up, they were not “marked to market.” Rather, they were carried at cost.

Second, “mark to market” has nothing to do with why financial institutions are failing. Harry, I think, is suggesting that we could avoid the bail-out simply by letting financial institutions carry mortgage backed securities at cost, thereby raising the capital on their books, at no cost to the Treasury. That’s wrong. If we could have done that, we would have.

The real problem isn’t accounting — accounting rules never makes a difference, so long as they’re accurate and transparent. The problem is that “mark to market” is an accurate representation of the firm’s financial condition, and there is no market.

In other words, no one is willing to buy these securities because their value is completely ambiguous. Securities that no one will buy are not worth anything. Thus, short-term lenders to banks are not willing to count those assets in looking at the banks’ financial condition, which makes them worried that the banks are insolvent — not on an accounting basis, back actually insolvent in the sense that they won’t be able to pay back the short term loan. If a lender is worried that a borrower is actually insolvent, they won’t lend to them on any basis. If a financial institution can’t get short-term loans, no one will do business with them. If no one will do business with them, they are out of business.

The problem isn’t accounting, it’s reality. The lenders wouldn’t act any differently if the banks were not forced to mark to market.

The point of the bail-out, which no one except people like Harry thinks actually involves handing $700 billion in real money to Wall Street, is to reassure the people who lend to banks that there is a market of last resort for the mortgage backed securities. If they can be sold, they have value and if they have value, then the lenders will count them towards assets. That makes the lenders willing to lend. So the bail-out as originally designed was a bit of slight-of-hand. The existence of a buyer of last resort (at, say, 30% of face value) would reassure the lenders even if the banks didn’t sell the mbs’s to the Treasury. Loans to banks would free up, banks would stay in business and most would probably choose to hold the mbs’s until maturity or until the market recovered.

Now the bill’s been larded up so much that I’m much less sure that it’s worth passing, but such is life in Washington.

Now, the question of why financial institutions have been systematically undervaluing risk for 10 years is an interesting and important question. It’s a question that’s never going to be answered while people settle scores with the mean Republicans or the sleazy Democrats.

Bret Friday, 03 October 2008 at 16:24

David Cohen wrote: “Second, “mark to market” has nothing to do with why financial institutions are failing.

I disagree with this. Lending institutions are required to maintain minimum capital assets in order to do various types of lending (in addition to a certain level of reserves). The valuation of those assets matter and affect their ability to lend.

It’s far from clear how much affect mark-to-market has on this, but I find it unlikely that it’s zero.

David Cohen Friday, 03 October 2008 at 16:57

Bret: That’s obviously true, but so what? Minimum capital requirements weren’t handed down by G-d on Mount Sinai. They’re federal regulations. Bank’s aren’t struck by lightening if they violate the minimum capital requirements, they’re just subject to regulatory action. If that was the problem, Treasury would just stop taking over banks when the but-for cause of their falling below minimum capital requirements was the market value of mortgages and mortgage backed securities. The feds did something like this during the S&L crisis, when they let thrifts satisfy their minimum capital requirements with “regulatory capital,” a made-up number that wasn’t that different from letting banks keep assets on their books at cost rather than market.

The problem with these institutions isn’t regulatory action. The i-banks aren’t even regulated in that way. The problem is that lenders think that, as a matter of economic reality, the banks might be insolvent because their mbs and sbm portfolios can’t be sold and are therefore actually (as opposed to on an accounting basis) not worth anything.

The real question is, is the problem liquidity or solvency. In other words, are buyers of mbs’s just spooked and unable to calculate the risk of default, in which case a buyer of last resort (i.e., the Treasury) will start the market up again, which will result in the mbs’s having value, which will raise the banks capital enough that they can start borrowing? Or, are the mbs’s really not worth anything, in which case we’re all screwed because banks will start dropping like flies — even the banks that don’t hold a bunch of mbs’s because all their lenders will have gone belly up? I think that the problem really is liquidity, so the Treasury plan will work at relatively little cost. If the problem is solvency, which is a small but non-zero possibility, then it really doesn’t matter because, as I say, we’re all screwed anyway.

Another thing for Harry to think about, though, is that the US government is the only government in the world that is even potentially going to do something constructive about this problem.

Harry Eagar Saturday, 04 October 2008 at 13:39

Hey, wait, somebody else brought up S-O. I just said it didn’t have anything to do with what I’m worried about, which is — and is ONLY — a liquidity crisis that drags down solvent firms, as happened in 1933.

A liquidity crisis that drags down insolvent firms is OK by me. If they’re all insolvent, then, as David says, screwed.

I was neither for nor against the $700B bill, since I don’t know that it will work.

I am, at a minimum, for making government lender-of-last resort to solvent institutions.

How figure out who’s solvent? Aye, there’s the rub. And it was not any government law that required the invention of these monstrous kinds of paper that are unasessable.

The market charged off, as it always does, hunting the goose that lays golden eggs without being fed corn.

As you guys still are not getting, the purpose of Glass-Steagall was to protect banks, which are places you put your money because you want it to be SAFE, from investment houses, where you put money where you want it to be AT RISK.

Most of the time, wringing at risk money out of a financial system cannot crash it. (I won’t say never, because as in the South Sea Bubble, you can have a system that doesn’t contain much safe money).

What we have here, as David just so clearly stated without (I think) quite understanding what he was saying, is a system in which nobody can tell which money is safe and which is at risk, so all of it is treated as at risk.

Your last remark may not be correct. The EU seems to be gearing up to act.

Hey Skipper Saturday, 04 October 2008 at 13:52


Those are two of the best posts I have ever read on this subject from anybody, anywhere.

Annoying Old Guy Saturday, 04 October 2008 at 14:42

• Mark to market can function as an accelerator for insolvency and make the problem more systemic than otherwise. If any institution sells a particular type of security at fire sale prices because that particular institution is near insolvency, mark to market pushes every other institution holding such securities closer to insolvency, even if the issue is purely liquidity rather than devalued assets. Therefore, regardless of the particular value set via regulation for capital requirements, mark to market magnifies the effects of a liquidity problem. As Bret noted elsewhere, this may be worth it if it overall decreases risk (which is possible), but contra Mr. Cohen it’s not purely an effective of regulatory fiat. This point was part of the argument about mark to market when it was originally instituted.

• I also fail to see Mr. Eagar’s point. Either there is systemic risk, or there isn’t. An artificial division created by Glass-Steagall is truly regulatory fiat that has little or no effect on the systemic risk. To illustrate this, consider the argument that the liquidity crisis could destroy local and regional banks despite the fact that they did not participate in the MBS market. If that’s true, then what ever was on one side of Glass-Steagall could drag down the other side. If it’s not true, then we don’t really have a crisis. Either way, G-S doesn’t seem to be of much benefit.

David Cohen Saturday, 04 October 2008 at 14:57

You’re assuming a formalism in the market that doesn’t exist. Assume two worlds, one in which financial companies are forced to mark mbs’s to market and one in which they can carry them on the books at cost. You’re saying that the same company, owning exactly the same mix of assets, is “insolvent” in mtm world and solvent in cost world and that lenders will lend money or not lend money based on that characterization even though the reality is the same in both circumstances. That would be completely irrational and, in fact, is not how the world works. Lenders actually do look at the economic reality.

There is one exception: where mtm doesn’t capture the economic reality and regulators will move in anyway, in which case the lenders are spooked by the possibility of regulatory action rather than economic reality. That’s a possible scenario, but it’s not what’s going on here. To reiterate, the problem isn’t that mbs’s are being carried on the books at zero value (which they’re actually not), it’s that lenders are afraid that they really are worth zero without a buyer of last resort.

Now, the reason that lenders are afraid that mbs’s are worth zero is liquidity (probably) not the economic reality of people not paying back their mortgages, but mtm has very little to do with that.

Annoying Old Guy Saturday, 04 October 2008 at 16:12

You’re assuming a formalism in the market that doesn’t exist

Formalism is created by regulation, such as capital reserve requirements and FASB rules (including mark to market).

You’re saying that the same company, owning exactly the same mix of assets, is “insolvent” in mtm world and solvent in cost world

Yes, because “solvent” is a legal definition.

lenders will lend money or not lend money based on that characterization even though the reality is the same in both circumstances

Yes to the first and no to the second. The reality is not the same, because the regulatory environment (and therefore the characterization) makes a very real difference. If it didn’t, why would we bother with any regulations at all?

It would be nice to think that most financial institutions actually look at the books, but I would think the current situation demonstrates quite conclusively that’s not the case. Instead they rely on the proxy of regulatory characterizations. This is one aspect of the moral hazard of regulation that is frequently overlooked.

For a more specific example, consider Senator Schumer and IndyMac, or Senate Majority Leader Reid and an unspecified but “big name” insurer. The first was driven in to failure because of Schumer’s characterization of its state, and Reid’s comment knocked off a large chunk of the market valuation of various large insurers, pushing them toward insolvency (due to reduced ability to raise capital).

My view is that, yes, just the characterization can make a very large difference.

the problem isn’t that mbs’s are being carried on the books at zero value

It is not just MSBs that are marked to market. If Bank A dumps some other type of instrument, that can affect Bank B because B holds the same sort. A positive feedback cycle can develop because of this, in almost the same manner as a liquidity freeze.

David Cohen Saturday, 04 October 2008 at 17:12

Now you’re agreeing with Harry that if we just came up with another word for “not having enough money to pay your debts” lenders would still be willing to provide new loans. Do you think that if the government just got rid of capital requirements or mtm lenders would care? Believe me, if Paulson thought he could fix this just be waiving a regulation, rather than go through the rigmarole of the last two weeks, he would have done that. Instead, Congress thinks that mtm matters and Treasury couldn’t care less.

Lenders won’t lend to financial institutions because they’re afraid that mbs’s are really worth zero because they can’t be sold, regardless of whether they’ve been marked to market. (And you’re just wrong that people don’t look the assets but just rely on the accounting statements. That’s why G-d created due diligence.)

Annoying Old Guy Saturday, 04 October 2008 at 17:24

Now you’re agreeing with Harry that if we just came up with another word for “not having enough money to pay your debts” lenders would still be willing to provide new loans.

No. I am saying that many institutions use the government’s opinion about “not having enough money to pay your debts” as a proxy for the reality. It doesn’t matter what it’s called.

If Paulson suddenly changed the definition, that wouldn’t help because it would be obviously a ploy. Yet gradual change is accepted, as one can see by looking at mark to market which has not always been important.

I am surprised that we can all agree that these institutions were buying derivates for which no one had a good valuation model or even a deep understanding and claim it was all done with “due diligence”. Were all of the MBSs sound until FM collapsed? Why is the result of due diligence so different just because some Senator shoots off his mouth, much less the federal government declaring an instutitution insolvent? What is, in your opinion, the causal mechanism there, given that the objective value of the assets didn’t change? Or was it just coincidence?

I think the big change here is psychological, like the bursting of any bubble, where some event forces a strong change in opinions with little change in the underlying reality.

David Cohen Sunday, 05 October 2008 at 08:46

Ok, let’s try this: Your house is an asset with a fluctuating market value. There is, however, no regulation that forces you to carry it at the lower of cost or market. To the extent there’s any rule, it is that you carry it on your “books” at cost. But when you go to the bank for a loan, the bank is going to get an appraisal. The bank doesn’t care whether you are required to mark your house to market, it wants to know the market value.

Now, let’s say that your house is in the middle of Love Canal. You bought it for $250,000, it cost $185,000 to build and it would cost $300,000 to replace. Similar houses in similar neighborhoods are selling for $400,000. The bank doesn’t care about any of that, because no one is going to buy your Love Canal house — there is no market, and thus no market price.

Returning to financial institutions with big mbs portfolios, lenders to those f.i.s don’t care about the mtm accounting rules, they care about the market value of the f.i.’s portfolio. They want to know the market price regardless of the accounting rules because that’s what tells them the risk that they won’t be repaid.

Now, what is problematic here is that the market price appears to have been wrong; the market was systematically underestimating the risk that these securities were going to go belly up. Why that happened is a serious, important and difficult question, but we’re never going to get to it because we just want to find a villain.

Annoying Old Guy Sunday, 05 October 2008 at 09:45

no one is going to buy your Love Canal house

Because the government condemned it. You keep skirting around that elephant in the room, but it’s still there. My understanding is that MBSs tanked on a wide scale when the FMs were shut down, when, in effect, the government condemned them.

I am not sure what you’re trying to show. As far as I can tell, it’s that government regulation has no effect on inter-FI trust relationships. Instead, the FIs perform explicit due diligence on their lending partners. Not only do I find that facially implausible, but the very crisis we are discussing shows that to be ahistorical. I find it amusingly ironic that you brought up the due diligence that the FIs would do when I try to get a loan on my Love Canal house, compared to the due diligence done on all those failed mortgages and home loans.

I think you are too caught up in theory. Yes, what you describe is how things are supposed to be done. My claim is that in real life, that’s the exception rather than the rule and if we want to discuss things as they are, that must be taken in to account.

And finally, my point is not that mark to market is the “villian”. My point is that it’s not, as I read you to claim, completely irrelevant.

Anyway, if you can hold off for a few hours, I will try to get a new post up later today to restart this discussion, which I find quite interesting. I want to restart because I think we’ve lost sight of the forest in the leaves.

Harry Eagar Sunday, 05 October 2008 at 13:38

OK, but if the problem was that the market did not or did not know how to accurately value the securities, that let’s the government regulators off the hook: They didn’t require the invention of these monsters.

Bret Saturday, 11 October 2008 at 01:55

David Cohen wrote: “Second, “mark to market” has nothing to do with why financial institutions are failing.… Minimum capital requirements weren’t handed down by G-d on Mount Sinai…”

aog admirably answered most of your comments following mine. I’d just like to add one more minor point.

As you know, the price of a security should theoretically be the Net Present Value (NPV) of all future revenue from said security. The inputs to NPV are the revenues and associated dates and a discount rate. The discount rate is defined as the rate of return that could be earned on an investment in the financial markets with similar risk. However, this is inherently subjective and really means the rate of return at which a given investor is willing to invest in a security with a given risk level. This rate of return is further dependent on how dear current cash is relative to future cash.

In typical situations, current cash is only a bit more dear than future cash. In other words, in typical situations, there’s plenty of liquidity (i.e., cash) available so buying and holding securities for modest future gain makes sense.

However, in extraordinary times like the present, current cash is extraordinarily dear relative to future cash, making the discount rate unusually large, thus making the price/value of securities delivering a return in the future extraordinarily low. The market price of such securities is “correct”, however, the primary reason for such a low valuation is the extraordinary discount rate, not the change in future revenues from said securities.

One of the implicit jobs of the Fed is to ensure that the aforementioned discount rate stays within a reasonable range. The Fed has failed completely in this particular task.

So that brings us to “mark-to-market”. The market value is low, not solely because the financial institutions underestimated the value of the future revenue from the security, but rather, primarily because the Fed was unable to maintain liquidity at a level that enabled a reasonably constant discount rate. Thus the banks balance sheets look bad to each other and the Fed because of the failing of the Fed. At that point, everyone should agree, in my opinion, to throw mark-to-market out the window and assume a more reasonable and typical discount rate for the purposes of valuing the portfolios of the banks, because one day, hopefully soon, there will be adequate liquidity and the discount rate will revert to a more typical level.

The market is not wrong in the low valuations but is mostly responding to the lack of current liquidity and so a different method of valuation should be used until there’s again adequate liquidity in the system.

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