Arnold Kling  

Hurricane Lehman Update, 10 AM EST

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Russ Roberts and Bob Shiller... The Shadow Knows...

Floyd Norris writes (see the 10:10 AM post),


It may sound foolish to see an encouraging sign in the fact financial stocks are only down about 3.5 percent so far today. But it is encouraging.

I don't think he's foolish at all. I'd almost call it a "relief rally."

Alex Tabarrok has a snarky comment on the Bear Stearns bailout. I'll let you read it. Let's just say that although bailing out Bear Stearns may not have been sufficient to prevent other firms from getting into trouble, it may have been necessary.

Deep in the bowels of Wall Street, there is something called the repo market. It used to be that Marcia Stigum's The Money Market was the classic to read on this. I don't know what people read today. Anyway, banks and Wall Street firms are constantly putting securities on repo. Suppose I own a five-year bond, and I want cash. I sell you the bond with an agreement that I will repurchase it in 7 days (or 14 days or 30 days). In effect, you are lending me cash, with the bond as collateral.

When a bond is considered safe enough, it can act as collateral in the repo market, and that makes it a very attractive asset. A year ago, it was easy to repo a bond backed by mortgages. Today, not so much. That is why credit markets have been looking sick.

What I'm guessing that the Fed is doing is making repo loans on mortgage-backed securities. By maintaining those securities as good collateral for repo, the Fed is keeping their value from falling. In that sense, it is being just as active with the Lehman bankruptcy as it was with the Bear Stearns bailout. Maybe more active, for all I know.

What everybody hopes is that a lot of the mortgage loans will continue to be paid. At some point, the securities that those loans are backing will stop being orphans that nobody wants to adopt. The outstanding balances on the securities will start to decline. Pension funds and college endowments will take them into their portfolios. And the crisis will be behind us.

If it plays out that way, then Ben Bernanke will look even better than General Petraeus.


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COMMENTS (6 to date)
dearieme writes:

Tell us when Harvard buys lots.

Steve Roth writes:

>At some point, the securities that those loans are
>backing will stop being orphans that nobody wants
>to adopt.

>Bernanke will look even better than General Petraeus

Curious:

Should that time arrive, is there any possibility that the govt will actually make money on its Frannie stock purchases?

Grant writes:

I'm curious as to why so many economists who seem to embrace public choice also seem to back bailouts and regulatory reform. I do realize that reformed regulations may well be better than what we have now, but from a public choice perspective, will they really be all that great?

Are we biased for short-term solutions (e.g., bailouts) at the expense of long-term stability and growth? I know politicians are - but how about economists?

E. Barandiaran writes:

Arnold, you write
"What everybody hopes is that a lot of the mortgage loans will continue to be paid. At some point, the securities that those loans are backing will stop being orphans that nobody wants to adopt. The outstanding balances on the securities will start to decline. Pension funds and college endowments will take them into their portfolios. And the crisis will be behind us."
There is nothing wrong with this paragraph. There is, however, a big problem: we don't know how close or far we are from that point. Indeed, it'll take some time to have robust expectations about the income flows from financial assets and therefore to know how large the losses (in relation to expectations a year ago) will be.
At this moment, it looks like the losses will be large and most asset holders want to transfer the losses to other people, in particular to taxpayers. Although I agree that ultimately the problem was created by the "imbalances" usually associated with periods of high growth (especially, the "imbalances" created by those that joint the party late and want to profit from it as much as those that benefited in the early stage), the US election has been a proximate cause because many people have talking the economy down and pressing politicians to intervene. Today it seems that the prospect that McCain wins the election further delays a solution because the losers will make him pay for his victory.
To make things more difficult, as people familiar with financial crises know, the government has to do something to persuade people that the problem will not reappear. We can hear many economists and experts asking for tighter regulations of all financial markets, although sooner or later it will be clear that existing financial regulations have been an important cause of the current problem. Politicians--the same politicians that benefited from the existing regulations--will promise new regulations. Indeed, the ongoing election process increases the probability of tigh regulations that will further delay the recovery of financial intermediation.
So, Arnold, you're right but do not expect a quick end to this process. If McCain wins, the losers will again oppose the surge and frankly I don't think Bernanke is Petraeus.

efrex writes:

What everybody hopes is that a lot of the mortgage loans will continue to be paid. At some point, the securities that those loans are backing will stop being orphans that nobody wants to adopt. The outstanding balances on the securities will start to decline. Pension funds and college endowments will take them into their portfolios. And the crisis will be behind us.

*Sniff!* what a beautiful vision! Cue the soft lighting over the pristine fields and the swelling string section! Okay, now back to reality.

These securities are going downhill because of fundamental corruption in their underlying mortgages. Too many people are in debt beyond their ability to ever pay. Whether this is due to individual greed, corporate greed, ignorance, predatory lending, or what-have-you is completely incidental to the fundamental economic issue. Yes, buying these securities out makes sense if they are fundamentally sound; however, every single reliable indicator I've seen shows that houses are still historically over-priced relative to income, that non-standard mortgages (0% down and/or adjustable-rate) are making up a disproportionate percentage of mortgages, and that people's wages aren't increasing fast enough to meet their debt load.

We're in for a long, hard slog here, and unless you can simultaneously create high-paying jobs for these debtors and give 'em a crash course in Financial Basics 101, it ain't gonna be pretty.

Mean Mister Mustard writes:

Why are there people talking up the credits (CMO,CDO, CLO, etc.) here and on redstate.com? Are these people stupid, ignorant or do they have a political agenda they are trying to defend? Maybe all three of those things are true?

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