Arnold Kling  

Morning Commentary

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Off the Record... Do Financial CEO's Have Enough...

Start with Markus K. Brunnermeier.


While the overall mortgage losses are large on an absolute scale, they are still relatively modest compared to the destruction of about $8 trillion in stock market wealth that occurred in the period from October 2007, when the market reached an all-time high, to a year later in October 2008.

Not to mention foreign stock market wealth. This is a very valuable paper. Pointer from Menzie Chinn.

More from the paper:


These structured investment vehicles (SIVs) raise funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year primarily to money market funds. The short-term assets are called "asset backed" because they are backed by a pool of mortgages or other loans as collateral...To ensure funding liquidity, the sponsoring bank grants a credit line, called a "liquidity backstop." As a result, the banking system still bears the liquidity risk from holding long-term assets and making short-term loans.

So we have Mencius Moldbug's favorite whipping boy, maturing mismatching. But it's not taking place through ordinary fractional-reserve banking. Instead, it's completely off-balance-sheet.

Next, we have my favorite whipping boy.


In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles (SIVs) was regulatory and ratings arbitrage. moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel I regulations while the risk for the bank remained essentially unchanged.

It sounds very wise nowadays to say that we need an international regulator. But the international-based capital regulations opened loopholes that banks could drive a truck through.

Another part of the ratings arbitrage game was the use of insurance.


As losses in the mortgage market mounted, the monoline insurers were on the verge of being downgraded by all three major rating agencies. This would have led to a loss of AAA-insurance for hundreds of municipal bonds, corporate bonds, and structured products, resulting in a sweeping rating downgrade across financial instruments with a face value of $2.4 trillion...a rating downgrade would have triggered a huge sell-off of these assets by money market funds.

Next, we have wonderful news in a report from FBR research


The financial services industry is in dire shape and needs between $1.0 trillion and $1.2 trillion in tangible common equity pumped into it

Meanwhile, Henry Paulson has engaged in a round of image-buffing in the last few days. Felix Salmon is not convinced.

And regarding the other member of the dynamic duo, Tim Duy writes,


I see a distinct lack of leadership from the Federal Reserve, and it suggests that Bernanke has used up his bag of tricks. And I don't think that he knows what to do next.

My opinion continues to be that you cannot prop up until you clean up. The first order or business is to shut down the weakest institutions. Only then should you look around and decide about capital injections and bailouts. We don't need a chief rescuer. We need a head janitor.

Think of the financial sector as a bunch of dishes sitting on shelves during an earthquake. Bernanke and Paulson are running around trying to hold the shelves in place. I think we would be better off letting a lot of the dishes fall and then tossing them into the trash. You can understand why my view could be unpopular, and it also could be wrong. But so far, the stock market isn't telling me that Bernanke and Paulson are right.


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COMMENTS (4 to date)
shayne writes:

In defense of Paulson/Bernanke ...

Much of the writing above (Felix Salmon, Tim Duy) seems a bit disingenuous at this point. I wonder if they actually read the text/terms of the bailout bill prior to its enactment. Or even actually listened to Paulson/Bernanke testimony requesting the bailout funds, prior to its enactment.

Neither Paulson nor Bernanke claimed or promised anything in their pleas for $700 Billion in testimony to Congress prior to enactment of the bailout bill. They both stated emphatically they had no systematic guidelines for how or where the monies would actually be disseminated, and did NOT offer any assurance that the bailout would avert recession or even 'save' the financial sector.

At best, Bernanke may have led people to believe that the funds were to be used to outright 'purchase troubled assets' with his statements regarding 'value if held to maturity', but nothing else. He may in fact have actually believed the funds were going to be used for that purpose. There was even a substantial amount of input to this blog during the period prior to enactment from folks who supported the bailout, assumed it would be used to buy 'troubled assets' and argued vehemently the taxpayers would actually 'turn a profit from the investment'.

But in Paulson's original 3 page request to Congress for funding, the 110 page House version that failed on Sept. 29, and the 451 page Senate version that passed on Oct. 3, the stipulation that Treasury had unimpeded discretion as to how, when, to whom the funds would be distributed was the central artifact. The initial first paragraphs of the final version that passed indicates the intent that the bailout bill funds were to be used specifically to purchase 'troubled assets', but subsequent paragraphs effectively restore the full Treasury discretion originally requested by Paulson, and supported by Bernanke.

Now, more than a month and a half after the bill became law (and half of the public money has been committed), these folks (along with Congress and Wall Street) are cranky because what they wanted to believe would happen didn't happen? Let's see - you provide $700 Billion to an un-elected individual, to spend entirely at their discretion, with nearly complete immunity from either malfeasance prosecution or even oversight, and you're disappointed with the results?

shayne writes:

Follow-up ...

In case there might be a misconception, I concur wholeheartedly with Dr. Kling - the players in the financial sector that are enmeshed in this mess need to be allowed to fail, not be continually 'propped up' with public funds. Many of us have been arguing that since late September.

My defense of Paulson/Bernanke is not that they didn't deliver what they 'promised' - it's just that they promised nothing and have delivered nothing. It's disingenuous to hold them accountable now for failing to deliver on something they never committed to.

eric writes:

In general, if you do the math, I doubt taking mortgages off your balance sheet, putting them in an SIV, and providing a credit backstop, saves on regulatory capital. Total capital is 5% for mortgages, because they have a 50% risk weighting. Of course, with Alt-A, subprime, prime, conforming, and the various spreads and subordination amounts required back in 2005, I haven't done the math on all the permutations. But in general regulatory arbitrage only makes sense for Fannie backed or prime home equity.

Steve Sailer writes:

But the total decline in real estate wealth in the U.S. is on the order of $6 trillion. That alone is enough to drive down economic activity (no more Vegas vacations paid for by home equity loans) and thus drive down the stock market some.

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