A Ruinous Bias Against Helping Detroit

That's the title to a post in The New York Observer, on which I'll comment but not link because it came to me as an email with Red Alert warnings about "phishing" and "potentially unsafe attachments."

Yes, I think there is a bias, but I would describe it as a bias in favor of Wall Street instead of a bias against Detroit. The financial industry has its money claws deeply into many, many government officials of both parties, and the financial industry is much harder for people to think they understand than is manufacturing. A lot of people understand the importance to the US economy and middle class incomes of the auto industry and its large supply chain, and they can more or less objectively assess the nature of problems and the proposed solutions. But when the financial industry says they must be instantly bailed out, no questions asked, or The Great Depression will recur, very few know enough to push back.

I'm not in favor of bailing out Detroit on the ground that fairness requires equal treatment of finance and manufacturing. Congress was right to send the Big 3 CEOs away with a scolding when they showed up without recovery plans. But if GM, Chrysler, and/or Ford come up with new business plans that show they can restructure their balance sheets, their off-balance-sheet obligations, reduce their overhead, produce vehicles that Americans will buy, and return to profitability in a few years, which I'm pretty sure they can do, then I would favor government acting as the investor of last resort if they are unable to raise private capital now because the financial system is temporarily broken. It would be preferable to do all the necessary restructuring without a bankruptcy filing, but bankruptcy has advantages, such as forcing creditors to accept a fair deal, and I don't think bankruptcy will result in liquidation unless there is no credible recovery plan. On the other hand, if there is no workable plan, they will just burn through whatever taxpayer money we give them and then collapse in a few months anyway.

As best I can tell, my position is like that of most Congressional Democrats and the Obama Administration. The GOP opposition seems to have two sources. Many hold to an ideology about markets that causes them to have a principled objection to government interventions, and many of them also opposed the TARP for the financial industry. The other source of opposition is that a big part of the GOP base is located in the old Confederacy, which has become the host to non-union assembly plants of foreign auto manufactures (Toyota, BMW, Benz and others). Being against a bailout for Detroit allows them to favor local businesses and workers and to stick their thumbs in the eyes of unions, both of which for them are good politics. The rest of the GOP base is in flyover territory where auto manufacturing is not felt to be important to the local economies.

Thanks to Christa for sending the question.

Update on Saturday, December 13, 2008 at 01:37PM by Skeptic

Speaking of "money claws," don't miss this story about the Senator from Wall Street in tomorrow's New York Times.  For about 3 decades, the financial services industry has funded both political parties and has gotten pretty much everything it wanted. 

“It’s better to have you suspect I’m broke than to have you know I’m broke.”

That's a principle suspected to be influencing financial institution accounting. For example, in the 3rd quarter, large US financial institutions reclassified $610 billion of assets into an accounting category that gives them maximum "flexibility" in assessing values, and that has increased concerns about hidden dangers on balance sheets, according to this Financial Times piece. Specifically, mortgage backed securities and collateralized debt obligations were moved from Level 2 to Level 3.

So-called "fair value" or "mark-to-market" accounting requires a 3-tier approach to placing current values on assets and liabilities. "Level 1" assets are widely traded securities with readily visible market prices. "Level 2" assets are those that lack such price data but have characteristics similar to other instruments ("proxies") for which there are observable price data. "Level 3" assets are not only hard to sell but hard to value because they lack any of those price data and have to be valued using "models." A useful discussion of these issues in an SEC-hosted roundtable in July is reported here. Speakers commented on how different companies have vastly different proportions of Level 1, Level 2, and Level 3 assets, how difficult it is to value companies by predicting earnings that are strongly influenced by revaluations, and whether fair value accounting does or does not result in more useful disclosures about financial condition.

One complaint about fair value accounting is that it makes earnings too volatile when investors want stability. One roundtable participant countered that the prices for these instruments are volatile and the financial statements should reflect that reality. That leads me back to the FT piece, where a financial industry insider is quoted saying, "A lot of banks are saying: 'I am going to move securities to level-three assets because I have more control over, and confidence in, the model used for their valuations'." In other words, securities that in the second quarter were valued by reference to observable proxy prices are now valued by non-standard models controlled by the reporting companies. The suspicion is that the reclassifications are being made in order to report higher and less volatile valuations—not because proxy price data are no longer available but because proxy price data are unwelcome. Nevertheless, the FT piece speculates that the next step after reclassification to Level 3 is further write-downs.

I previously commented on the controversy about whether fair value accounting rules should be suspended and, if so, what should take their place.

Perhaps a state law remedy for under-water home buyers in Massachusetts

In Massachusetts, making a loan that a lender could not reasonably expect to be repaid in the absence of steadily increasing real estate prices may be an unfair and deceptive practice under state law, in which event the lender may not be entitled to foreclosure, according to the Supreme Judicial Court in an action brought by the Attorney General in October 2007.

Update on Tuesday, November 3, 2009 at 07:47AM by Skeptic

Many States' attorneys general are moving toward enforcement of State consumer protection and anti-fraud laws against national banks, since they were given a limited green light by the US Supreme Court in June 2009 (Cuomo v. Clearing House Ass'n), according to this NYT report. Naturally, the banks are promoting, with some success already, federal legislation to preempt state law. 

The one fundamental blunder that led to all the other blunders that caused the current financial crisis

Outsourced to Joseph Stiglitz:

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. . . . The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

This is from Stiglitz's article in the current Vanity Fair. For a summary, see this post on Mark Thoma's blog, which is where I got it.

Grover Norquist, meet Dean Baker.

Dean Baker doesn't want to eliminate the financial industry.  He just wants to shrink it until it's small enough to drag into the bathroom and drown in the tub.  He says the financial industry has become so powerful that it has been politically impossible to regulate it. 

It wasn’t even a learning experience for Bush.

Today, 44 days before the end of Bush's term and the start of Obama's, Obama demonstrated in this Meet the Press interview a clearer understanding of the challenges facing the Nation and the President, and what to do about them, than Bush did on his best day in office. Video and transcript here.

They’re baaaack! Keynesians to the rescue.

Nobel laureate Joseph Stiglitz says 3 decades of wrong-headed economic policies did great harm in the developing world, but only when we inflicted the same kind of damage at home did neo-liberal economists rediscover their inner Keynes. Stiglitz points out some subtleties in selecting the best Keynesian remedies and worries that the same greedy market fundamentalists who created the crisis will make out like pirates again while flying the Keynesian flag.

Our only energy insecurity is exposure to high energy prices.

To suggest, as the Western Governors' Association does in its energy policy recommendations to the Obama-Biden Transition Project, that it makes a difference whether we import oil from "friendly trading partners" or from others is a common misconception that could lead to policy blunders. For example, importing oil from nations X, Y, and Z instead of from A, B, and C would not ameliorate our real energy security problem, and US military occupation of oil producing regions is counterproductive.

Any supply disruptions, such as occurred twice in the 1970s, do not cause the customary buyers of the interrupted supply to be without oil while buyers from uninterrupted supplies are unaffected. Instead, worldwide prices shoot up and tankers are re-directed to different refineries around the world until the reduced worldwide supplies are meeting the highest value needs everywhere. The recent excursion of the benchmark petroleum price to $147 was a worldwide phenomenon, and prices of domestically produced oil increased no less than OPEC prices.

The US now uses 20-21 million barrels per day of petroleum. At $70 per barrel, that is about 3.5% of GDP. When the price doubled to $140 this year, it became 7% of GDP, depressed economic activity in the US, Europe, and Asia, and caused large permanent transfers of wealth to exporting nations. If we were consuming only half as much oil, the impact of the price spike would have been only half as large and would probably have been tolerable.

The only effective solution to our real energy insecurity problem is to make our economy generally more energy efficient and specifically to consume less petroleum from all sources. Increasing efficiency of petroleum use will also ameliorate, if not eliminate, our chronic negative balance of trade, reduce our contribution to global climate change, and boost growth industries employing middle class and working class Americans at good wages.

BTW, ordinary citizens can review and comment here on all(?) written materials submitted by interest groups to the Obama transition team. And there is a video of a guy who says all the comments and submitted materials get considered. Hmmm.

Update on Tuesday, December 9, 2008 at 11:25AM by Skeptic

A slightly-modified version of this comment in PDF format is here.

Update on Wednesday, January 7, 2009 at 09:07AM by Skeptic

The premise of this post is that US refiners are not limited to a sole source of crude oil by dependance upon a a single international pipeline connection.  That's true with one exception.  US refiners in the Rocky Mountain region could not easily replace crude oil that they receive by pipelines from Canada.  Pipeline route map is here. There is much contention, based on environmental issues, about 1.2 million barrels per day of oil coming in from Alberta tar sands, which could potentially double if crude oil prices were higher.  See NYT article.  I don't think many folks think Canadian oil is "insecure" or subject to sudden interruption.

On the other hand, other nations with landlocked refineries may be dependent on crude oil coming from a single pipeline from a politically volatile region such as Russia or Central Asia.  I haven't checked.  And natural gas is a different matter, as Europe is being reminded this week.  Europe gets 40% of its imported fuel as natural gas from Russia via a pipeline through Ukraine, and Russia has curtailed shipments because of a pricing dispute with Ukraine.  In recent decades natural gas has begun to move across oceans in refrigerated LNG (liquified natural gas) tankers.  If there were lots of LNG loading and unloading terminals (which there aren't) and excess or independently-own shipping capacity (which there probably isn't), a curtailment of one source of LNG could be replaced from another source.  But so far, it's probably best to regard natural gas as moving exclusively through pipelines and "virtual pipelines" involving LNG tankers.

Update on Saturday, January 10, 2009 at 03:26PM by Skeptic

Europe has an energy policy too, and a conception of "energy security." I haven't looked into it at all deeply, as I should, but here's a link to pursue later. Based on the excerpts, it appears Europe does not aspire to be free of imported energy, but to have good political relations with energy suppliers. I didn't find any language about their views as to the relative importance of cost and risk of curtailment.

Update on Wednesday, January 14, 2009 at 08:43PM by Skeptic

So, Mr. Secretary, high gas prices were the solution, and now they're the problem.  Could you explain?

Atmospheric CO2 measurements by satellites start next month.

This ought to settle once and for all the question whether ambient CO2 has anthropogenic sources and help monitor changes in CO2 emissions and concentrations as regulatory programs take effect.

In January, the next frontier of atmospheric CO2 measuring instruments will begin when the National Aeronautics and Space Administration launches the first carbon-scanning satellite, called the Orbiting Carbon Observatory.

Each day, the satellite will orbit Earth 15 times, taking nearly 500,000 measurements of the "fingerprint" that CO2 leaves in the air between the satellite and Earth's surface. The data will be used to create a map of CO2 concentrations that will help scientists determine precisely where the sources and sinks are—showing differences in trace gases down to a 1 part per million precision against a background of 380 parts per million CO2 equivalent.

Update on Wednesday, February 25, 2009 at 08:27AM by Skeptic

Oops.  Yesterday's launch failed, and the NASA satellite crashed into the ocean.  Japan successfully launched a similar satellite last month, and it is undergoing tests.

Risk management means taking the risks your competitors take.

It is frequently said nowadays that the risk management function in Wall Street firms failed because of lack of accurate and credible information and/or executive incompetence. However, the piece of information that generally overwhelms all other information about the riskiness of an investment is whether competitors are taking the risk. Consider this reflection of completely ordinary business behavior from Rubin's Teflon Finally Wears Off:

Mr. Rubin was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth, according to people familiar with the discussions. They say he would comment that Citigroup's competitors were taking more risks, leading to higher profits.

The problem isn't limited to investments, of course. Businesses everywhere are having frequent and agonizing meetings of their credit committees to decide whether to accept, for example, the next order for parts from GM or Acme Widget when they have been refused COD, credit insurance, and factoring. Or whether to ship to a large retailer with disturbing credit scores and rumored to be on the edge of BK. If they don't take the order, the consequences for their business may be dire, permanent loss of the customer, for example. Usually, they will wring their hands and take the risk.

Credible technical information about risk is not enough. There must be prudential regulation to keep financial firms "too big to fail" from following the herd onto dangerous ground. I am much more upset about Rubin's failings as a government official than I am about his performance at Citi. The scandal of the subprime mortgage meltdown is not that a few bad apples committed crimes or deceit but that practically everything that happened was perfectly legal.

Update on Monday, December 1, 2008 at 09:55AM by Skeptic

What got me thinking about this was this excellent Mark Thoma post saying the key missing ingredient in the current financial markets is reliable information about risks, and speculating about whether "trust" could be a short-term substitute.  The "efficient market" hypothesis, the idea that the only requirement for the smooth functioning of markets is good reliable information, comes through implicitly if not explicitly in many of the comments.  My view is that, while good reliable information is important, it is not sufficient.  Other than religious leaders, I can't think of any group more apt than economists to push magic bullet solutions for complex problems.  If they were medical professionals we would happily call them quacks. 

Update on Monday, December 8, 2008 at 09:48PM by Skeptic

Ezra Klein quotes Henry Blodgett and adds some comments of his own here about conflicts of interest and collective action and the inability of the market itself to correct a collective action. 

Update on Saturday, January 3, 2009 at 10:36AM by Skeptic

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, “As long as the music is playing, you’ve got to get up and dance.” Or, as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

From this fine Joe Nocera article about the rise of Value at Risk ("VaR") modeling in the financial industry.  Update 1/4/09 at 10:00 p.m.: This article is discussed here on Mark Thoma's blog.  Among the points made is this one:  Not only are prices not normally distributed in the past (a key assumption in the VaR models) but events can make futures vastly different from pasts--for example, the Bull's won-lost record vs. the Knicks was not the same before and after the Bulls drafted Michael Jordan.

Update on Saturday, January 3, 2009 at 11:10AM by Skeptic

Some academic research finding support for the hypothesis that individual investors are inclined to follow the herd, by an adjunct professor at Columbia Business School and former investment banker, is reported on Mark Thoma's blog here.  Just posted, but there are likely to be a lot of good comments. Update 1/1/09 at 9:30 p.m.:  Indeed there were, especially the rejoinder this morning by author Eric Schoenberg.  He points out that investing and not investing both have risks and that while not investing may have a less catastrophic potential outcome, the less-than-catastrophic outcome is highly likely to occur.

Update on Sunday, April 12, 2009 at 02:06PM by Skeptic

"Leverage cycles happen not because people are stupid, or because they ignore danger signs. It’s in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects," according to David Warsh discussing the work of John Geanakoplos. 

Geanakoplos offered a clear and straightforward explanation of the path by which the world had gotten into the current mess. He shed fresh light on the halting steps now being taken to get out of it.

For at least a century, he noted, economists have been accustomed to thinking of the interest rate as the most important variable in the economy – lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands – alternatively, margin requirements, loan-to-value ratios, leverage rates or “gearing” – become much more important.

Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down – say, the down payment on a house – prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, he said, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It’s in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.

Who will tell Obama about the flaws in his advisors’ core economic beliefs?

Bob Kuttner reflects on Obama's economic policy challenges and is "a little nervous about who he's listening to." He's referring to Robert Rubin and his protégés, Summers and Geithner, and other gatekeepers who embraced the failed mainstream economics of the last 25 years. Obama correctly says the Administration needs people with actual government experience in key positions, but he also says he wants new ideas. How do impressive heterodox people like Kuttner, who got right what the gatekeepers got wrong, get heard?

Update on Saturday, December 6, 2008 at 12:54PM by Skeptic

Maybe this way.  Labor-oriented economist Jared Bernstein at Economic Policy Institute makes it into the White House as Biden's Chief Economist and Economic Policy Advisor. 

President Washington’s first Thanksgiving Day proclamation. It wasn’t about the harvest.

Whereas it is the duty of all Nations to acknowledge the providence of Almighty God, to obey his will, to be grateful for his benefits, and humbly to implore his protection and favor -- and whereas both Houses of Congress have by their joint Committee requested me "to recommend to the People of the United States a day of public thanksgiving and prayer to be observed by acknowledging with grateful hearts the many signal favors of Almighty God especially by affording them an opportunity peaceably to establish a form of government for their safety and happiness."

Now therefore I do recommend and assign Thursday the 26th day of November next to be devoted by the People of these States to the service of that great and glorious Being, who is the beneficent Author of all the good that was, that is, or that will be -- That we may then all unite in rendering unto him our sincere and humble thanks -- for his kind care and protection of the People of this Country previous to their becoming a Nation -- for the signal and manifold mercies, and the favorable interpositions of his Providence which we experienced in the tranquility, union, and plenty, which we have since enjoyed -- for the peaceable and rational manner, in which we have been enabled to establish constitutions of government for our safety and happiness, and particularly the national One now lately instituted -- for the civil and religious liberty with which we are blessed; and the means we have of acquiring and diffusing useful knowledge; and in general for all the great and various favors which he hath been pleased to confer upon us.

And also that we may then unite in most humbly offering our prayers and supplications to the great Lord and Ruler of Nations and beseech him to pardon our national and other transgressions -- to enable us all, whether in public or private stations, to perform our several and relative duties properly and punctually -- to render our national government a blessing to all the people, by constantly being a Government of wise, just, and constitutional laws, discreetly and faithfully executed and obeyed -- to protect and guide all Sovereigns and Nations (especially such as have shewn kindness onto us) and to bless them with good government, peace, and concord -- To promote the knowledge and practice of true religion and virtue, and the encrease of science among them and us -- and generally to grant unto all Mankind such a degree of temporal prosperity as he alone knows to be best.

Given under my hand at the City of New York
the third day of October in the year of our Lord 1789.

George Washington

(Thanks to Lynda C. for sending this.)

Lessons from The Great Depression--Part 2

Keynes or Friedman? Monetary policy became an impotent tool, or the Fed caused The Great Depression by not expanding the money supply enough fast enough and rescuing banks? Paul Krugman points out that in the current crisis the Fed and Treasury have been aggressively implementing the Friedman cure, and it isn't working.

I hope Obama's economic policy team can get beyond this academic cat fight, recognize that neither Keynes nor Friedman nor any other economist has the whole "truth" about this, and make some sound pragmatic judgments--and be ready to adjust based on results and changing circumstances. 

Part 1 is here.

Update on Friday, November 28, 2008 at 09:32PM by Skeptic

In a mashup of Keynes and The Shadow, Krugman says—

[T]he the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

OK, I’m ready to move on if you are.

Update on Saturday, November 29, 2008 at 11:28AM by Skeptic

Sorry, but I had to mention that Greg Mankiw has gone more or less competely over to the Keynesian side.  Since he was formerly economic policy advisor to President Lame W. Duck and to Mitt Romney, it seems we have enough of a consensus about the need for fiscal stimulation of the economy that we can just get on with it. 

Atlas Shrugged updated for the current financial crisis

The link. 

How cartels lose control—Part 3

Free riders. Russia's budget, current account, and exchange rate are all hurting with crude oil prices below $70, and they have to worry that OPEC might keep production high just to discipline Russia for its refusal to share the pain of production cuts. So now Russia says it will "coordinate" with OPEC, but not "collude." Don't you admire Russia's principled stand? FT story here.

Update on Saturday, December 13, 2008 at 07:17AM by Skeptic

Russia will "take part" in the OPEC summit next Wednesday in Algeria, according to this report.  The report does not say whether Russia will coordinate or collude. 

How cartels lose control—Part 2

With petroleum prices lower than probably any OPEC member wants them, $52 this morning, member nations are split between those who want to agree on further production cuts and those who want to have everybody comply with the already-agreed cuts. The difference between the production cuts announced by OPEC and the actual reductions by OPEC members is often considerable and always a source of distrust amongst the members. Because of rampant cupidity and incompetence, nobody trusts official production figures like these.

For example, Venezuela has to adjust its official production figures periodically when the amount of cash coming into the treasury gets out of whack with the volumes claimed by the production people. Consequently, even OPEC members rely on data from third party networks of spies and from the anti-cartel, International Energy Agency. Financial Times has the story here. Part 1 of this n-part series is here.

The Financial System: Proudly bringing you disasters since 1720.

The author of The First Crash: Lessons from the South Sea Bubble asks why few if any of the 4000 university professors of finance didn't see the dangers in the recent credit bubble or in the recombination of commercial banks and investment banks into universal banks and financial services firms.

Update on Thursday, November 27, 2008 at 10:52PM by Skeptic

Martin Wolf of the Financial Times laments the failure of the economics profession (with a very few exceptions) to predict the financial crisis and ponders the causes and implications in this speech today. 

He speaks, inter alia, of enslaved minds rather than the more common groupthink diagnosis.

Keynes said, of course, that “practical men . . . are usually the slaves of some defunct economist”. So, of course, are economists, even if the defunct economists are sometimes still alive.

Nobody coulda foreseen the subprime mortgage meltdown—except for a lot a people who blew the whistle years ago.

This is an absolutely riveting account of the inflating subprime bubble told mainly from the perspective of industry insiders who understood there was no there there and bet heavily against these securities and the equities of firms that created, rated, and owned them. It describes how the volume of credit default swaps exploded because they were the "side bets" that allowed speculators to short mortgage backed securities and other collateralized debt obligations at much lower cost than borrowing and shorting the actual securities. Then the sellers of credit insurance packaged and subdivided the swap contracts to mirror the "shorted" securities. Normally the longs hate the shorts, but in this case people who were long on the MBSs and CDOs loved the short sellers because it increased the volume of activity on which they earned large fees while their clients were being walked over a cliff. Not only is the piece informative, it's a fun read by the author of Liar's Poker and has names and dialogs of knaves and fools as well as truth-tellers.

Update on Tuesday, November 25, 2008 at 11:06AM by Skeptic

Here's another fun fact:  At least one company's MBS risk model did not have the flexibility to allow the entry of a negative number for the rate of housing price increases. 

Lessons from The Great Depression

What are top economists saying about what lessons should have been learned from The Great Depression and what we should and should not do now? Mark Thoma has collected and republished diverse views in a forum going on right now here. Not surprisingly, one focus of attention is what Christina Romer (to be head of Obama's Council of Economic Advisors) may think about certain policy options. Something I had not heard before is that in the late 1930s there was a large influx of foreign money into the US as Europeans sought safe investments, and that this was an important stimulus to the US economy before 1942.

Some of what you wanted to know about the instruments at the heart of the financial crisis

Here is a good explanation of how mortgage backed securities and other collateralized debt obligations work and why the individual tranches can be impossible to value. For example, the value of middle and lower tranches depends not only on default rates and recovery ratios but on whether the defaults occur in a big spike, especially early in the term, or at the same rate throughout the term. Thus, ultimate payouts may depend greatly on whether housing values are at the bottom now or will decline another 15%, whether the current recession in the real economy is nearly over or will get deeper and last a long time, whether adjustable mortgage interest rates go up or down, and on anything else that affects whether large numbers of people will pay their debts or default.

BTW, this explanation was posted in March 2007, so nobody in responsible positions in financial institutions or government should have been surprised by the public emergence of big problems more than year later.