Really good article,Thanks a lot

"These are exciting and troubling economic times for an economist-the general public can use less of both!"

Less of both what? -- times and economists?

You make some extremely valuable points in this analysis--especially your scepticism about the total magnitude of the taxpayers' losses. Surely not all of the illiquid assets the Treasury takes onto its balance sheet will turn out to be totally worthless, so authority to make $700 billion in purchases does not necessarily imply $700 billion in losses.

The most troubling consequence of the government's intervention is the moral hazard it may create. I wonder if the very ad hoc character of this intervention may not turn out to be our best defense against the expectations that may lead to even riskier behavior. Is it really possible to predict, based upon anything the government has done so far, which firms might be "rescued" in the future? And if the "rescue" involves the total ruin of that firm's equity holders (and, ideally, bondholders as well), is that prospect not a better deterrent than any regulatory scheme we might concoct?

"the government may well make money on its actions"

This is true. At the same time, though, the government could lose more than 700 million. It all depends on the structure of these assets. Most certainly, obligations associated with them could exceed their current market value. These aren't simple contracts like taking a long position in stock.

Additionally, we have to trust that the government can properly valuate these assets, so as not to have an immediate loss. Given that there isn't a competitive market to guide them, this is vital. If Goldman tells Paulson "This CDO is worth $1bn as evidenced by its last traded price two years ago," I hope that Paulson will at least counter with a calibrated Gaussian Copula valuation. Because if he takes a bank's word about assets' value, then taxpayers may use 700bn to buy 300bn dollars worth of rancid assets.

Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities [...]

That isn't a problem, because the cause of the current crisis was excessive leverage -- too much debt and not enough equity. The extreme leverage was allowed by law. Presumably that will henceforth be forbidden by law now that it's obvious that such leverage places the economy at risk. So there will be no choice but to raise more equity and less debt than has been the case.

Many debtholders -- particularly holders of CMOs -- lost a lot of money. And, tellingly, the collapse in the market for commercial paper shows that buyers of the paper didn't trust it -- even though just days earlier the government effectively guaranteed the bonds of large financial institutions. A little moral hazard might have helped matters last week, but none was to be found.

But the discussion of moral hazard misses the point. Regardless of what the government does now, it is axiomatic that if the failure of private organizations/agreements can cause systemic failure, the government cannot allow those organizations/agreements to fail. Period. So it is always in the interest of organizations/agreements to become vital to the system. And it is always in the interest of the public to prevent them from doing so.

That is the function of financial regulation. But that point seems to have been lost over the last 20 years as people fixated on increasing the efficiency of financial markets (in non-crisis times). Moral hazard is the inevitable consequence of inadequate regulation.

excellent post professor. you always write in a lucid prose, so laymen folks like me can understand

This is the savings and loan fiasco by a different name and the same economist was largely responsible for both, ie. Alan Greenspan. He supported the deregulation of the s&ls and he reduced the interest rates to levels begging borrowers without regulations in place. The mortgage brokers then loosed their greed, the banks were just plain stupid and the investment banks were both greedy and stupid. The problem now is not the taxpayer burden as the losses will mostly be recuped through eventual asset sales but that the prevaing economic belief will be the greatest profit at the lowest cost. How about the caveat that that is OK as long as the profit benefits the society as a whole which is the only way capitalism will survive. Otherwise some convincing political moron is going to come around and convince the voters that capitalism SHOULD be dead. The givernment cannot control greed and stupidity but it can set parameters which make the exercise of those sins more difficult and less damaging.

Some may find me somewhat callous in this response, but I find these "crises" on Wall Street and in the Financial Investment Banking world somewhat amusing. Here we have the very individuals who were most vociferous in extolling the "benefits" of deregulation and free markets, not too mention, condemning the "evils" of regulation and market controls over the last twenty five years or so in the same breath, are now crying another tune. Demanding bail-outs and regulation and an end to their ill-considered actions. Too bad we can't let them drown in the swamp of their own making.

Just one simple question, "Why didn't the government step in and save the American Industrial base"? It was and is (to a much lesser extent these days)the true basis of American Wealth. Or all real wealth for that matter.

Thank you for the writing. I have been expecting for your views. I agree that this is not the end of capitalism. And I also worry a lot about the moral hazard. Some say the Wall Street was the symbol of global capitalism. I have always felt that the financial services sector is not representative of the free market. It does not have the look and feel of a 'typical' free market, like retail or Internet businesses. The key words that come to my mind are regulation, difficult to start as an entrepreneur, politics-influenced, moral hazard of participants, speculation opportunity created by government politics, herd instinct, etc.

Isn't the moral hazard a cause as well as a result of all this? I am just guessing, but isn't it possible for the people at large financial institutions were engaged in excessive risks because they did not act like owner-managers? An owner-manager (e.g. A CEO who owns 60% of a company) would hesitate to approve a use of a complex derivative that he does not understand himself or participate in mortgage lending if he views his firm is overly exposed.

Also, isn't it possible that the belief among market participants that "the US government will not let mortage and/or financial markets to suffer which will hurt Americans' dream of owning a home" made them biased towards taking more risks?

Third, isn't it possible that this kind of government intervention will cause financial market participants to move directionally together (bullish together and bearish together)? Because by moving together they are more likely to get government protection. If that happens, that means the financial market could become more likely to have system-wide risks.

Also, the mainstream(?) view that unless the government does something, the financial market will stop functioning ("nobody will lend money") may or may not be true. If there are lenders who view this as a great opportunity to make higher than normal profits, they will lend. It is hard to imagine there won't be any.

Lastly, it is very difficult to start a financial institution. That's true in Korea, which I am a citizen of, and I would guess it is also difficult in the US. If that's easy, I would imagine that there will be new entrants who would fill the empty space. I would be interested too.

It is pointless to complain about what happened already, but if there is one thing I would like to see happening, that is lowering entry barriers. Have entrepreneurs start new banks, IBs, and insurance companies with ease. Let them challenge the status quo.

Why believe that purchasing $700bb of "toxic" mortgages will ultimately be a "winner" for taxpayers?

Your hope that the Treasury will profit with TARP reminds me of Paul Wolfowitz's hope that toppling Saddam Hussein would ultimately pay for itself (by way of lower oil prices, more democratic regimes in the Middle East, etc.).

If the problem is declining creditworthiness due to overvalued real estate collateral, why believe that the Treasury's TARP will stabilize or reverse the downward trend of the underlying real estate collateral value, especially given that its ascent was due to one-time factors such as:

1) Greenspan keeping interest rates too low for too long.

2) the mortgage origination & securitization industry enabling dodgy borrowers access to credit.

Eliminating the least credit-worthy borrowers from the pool of potential homebuyers means reduced future demand for housing.

With less demand, the asset's price should continue to fall.

Since TARP will raise the federal debt as a percent of GDP, the price of credit default swaps (CDS) on UST-bonds is likely to rise.

Such an uptick is worrisome since it will precede a "run" on the dollar and other negative externalities.

Why believe that purchasing $700bb of "toxic" mortgages will ultimately be a "winner" for taxpayers?

Your hope that the Treasury will profit with TARP reminds me of Paul Wolfowitz's hope that toppling Saddam Hussein would ultimately pay for itself (by way of lower oil prices, etc.).

If the problem is declining creditworthiness due to overvalued real estate collateral, why believe that the Treasury's TARP will stabilize or reverse the downward trend of the underlying real estate collateral value, especially given that its ascent was due to one-time factors such as:

1) Greenspan keeping interest rates too low for too long.

2) the mortgage origination & securitization industry enabling dodgy borrowers access to credit.

Eliminating the least credit-worthy borrowers from the pool of potential homebuyers means a reduced number of bidders for housing.

With less demand, the asset's price should continue to fall.

Since TARP will raise the federal debt as a percent of GDP, the price of credit default swaps (CDS) on UST-bonds is likely to rise.

Such an uptick is worrisome since it will precede a "run" on the dollar and other negative externalities.

Let me ask some questions that might be needed to ferret out some unjustified assumptions in Professor Becker and Judge Posner's comments.

1. Why is heading off a major depression justified at all costs?

2. Are there any benefits from a major depression, socially as well as economically?

3. Did Federal Reserve monetary policy (mis)signal investors that there were sufficient savings to finance the expansion of credit over the past twenty years or so?

4. Did governmental policy to outlaw racially discriminatory policy in lending (so-called “red-lining”) create market distortions in the credit market coupled with an active policy at Freddie Mac and Fannie May to lend to those who could not afford to pay home loans in the private credit market?

5. A related possible problem to the ones raised in Question 4 is what role did the 1977 Community Reinvestment Act (CRA) play in this overinvestment in low income housing? What role did community organizers such as ACORN play in this process?

6. Could the combination of concerns raised in Questions 3, 4, & 5 create a huge malinvestment in real estate over the past twenty years or more?

7. Could the expectation of a bailout blind Boards of Directors to foolishly agree to terms with CEO’s that protected the CEO’s against downturns in the fortunes of the company or the market as they provided incentives for high short-run performance?

8. Since much of the distortions in the financial markets came from packaging highly risky loans to people unlikely to be able to repay them if interest rates increased with a host of other sounder investments in order to deceive the buyers, would more personal face-to-face ways of buying and selling make such unethical selling less likely? Has the fact that capitalism as it has become unmoored from personal relationships with those whom one is likely to consider at least a person and engage in business with again loosened a constraint on exploitive behavior?

9. Given Robert Axelrod’s analysis of cooperative behavior being fostered by the ability to retaliate against people one consistently interacts with over time, how can global capitalism that trades on transience and impersonal exchanges promote mutually beneficial cooperation in markets?

10. Why does the Swiss banking system rarely have a bank failure or a credit crisis? Could it have to do with their more tranquil social order, which is similar to the Jeffersonian vision in the U.S.?

11. As people move into banking (or any field) only to make money instead of taking up a profession as a calling, has such a move interfered with the development of a special expertise in the field so that the players are less likely to intuitively sense long-term prospects for investment strategies? Consider here Hubert Dreyfus’ work on expert knowledge where an emotional attachment to the skill being exhibited must occur if the person is to advance past the intermediate level to the expert skill level.

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I would echo Chris Graves' sentiment in his question #8 above. The baby is in some filthy bathwater, with rumblings of widespread fraud -- or at the very least a staggering lack of due diligence on the part of investment banks in mortgage packaging.

The secondary market was flooded with paper whose value was greatly inflated, whether by reason of fraud or monumental failure to properly assess risk.

I think the concern should be for the market's susceptibility to manipulation and/or distortion. Marx said capitalism's excesses would be its undoing, but nothing in the capitalist model endorses outright fraud or quasi-fraud through extreme lack of transparency in publicly traded securities.

It's way past the time to pass a big clawback tax on "windfall incompetence bonuses" -- those undeserved million dollar bonuses (or severance packages).
The US President makes what, some $200 000/year.

If a company needs gov't bailout money, its leaders making more than that are 'obviously' overpaid. Past bonuses (over the last 5 years?) should be subject to very high "incompetent profit taxes", up to 90% on amounts over $2 mil (10*President salary).

The top decision makers at the big companies need to have the fear of Personal Wealth Reduction to become more prudent.

Too bad letting Fannie Mae fail, go bankrupt, and having shareholder lawsuits galore against all of its leaders and auditors would be too expensive for the real economy. I'm glad Lehman Brothers went belly up, Bear Stearns should probably have been allowed to try Chapter 11, too-- and more court ordered debt to equity clearances...

I'm enraged at top CEOs not taking more protective measures over the last year. I don't think I'm alone. And yes, if the Big Boys become 'too cautious', that will allow more room for real risk takers to offer new, better, but untested financial instruments -- and not be 'too big to fail'.

It's so cute the way you write about "Stanley Morgan" and "Bears Stern," you ol' absent-minded professor, you. BTW, there actually was an excellent NFL wide receiver named Stanley Morgan in the 1980s.

Excellent and thought provoking articles by both Becker and Posner. I have also read the following article by Prof. Rajan with great interest:
http://www.ft.com/cms/s/0/13a60574-862b-11dd-959e-0000779fd18c.html

A few comments:
- The moral hazard issue is adequately stated in the post and comments
- The taking over of these bad assets and the eventual calculation of losses/gains associated with them do not answer why the government should be in the real estate business in the first place. Philosophically speaking, the government is playing with the tax payers' money. And I disagree with that action.
- There is little reason to believe that the entire process of valuing these assets, holding them and then eventually disposing them off will be efficient in the government's hands.
- If a profit is indeed made, where will those profits go ? Will that money be spent on earmarks and pork belly projects ?
- Much has been made of a potential crisis if these (the rescued) institutions failed without adequate explanation of what exactly would happen and why that is an undesirable thing in the long run. I would rather let the system collapse, purge itself out, have the general economy bear the brunt of it and then emerge as a more prudent society.
- I am not sure that regulation approved in a rush adequately weighs out all possible outcomes and risk-weighs them. It is highly likely that unintended and negative consequences of regulations will show up several years down the road leading to more problems as yet to be defined. Solutions to financial crisis do not have to entail increasing regulation. Financial markets will largely regulate themselves if allowed to face the consequences of their actions.

I believe there is a serious flaw in Bankruptcy law as well. The standard two year look-back provision is inadequate. Smart managers are gaming the system by taking out huge bonuses in real time, then backing up the long term consequences to shareholders in the end game. This is part of life in capitalism, and intentional abuse is only possible if there is fraud, but fraud should be generously defined in favor of shareholders, and any hint of it should be greatly punished.

How will Treasury price what it buys? Are the assets worthless? Is there moral hazard in the Treasury scheme? Should Congress/Treasury set CEO compensation?

It seems to me that some commentators misunderstand the nature of the Treasury proposal. Subject to correction, I believe it is quite simple. The Treasury will make a market for securities that currently are not trading. Because there is no market for these securities at the present time, they must be carried on the owning institution's books as of zero value, under the "mark to market" accounting rule.

However, the securities have some real residual value to the extent that they pay income
to securities owners based on mortgage payments by property owners.

I think the Treasury would buy these currently illiquid assets at the lowest price offered. Institutions seeking to unload them would compete with each other to sell. Meanwhile, I would anticipate that once trading begins, there will be other buyers looking for bargains. In short, the Treasury intervention would unfeeze a now frozen market. Once a market price is established for currently illiquid assets, accounting rules will permit that value to be reflected positively on balance sheets. Eventually, perhaps quite soon if a recession does not intervene,, the Treasury could stop buying this paper and begin selling off its holdings, probably at a profit.

If there is moral hazard here, I fail to see it. Some of the moral hazard underlying the current market failure was created when Freddie and Fannie were allowed to go public but also pushed to fulfill a federal government objective of increasing home ownership, with an implicit government guarantee as an incentive. Some was created by a regulatory breakdown at the state and federal levels when essentially unregulated mortgage brokers and mortgage lending institutions competed to sell subprime mortgages without any institution, private or public, performing due diligence on their products. In other words, with the exceptions noted by Professor Becker, I see the moral hazard in this crisis as a product of past actions and inactions.

I see no reasonable argument for giving Congress or the Secretary of the Treasury the power to set salaries in the private sector. I am sure that they wouldn't get it right. Not that boards always do, of course, but at least boards are responding to market signals about the value of a CEO. It seems to me that Congress has already demonstrated its inability to set physicians' salaries without distorting the incentives for engaging in different types of medical practice. Why should it be trusted when it seeks to extend its power to the financial sector? If there is reason to believe that CEOs have defreauded anyone, they should be prosecuted, of course.

Predictably the defense of global capitalism is perpetrated here. If the global economy is as resilient as argued, if the forces of market capitalism, and supply-demands from a global/geopolitical formulation are so ample, then why the need for a bailout? This is a bailout. Nothing less, but a good deal more, in fact.

Rather than echo tired old aphorisms about the indestructibility of the market, why don't we confess and say: the market failed because of greed, and, well more greed, coupled with short-term philosophies. A few speculators undoubtedly ended up well off, and a good deal of less fortunate, less financially backed individuals -- traders, marketers; the back-bone, smaller fish of a massive infrastructure, did not.

What we have is the government bailing out capitalism. The creation of an agency, which I am certain will cost towards (perhaps, upwards) of a trillion dollars, to buy failed companies is sort of like a backward socialism. I'm not even sure what to make it of, especially with a politically, ideologically conservative government driving the call for its creation. --Using taxpayer money to buy companies in a market system? To pick and choose, to in effect, be a stock-marketer, again with public resources? If we have such collective confidence in the strength of the market(s) -- and I, for one, am all for such an approach, then let's see what happens when the failures accumulate, and large corporations (which, really, should have known better) fare less than well. It might result in a leaner, tighter, more savvy market, and then again, it just might spook some old revolutionary ghosts out of the closet, and make our country a better place.

Irrespective, I think the terms of engagement in the debate have radically changed with the government's response to these failing companies, and the market economies faltering -- it is no longer illusory, or mere liberal ideology to speak of national healthcare, free university educations, or the like. In light of the substantial direction of public finds being invested in these companies which may, it is conceded, bring (although I highly doubt this; though, I might just live long enough to see it) revenues and returns, so too would national health care and free higher education create significantly equal, and arguably, better returns, and at an overall better cost to the market's health -- and maybe, in the end, to the development of our collective soul.

Predictably the defense of global capitalism is perpetrated here. If the global economy is as resilient as argued, if the forces of market capitalism, and supply-demands from a global/geopolitical formulation are so ample, then why the need for a bailout? This is a bailout. Nothing less, but a good deal more, in fact.

Rather than echo tired old aphorisms about the indestructibility of the market, why don't we confess and say: the market failed because of greed, and, well more greed, coupled with short-term philosophies. A few speculators undoubtedly ended up well off, and a good deal of less fortunate, less financially backed individuals -- traders, marketers; the back-bone, smaller fish of a massive infrastructure, did not.

What we have is the government bailing out capitalism. The creation of an agency, which I am certain will cost towards (perhaps, upwards) of a trillion dollars, to buy failed companies is sort of like a backward socialism. I'm not even sure what to make it of, especially with a politically, ideologically conservative government driving the call for its creation. --Using taxpayer money to buy companies in a market system? To pick and choose, to in effect, be a stock-marketer, again with public resources? If we have such collective confidence in the strength of the market(s) -- and I, for one, am all for such an approach, then let's see what happens when the failures accumulate, and large corporations (which, really, should have known better) fare less than well. It might result in a leaner, tighter, more savvy market, and then again, it just might spook some old revolutionary ghosts out of the closet, and make our country a better place.

Irrespective, I think the terms of engagement in the debate have radically changed with the government's response to these failing companies, and the market economies faltering -- it is no longer illusory, or mere liberal ideology to speak of national healthcare, free university educations, or the like. In light of the substantial direction of public finds being invested in these companies which may, it is conceded, bring (although I highly doubt this; though, I might just live long enough to see it) revenues and returns, so too would national health care and free higher education create significantly equal, and arguably, better returns, and at an overall better cost to the market's health -- and maybe, in the end, to the development of our collective soul.

A few questions from the ill-informed:

Do Fannie Mae and Freddy Mac have anything resembling a board of directors?

If so, what is their exposure from the chicanery of Raines, Johnson et al? I thought after the Enron debacle the boards got some serious exposure to being asleep at the switch.

Is there any indication that these CEOs with the golden parachute have kicked back part of their bonuses to a compliant board?

My political slogan for the aftermath of this crisis is:

Any financial institution too big to fail must be too well regulated and too transparent to fail.

We now have quite a few big players that may find it advantageous to break themselves back up if we instituted enough regulations to protect tax payers against bailouts of "too big to fail" enterprises.

Once a corporation throws itself upon bankruptcy court to stanch the bleeding of corporate assets, why should the court not be empowered to consider the fact of bankruptcy itself as overwhelming evidence that management bonuses could only be paid out of an intent to defraud the creditors? There would obviously have to be some kind of proration of claims against already-paid bonuses from previous years, but I don't see anything wrong with the court seizing, say, three years of bonuses retroactively.

Great little pieces from both of you. I hope members of Congress are paying attention.

How much and how to finance? Those are the gut-check issues. Let's get that $700 Billion guesstimate whittled down by every means possible. If that means assessing a huge tab back to Wall St so be it. The commercial banks took such a hit in '90-'91. Congress could create a fiction like the Resolution Funding Corporation of the '89 Act and authorize it to issue "off-budget" bonds, to the public - anybody who wants to buy them, to finance working capital. That's a better approach (not to mention more constitutionally-defensible) than giving the Treasury Secy authority to write a staggering blank check.

I believe we all know what really has to happen - figure out 1) who/what actually owns/holds the legal right to foreclose the defaulted/defaulting loans and 2) how to get it done at least cost to ultimate resolution. That's tough love but anything less will cripple global confidence in our financial system and what's left of respect for our rule of law.

Ignoring Fannie and Freddie, because that involves an examination of an additional question of possible corruption, causation for the crisis involves on the one hand pressures by the Federal government to make unsafe loans (as in the Community Reinvestment Act), aided by the Federal Reserve providing easy money, and on the other hand stringent regulation, particularly in the form of the mark-to-market rules for reporting on bank capital. One is tempted to think of this scenario as a trap set out for the banking system. Given the underlying situation it is superfluous to worry about whether the solution undermines the free market nature of the economy. Government is deeply involved in both creating and resolving the problem.

....

But of the possible solutions discussed here and elsewhere, a government purchase of troubled assets seems to be one of the least intrusive--certainly less intrusive than acquiring stock in and onership of a lot of banks. These assets can be held serenely by the Treasury and sold back into the markets as they recover value. Treasury will not trouble itself with a mark-to-market rule. Very likely the taxpayers will have a profit.

...er,--that would be "ownership".

Very good article, I learned a lot of knowledge in the hope that we can together

a very good exchange, Guizhan also hope that better and better, I will frequented, thank you.

Darn, somebody made the Stanley Morgan call before I did, that fact bears sternly upon me. I'm just worried that Irving Fryar & Co. will also go under.

It's a bit early to speculate that these crappy level III piles of junk are going to net the Gov't cash at the end of the day. IIRC, the S&L bailout was eventually paid for as the asset pool (primarily real estate, ironically enough) appreciated in value over time to the point where the sale of such proved profitable.

The derivatives and other toxic level III assets being bought by the government here also relate to real estate but not in the same way as in the S&L crisis context. My understanding is that, rather than being tied to a piece of land, these instruments are tied to tranched up asset-backed obligations that are difficult to unwind, and in many cases to synthetic reference obligations that have no inherent value at all. Waiting for these things to appreciate in value does not seem as likely to me.

No, that's not viable. All you can do is try to take enough volatility out of the bets to take speculators (who thrive on fear premium) out of the money. It doesn't work every time - consider successful attacks on currencies. But a disciplined containment policy tends to succeed longer term. It's a near-miracle, for example, that the U.S. Dollar has held as well as it has over the past two years. We're long on American talent capable of executing a clean-up. The mess became as ugly as it is because politicians, policymakers and law enforcers slept at the wheel while profiteers ran amok.

Start flushing those Trillions down the Toilet !

And start learning to speak Mandarin !

The Chinese are coming...

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YOURS FAITHFULLY MINISTER OF TREASURY PAULSON

I am disappointed no one at Chicago predicted this event, we should have gotten closer.

Chuck GSB '85

I am disappointed no one at Chicago predicted this event, we should have gotten closer.

Chuck GSB '85

I am just thankful to be able to get out of bed every morning and go to work.

If you learn to lower your expectations dramatically, it makes it easier to tolerate things such as Arthur Andersen, Worldcom, Enron, AIG, Lehman, Merrill's sale (tentative and not final), etc.

And at least we now have blogging to offset things that have been destroyed.

Chuck, No one at Chicago could have predicted the "meltdown", given it's economic ideological stance over the years. If they could have, they were effectively muzzled. Much like the rest of the "Economic" Schools worldwide.

The Schools of Historical Economics are going to have field day with this one.

You don't have to be a GSB student to know that
there are any number of books which one could have read which DID predict this in general terms, not to mention the biblical proscription about GREED. The dot-com bubble was the modern template for this housing bubble. No one can predict the exact time of a bubble burst but my bet is that the next one will be about "energy". Since we don't have any real method of capital formation anymore, bubbles is all we have in our future. And the geniuses who cooked this one up will skate with their filthy lucre and the voters will elect a "savior" who will be faced with no monetary discretion except to print money and lower the value of the dollar. Maybe the US should declare bankruptcy and start over.

Neil, Ha! would agree that it would be counter-ideological for "Chicago" even to suspect something could go wrong due to a lack of regulation; after all "the market" "should" be knocking off concerns that made mistakes and there assets would then be gobbled up by those .......... playing by sound business rules?

What's of interest now is WHY was no one listening to those of us who clearly saw a "bubble" atop a house of cards. Several years ago I saw a (wise) old trader on TV remarking that buyers of portfolios of derivatives etc. had NO idea what was in the ports they were buying.

Now WHY is that? If one Wharton hotshot (or ex-securities salesman?) can encode these messes why would century old financial houses not have a decoder? if only for the selfish motive of beating down the price for the pile of junk, not to mention the due diligence any individual or company would be expected to do for self preservation.

Why? in a decade or so were there not economic studies of the underlying asset values? For example those LA bungalows we saw on "Flip this house" (which seemed a warning billboard itself) selling for $400,000 or so. We know the obsolescent structure of 1200 sf or so to have a depreciated replacement value of less than $100,000 so "we" then assess the postage stamp lot as the other $300,000.

Surely there are thousands of economists or real estate professionals who would begin to ask "At prevailing wages who can afford to pay for this house??" Another clue in many areas was that while the payment on this example would be $3000 per month plus taxes and maintenance, similar homes would rent for less than half that amount.

One aspect that probably WON'T be discussed is the tax aspect of bubble building. Buying house is the only investment I can think of where the interest is deductible but the capital gain can be kept tax free. Surely this is a strong incentive to by nearly as much house as one can afford as one's income increases. With higher incomes, perhaps 7? or was it 8? Great public policy that surely tends to inflate home prices as well as providing far larger tax subsidies to the wealthy than to lower income folks.

Jack wrote: "Surely there are thousands of economists or real estate professionals who would begin to ask 'At prevailing wages who can afford to pay for this house?'"

Great question, Jack, that gets right to the heart of the matter. I am also not impressed with the Wall Street apologists who are "shocked, shocked and dismayed" that all those bright girls and boys simply MISUNDERSTOOD the nature of the securities changing hands.

If anyone believes that, I've got a AAA-rated tranch for you to buy. Sure it's too complex for us mere mortals to unwind, but trust me, the underlying mortgages on McMansions, urban ghetto triple-deckers and crack-house brownstones are SOLID GOLD, baby.

Dr. Becker,

Altough I usually agree with you, this time I differ greatly in your assesment of the situation. In first place, it's highly unlikely that the Paulson plan will derive in profits for the tax payer, since the current crisis derives from a bubble that is currently deflating, so the declines in prices the MBS and other derivatives is not a mere a problem of liquidity in this assets.

for the Paulson plan to work it will have to buy these assets at a price significantly above the current market price (more surely closer to their value in books so the banks can fix the problems in their balance sheets), which will certainly bring looses to the tax payer since the "fair value" of this assets is closer to their current value than to their book value.

Looking ahead, the house prices still have further to drop so this would mean that the provisions that the Paulson plan would requiere even more than the 700 billion are may not be so wrong after all.

You're right about some of those mortgage-backed fractional interests that'll never be unwound. It'd be comparable to trying to clear title to every old piece of dirt in Texas that was ever leased out for oil & gas. In the interest of time, can you say eminent domain? Condemnation? Might as well, if the collateral's worth less than the securitized debt against it. The washout could become a wipeout for lots of investors who are still clinging to faint hope.

I enjoyed Professor Becker's blog and agree that it made some excellent points. But, he essentially asks us to place this in perspective and recognize that the drop in GDP won't be anywhere near the collapse seen in the Depression. GDP's a function of consumer spending and exports, among other things. Maybe as the dollar weakens, U.S. exports will make up for losses in consumer spending. But isn't the problem here fundamentally that a large chunk of consumer spending has been based on debt? If the loans dry up-- which is almost a certainty-- consumer spending will have to fall. How much of consumer spending is based on debt? Well I see a lot of people using credit cards to purchase groceries, and here in Ohio there's no shortage of Pay-day Loan outlets that will lend you enough to make it to the next pay check at a 25-30% rate.

Jack, From a purely operational standpoint, I've always considered this "meltdown" as the direct result of of the old market scam, "the pig in the poke". I won't elaborate on it, once it becomes known, it doesnt' work very well. Clearly, there's a lot of MBA's out there that don't know what it is.

Perhaps we all ought to go back to the nursery and study our Nursery Crymes:

To Market, to Market, to buy a fat pig.
Home again, Home again, jiggty jig.

And once I get home, what do I find?
Just a worthless rind!

Ha! good comments Dan and Neil! Dan, sight unseen my bid on your triple A's is .00015/dollar of ""face"". I'm sure there are some worthy assets in there but am concerned about my cost of workouts especially if housing continues to fall.

One more random thought on the past 25 years. For a long time now 'investment' talk at cocktail parties seemed to center on home appreciation and what the home might bring were it sold to someone else at the same party or the one down the street. Though few were painted the color of tulips, somehow I was reminded of the tulip bulb mania of a century ago.

More seriously, I've wondered what's going on here? to be sure with the tax breaks, low interest rates and all, investing in a cushy home seemed more attractive than the similarly overpriced stocks of the last decade, and bonds? forget it, what little yield there is, is taxable, and doesn't keep even with inflation.

So what does this mean if, as Buffet laments, there are few worthy investments to be made? Is all our work done? Our "economy" that of selling each other "flip homes", lattes and tattoos and buying foreign made goods with the "profits?"

It doesn't appear so. We've something like a Trillion worth of infrastructure maintenance and upgrades to tackle, a whole new energy infrastructure to build, and why don't we have at least one high speed train plying the busiest commuter routes on our east or west coasts?

Have we as a democracy so skewed our policies as to over-reward housing to the detriment of truly investing in the productive assets we'll need to remain competitive in a much tougher world than we faced in the post WWII era?

For example, Barack has been taking flak for proposing some sort of taxes on capital gains from homes; but from what we've seen in the last few years wouldn't we be far better off shifting our tax incentives to investing in a windmill or research on enzymatic bio-fuel tech instead of more, even larger homes that have been, and are being built to minimal energy conservation standards with each being a long term drain on limited or increasingly costly energy reserves?

Take a quick look at this graph of US energy consumption. It shows per person energy consumption of CA being flat since the mid-70's while the higher, US average increased by over 25%. Had our whole nation just accomplished the flat curve of CA we'd be using 25% less energy, meaning no M/E oil would be required and we'd not be bearing the hefty costs of bringing LNG across oceans and would have a 25% smaller CO2 problem.

http://www.data360.org/graph_group.aspx?Graph_Group_Id=985

Dare a new President......... "Ask not........?"

I have been thinking a lot about this $700 billion bail out. I am so surprised that Wall St. and the Treasury can’t figure out how to fix this problem. Its super easy. We have to STOP the residential real estate pricing from falling further. As it falls, more and more homeowners are underwater and go into foreclosure. To do that, you have to figure out why its falling.

It’s Simple - foreclosures are driving the market down.

Every time a homeowner defaults, their home goes through a fire sale and prices drop in that area and make the problem even worse then before. Today, 2.5% of homes are in foreclosure up from 2%. No wonder the housing market is in free fall.

The answer isn’t using the $700 billion to buy mortgage back securities.

One, it won’t solve the problem. There are more mortgage back securities outstanding then government and corporate debt combined. $700 billion is a drop in the bucket so those markets will continue to be illiquid even after the bailout. It would take several trillion dollars to solve the problem that way. Two, it doesn’t solve the foreclosure problem. Foreclosures will continue because the real estate market will continue to fall. As a result, the marks on these securities will continue to erode pushing more banks, insurance companies and pension funds into insolvency.

Let me explain what we should do. To do so, you have to understand how securitizations work. A pool of mortgages gets placed in a trust and then investors buy bonds secured by that pool of assets and the cash flow they throw off.

The solution to our Wall St. problem is to go the trustees of those pools of mortgages and buy the defaulted loans at a predetermined price. The price is easy. Use the average price per square foot for homes that sold in the last 12 months in that zip code. Then, either modify the loan terms to keep that family in their home or foreclose.

The TRICK is to NOT SELL these foreclosed homes.

Through the FHA, the government can put together a rental program that then rents those homes to middle class families. The United States is in desperate need of more rental housing. This problem solves that problem. Then as the market recovers the government can then sell those homes and get back the $700 billion and probably some profit on top of the income from the rentals.

By NOT SELLING these foreclosed homes, the residential real estate market will quickly recover and home prices will start to rise. Then, homeowners who cannot afford their mortgages will be able to sell their house for a profit or cover their mortgages.

ALSO, by buying these non performing loans the fundamentals of these mortgage back securities will quickly recover and the market for them will stop seizing up. Then the value of these securities will normalize and the banks, pension funds and insurance companies that own them will stop losing billions of dollars.

But will this work? The average home in the US is around $300,000. Assuming they are 100% leveraged between first and second mortgages, the government can buy 2.3 million defaulting mortgages. According to the Mortgage Bankers Association, there are 1.1 million homes in foreclosure. That means we could buy 2x the number of mortgages in foreclosure with this $700 billion. That’s much better then buying up less than less than 10% of the mortgage securities.

This plan does several things:

1. It stops the free fall in the residential real estate market which will prevent more foreclosures.
2. It repairs the fundamentals of the ENTIRE mortgage back security market and the marks of these securities will rapidly increase, which breaths life into the banks (they might need some money in the meantime but not hundreds of billions).
3. It solves our rental housing crisis.
4. The government will not lose any money and will gain a good stream of cash flow.
5. It will stem losses at the pension funds that haven’t even been discussed yet.
6. This also solves the pricing conundrum with the current Paulson plan and helps Main St. WHILE also helping Wall St.

Grant,

I think the flaw in your analysis is that assets were overvalued due to systemic fraud in the residential real estate business on at least two levels.

First, let's just say that the "independent judgment" of home appraisers during the housing bubble has been dubious at best...

Second, Bloomberg's began an exclusive investigative report yesterday detailing corruption at S&P in providing sight-unseen (Jack!) ratings of mortgage-backed securities as AAA when any amount of due diligence would have revealed that they were anything but.

See: http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s&

So I would argue that residential housing prices should and must come down dramatically to correct for the combination of fraudulent over-valuation and bubble effect. Professor Shiller at Yale projects that we are only halfway there...

The "moral hazard" here is extreme, not merely because of the risk of rewarding imprudent/corrupt behavior, but because the urgency with which a bailout plan is being pitched is riding roughshod over constitutional considerations.

I am numb with disbelief hearing Professor Shiller and members of Congress say that "no one knows" whether the Paulson plan will work but that it "beats the alternative of doing nothing." And let's all be clear: knowledgeable people are projecting the actual bailout cost to be AT LEAST $1.5 trillion and not merely $700 billion.

Someone please pinch me. Because I would really, really like to hear how $1.5 trillion in a potentially failed bailout is trivial compared to the global economic catastrophe that will inevitably follow. That is the only rationale I can think of to explain why Nobel prize-winning economists and the "best and brightest" financial minds are backing this non-plan while we teeter on some kind of precipice.

Lemmings of the world unite!

Well, as David Hume, Thomas Jefferson, and even Richard Posner himself have observed, the people with the highest IQ may lack the common sense needed to make real world decisions. That seems to be what is going on here--both in creating this mess and now in resolving it.

As long as the Federal Reserve does not act on the basis of a monetary rule or some other discipline to provide a predictable and proportional growth in the money supply, and as long as the Congress votes to subsidize and mandate lending to people who are not creditworthy, and as long as we bail out irresponsible behavior, banking crises will continue to spring up. Each crisis will build on each other until we reach a breaking point, and then we will find ourselves in a depression more comprehensive than the 1930's.

I think the US government should encourage/force banks in restructuring bad debts instead of providing this bailout. I am not sure if the bailout plan offers the right incentive for banks to restructure bad debts. If any potential bank failure would end up making taxpayer bear the final cost, the US banks would always lack the incentive to make good loans in the future. In fact, the government should encourage mergers among private sector and introduce foreign banks of healthy balance sheet to absorb the ultimate bad debt risks. History suggests that financial markets always returned to calamity more quickly with private investment than government intervention.

I am worried that continuing deterioration in the US treasury's balance (like financial bailout) will result in a significant higher long-term interest rate and steep depreciation in the USD. The combined effect, along with bank insolvency, could potentially hurt the long-term growth of the US economy to an extent beyond our imagination.

I am against this bailout as I could imagine that the government will need to provide more bailouts in the future. Let me emphasize that we still have NOT experienced serious pick-up default rates among CORPORATE and RETAIL loans. We are just dealing with a country-wide mortgage default now. Could/should/would the US government continue to bail out banks' balance sheets if rising defaults in corporate and retail loans put bank survival in danger again?

I feel that the government starts bailing out way too EARLY. Instead, now is time for introduction of healthy international banks into the merger/acquisition process and speedy restructuring of bad debts. We should get our hand dirty to clean out as many bad mortgage debts through the private sector as possible because more (from corporate and retail loans) may come soon.

Grant; I like some of your ideas, and being somewhat close to the housing biz it does seem that the plan before Congress ought to include work-out aspects as we know it is costly for all involved to go thru foreclosure. My guess is that most who are squeezed but not in a hopeless mess, would go for a deal that even left them slightly underwater if the terms were something they could handle.

I'm guessing that you and others may be underestimating the amount of price contraction yet to come. Forget for the moment the forced "sales" of foreclosures and the effect they have on the local market and focus instead on there being 10 months of unsold new homes in inventory (5 mos is common) Then consider that most new home sales (especially anything above entry level pricing) requires getting the customer out of his existing home with enough equity to make the (forthcoming??) down payment and bear the other costs of moving.

So, we'd need to know how many prospective new home customers are now at break-even or worse on their existing home and how long it might take to sell it in an uncertain market. Where both new and older home prices are falling, many, most? will tend to stick with their older, lower priced home and wait for things to settle out.

What happens next? Some large builders may be able to carry inventory for a year or so rather than throw their product on the sale table, but, smaller builders will face dumping at fire sale prices or having big problems with their bankers.

Meanwhile "the market" may be that of the foreclosed homes of a wide array of price points, while new home prices, constrained by building costs and what the builder paid for the land are not seen as competitive, unless, the builders sell below cost.

So..... is next year a market of falling prices with recycled foreclosures, and emergency sales by those who are underwater and can not get out from under onerous loan terms adding to the problem of excess new home inventory?

Lastly, do they even KNOW what the inventory is? For several years now it's been a fine game for "investors/speculators" to buy a number of unfinished homes that they might sell as soon as they were completed in the hot markets or after a year or two year hold to get further appreciation at "long term capital gains" tax rates.

Does the 10 month "inventory" figure include this phantom inventory? In LV and some of those superheated markets the "investors" who flew in with a pen and a check for $100 are not likely to be able to hold for a better day, especially as LV's biz model is contracting due to energy costs, inflation et mess leaving folks with too little for an LV trip.

But......... you're suggestions would seem to be a good or better than what we're seeing from Paulson regardless of the size of the mess. Good ideas! Jack

The crisis as I understand it is caused by a conflict between debtors and creditors over how much the toxic mortgage debt on banks' balance sheets is worth. The inability to agree is causing the credit markets to freeze up because the junk still on the balance sheets of banks trying to borrow makes them uncreditworthy while making relatively solvent banks more unwilling to lend for fear of future adverse shocks to their balance sheets as the contagion spreads. The solution is to get the junk off the balance sheets of the banking system. But the problem with doing that is that creditors won't accept what debtors are willing to offer. So Paulson is proposing that the government buy up the junk for more than the junk is now worth in the hope that it will appreciate once stability is restored and the real estate market recovers. So Paulson wants the risk to be socialized and forced on to the taxpayers. But there is an alternative solution. Force the junk to be converted into equity for 50 cents on the dollar which appears to be about half way what debtors are offering (35 cents on the dollar) and creditors are willing to settle for (65 cents). This way the banks will be recapitalized by those involved and with the most at stake (i.e., creditors) not by taxpayers. The market will be unfrozen because the losses will have been made bygones. It is the fear of loss and the attempt to avoid it that is causing the panic. Yet another application of the Coase Theorem. Once the losses are finally allocated (the bottom is hit), the recovery will start because the focus of the market will revert to the creation of wealth rather than the avoidance of losses (and fighting over who is stuck with them)

The crisis as I understand it is caused by a conflict between debtors and creditors over how much the toxic mortgage debt on banks' balance sheets is worth. The inability to agree is causing the credit markets to freeze up because the junk still on the balance sheets of banks trying to borrow makes them uncreditworthy while making relatively solvent banks more unwilling to lend for fear of future adverse shocks to their balance sheets as the contagion spreads. The solution is to get the junk off the balance sheets of the banking system. But the problem with doing that is that creditors won't accept what debtors are willing to offer. So Paulson is proposing that the government buy up the junk for more than the junk is now worth in the hope that it will appreciate once stability is restored and the real estate market recovers. So Paulson wants the risk to be socialized and forced on to the taxpayers. But there is an alternative solution. Force the junk to be converted into equity for 50 cents on the dollar which appears to be about half way what debtors are offering (35 cents on the dollar) and creditors are willing to settle for (65 cents). This way the banks will be recapitalized by those involved and with the most at stake (i.e., creditors) not by taxpayers. The market will be unfrozen because the losses will have been made bygones. It is the fear of loss and the attempt to avoid it that is causing the panic. Yet another application of the Coase Theorem. Once the losses are finally allocated (the bottom is hit), the recovery will start because the focus of the market will revert to the creation of wealth rather than the avoidance of losses (and fighting over who is stuck with them)

David, Are you willing to take the fifty cent loss per dollar? Especially, when that fifty cent piece loss is going to add up to 100's of billions, if not trillions of dollars? I think not, and there is the sticking point.

The gist of the problem is not that there are bad loans floating within the Banking system (there have always have been bad loans floating in it), but lies in its scale and magnitude. The financial industry cannot by itself absorb this scale of loss without going under. Dragging everything else along with it.

Ever had to line up at the bread line to get your one square a day?

Neilehat,
I agree with what you say in your most recent post about the scale of the ill-advised loans. How do you think such a massive mistake happened?

Chris, See my comments above. Especially the one on "pigs in a poke".

!!NEWS FLASH!!

Mayor Bloomberg of New York requests City and State Attorney's Offices to begin investigations into "Short Selling" on Wall Street. Especially, into the recent activities of multiple "Sovereign Funds".

Question: Is all this just simply a market anomalie and correction, or is it something more insidious, such as an Economic War?

The coming economic meltdown may not return the country to the days of the Great Depression. But even if it isn't quite that bad, we should remember that it took the Second World War to lift the country out of that earlier economic malaise. Will the economy be able to recover on its own this time?

I find myself genuinely asking the question:

What would Milton Friedman do? Bless his soul.

Interesting blog. I wanted to clear up a few misunderstandings about the GSE companies Freddie Mac & Fannie Mae. I currently work at one of these. The GSEs do not lend or originate loans. They buy loans from mortgage originators. If you look at the market over the last decade, the GSE's market share fell to 35%. That means the non-GSE's were responsible for 65% of the MBS securitization market. Most of this activity was in the subprime sector because the GSE's would not participate. Blaming the GSE's for this current asset value implosion is largely political. It is well to remember that it was a government agency, Ginnie Mae, in 1971 that created the first MBS. Our role is largely one of creating the overall framework of this market. This whole mess is just a classic asset bubble pure and simple. As more money flowed into the housing sector, asset values climbed, lenders kept lending because collateral was worth more. The leveraging continued as lenders moved further and further out the credit quality curve as they sought higher yields. Finally, the top of the pyramid was reached. We are now in a dangerous situation. As asset values fall, companies balance sheets will become impaired. Monetary policy will become relatively ineffective in this environment as companies strive to shore up their balance sheets by paying down debt. Even if rates fall to zero, companies will stop borrowing because the goal will be to repair their underwater balance sheets - a process we saw in Japan from 1990 thru 2005. The $700B bailout is right on. As assets are sold, and deflation threatens, the goal is to get the toxic waste off of balance sheets and for the gov't to implement a fiscal policy of massive borrowing to balance the lack of borrowing in the private sector. Monetary policy will be useless in the shortrun.
I guess we'll see.

Please read the chapter on "well kept secrets" in William Greiderer's book "Who will tell the People". The present mess is the S&L repeated on steroids. Plenty of folks saw it coming but the congress swept it under the rug until after the election. My guess is that 700B is the tip of the iceberg but that won't be public until after November and that the needed fundamental changes to our economy and government will not be made until the entire system collapses. Anyone who thinks that the American people have any connection to their government or that the government acts on anyone's behalf other than their "clients" has been smoking very old economic textbook pages.

What I do not see in the comments of those critical of the market or believe Fannie Mae, Freddie Mac, and CRA are necessary supplements to a free market is a clear explanation for what caused this mess in the first place. Let me suggest that the fundamental cause of the crisis is discretionary monetary policy coupled with a hyper-focus on avoiding a recession/depression at all costs.

We are already building one monetary expansion to relieve deflationary pressures from one crisis on top of another. The faulty assumption motivating these actions by the central bank is that the market cannot adjust properly to economic crises. I would suggest that the market is the only way to restore balance to the economy, and government action (uneven as it has been) is the primary culprit here. Further, bailouts and successive monetary expansions will only delay and worsen the inevitable day of reckoning.

In order to determine safety ratio Capital/Assets, I suggest you to read an interesting article by Roy:
Safety First and the Holding of Assets: Econometrica 1952.

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Professor Becker, Judge Posner, and everyone else:

I want to offer a proposal and see what people think.

I’ve been skeptical that the credit crunch is all that serious for quite some time because of Federal Reserve data re. loans to businesses and consumers. And I have been very opposed to the Paulson Plan for this and many other reasons. Now, admittedly, the freeze in interbank lending (et al) might finally be starting to have some significant impact on the non-financial sectors of the economy. Assuming that this is true for the sake of argument, and that the government needs to step in (which I have no problem with in theory being a Liberal Democrat), what about low-interest or interest-free loans to the banks and institutions that didn’t invest in mortgage-backed securities? In other words, if the problem is that there is insufficient credit getting to the “real” economy, the government can use the 700 billion (or some other amount) to extend loans to banks that followed the best practices, and these banks can in turn lend the money to consumers and businesses at more standard rates. It seems to me that this would more directly address the problem of insufficient credit while at the same time avoiding the moral hazard created by bailing out banks and other firms that overextended or made bad bets. To paraphrase what Alex Tabarrok, Professor of Political Economy at George Mason University, said – why not increase lending “traffic” over the good bridges (i.e., banks, the intermediaries between lenders and borrowers) rather than trying to rebuild the bridges that have burned down (the banks with the “toxic assets”)?

Thoughts everyone?

You make some extremely valuable points in this analysis--especially your scepticism about the total magnitude of the taxpayers' losses. Surely not all of the illiquid assets the Treasury takes onto its balance sheet will turn out to be totally worthless, so authority to make $700 billion in purchases does not necessarily imply $700 billion in losses.

The most troubling consequence of the government's intervention is the moral hazard it may create. I wonder if the very ad hoc character of this intervention may not turn out to be our best defense against the expectations that may lead to even riskier behavior. Is it really possible to predict, based upon anything the government has done so far, which firms might be "rescued" in the future? And if the "rescue" involves the total ruin of that firm's equity holders (and, ideally, bondholders as well), is that prospect not a better deterrent than any regulatory scheme we might concoct?