[papabear]

http://www.counterpunch.org/hudson07152008.html
Why the Bail Out of Freddie Mac and Fanny Mae is Bad Economic Policy

By MICHAEL HUDSON

[papabear]

http://www.counterpunch.org/whitney07182008.html
Eulogy for the Ownership Society
Swan Song for Fanny Mae

By MIKE WHITNEY

The Fed's emergency rescue plan for the financial markets is hopelessly flawed. It's a scattershot approach that doesn't address the real source of the problem; an unregulated, unsustainable structured finance system that emerged in full-force after 2000 and spawned a shadow banking system that creates trillions of dollars of credit without sufficient capital reserves. This is the heart of the problem and it needs to be debated openly. The present system doesn't work; it's as simple as that. It makes no sense to provide trillions of dollars of taxpayer money to shore up a system that is essentially dysfunctional. It's just throwing money down a rat-hole.

The Federal Reserve and US Treasury want a blank check to prop up Fannie Mae and Freddie Mac, the two war-horses of the mortgage industry, that currently underwrite nearly 80 per cent of all new mortgages in the US. But by any objective standard both of these GSEs are already insolvent. Thus, the taxpayer is being asked to rescue a failed industry that has been used for private gain so that speculators will not have to suffer the losses. Even worse, Fannie and Freddie have written hundreds of billions of dollars worth of mortgages that have not yet defaulted, but will certainly default within the next two years. This is bound to batter the already faltering economy.

The bad paper held by Fannie and Freddie are mortgages that were made to unqualified applicants who are presently losing their homes in record numbers. Their loans were approved because there was no functioning regulatory body to oversee their issuance and because the mortgages were transformed into complex securities that were sold to credulous investors around the world. The ratings were fixed to meet the requirements of their employers, the investment banks, which marketed these exotic bonds to foreign banks, insurance companies and hedge funds. That puts Fannie and Freddie at the center of a system that needs radical surgery to eradicate the bad paper. If this doesn't happen in a timely fashion, then foreign investors will stop purchasing US debt and the dollar will crash. By creating a backstop for Fannie and Freddie, the Fed is linking US sovereign debt with mortgages and derivatives that are already known to be fraudulent. This is a big mistake. According to Merrill Lynch, the US is already facing a long-term "financing crisis" as the weakening US economy and sluggish consumer spending could signal an end to the $700 billion in foreign investment that covers America's current account deficit. By assuming the GSE's enormous debts, the Bush administration is just speeding this process along and inviting disaster.

Treasury Secretary Henry Paulson has been intentionally oblique about the implications of the proposed bailout. On Tuesday, he delivered a statement in front of the massive stone columns of the Department of the Treasury, a towering monolith that arouses feelings of confidence in rock-solid institutions. He made it clear that Fannie Mae and Freddie Mac would have the "explicit" backing of the US government:

"First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards."

It was an impressive performance from a public relations point of view, but it didn't fool anyone on Wall Street. What Wall Street wants is details not blather. Paulson gave no specifics about how much money the government would provide or what the nature of the new relationship would be; conservatorship, recievorship, nationalization? What is it?

The truth is that Paulson was deliberately vague because he and friend Bernanke would like to have it both ways; they'd like to provide a liquidity backstop and an endless line of credit for the two GSE's without formally nationalizing them. That would avoid the further dilution of stock values while keeping the US government from taking another $5 trillion of mortgage debt onto their balance sheet. It is a delicate balancing act, but Paulson seems to think he carried it off. He's wrong, though, and volatility in the stock market proves it. Investors are clearly skittish about the new arrangement. They want to know the facts about the government's commitment. Paulson is discovering that deceiving investors is not as easy as duping the public about fictional WMD or Niger uranium. Sometimes even the dullest person can grasp the most complex matters when it comes to his own money.

Fannie and Freddie have been insolvent for ages, but it hasn't stopped lawmakers from pushing the envelope and loading more debt on their balance sheets. Here's how Barron's summed it up more than six months ago:

"Fannie's balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A -- often called liar loans because borrowers provide little documentation -- accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love -- and market share -- in some of the wrong places."

Rampant speculation, risky investments, and Enron-type accounting; hardly the stuff of solid portfolios. That's why the two mortgage giants are stumbling headlong towards oblivion despite the Treasury's panicky relief operation. By last Friday Fannie's stock had fallen 47 per cent while Freddie was down 50 per cent. The public may still be in the dark about what is going on, but investors have a pretty good grip on the situation; they can see the great birds are already circling overhead and its just a matter of time before they descend on their prey. Paulson's attempts to muddy the water have amounted to nothing. The fact remains that the two biggest mortgage-lenders in the world are busted and last week's stock sell-off was tantamount to a run on the country's largest bank. Paulson's statement was really nothing more than a eulogy for the mortgage industry; a few heartfelt words over the rigid corpse of a close friend.

When the housing market started to tumble and Wall Street's "securitization" model froze-up, Fannie had to take the lion's share of the mortgages to keep the real estate market hobbling along. In a two year period, between the housing peak in 2005 and 2007, Fannie went from roughly 40 per cent of the market to about 80 per cent. The Congress even enlarged the size of the mortgages they could underwrite from $417,000 to over $700,000. The prospect of bankruptcy never diminished congress's generosity.

Fannie and Freddie currently own or underwrite roughly half of the nation’s $12 trillion mortgage market. Basically, every home mortgage lender depends on them for financing. Their shares are owned by individual investors and banks around the world. Foreign investors have always believed that the GSE bonds were as risk-free as US government Treasuries. Now they are beginning to wonder. (Foreign central banks, led by China and Russia, hold at least $925 billion in U.S. agency debt, including bonds sold by Freddie and Fannie, according to official U.S. statistics)

Whatever happens to Fannie, the loss of investor confidence will send long term interest higher as investors demand bigger returns for the risk they're taking on GSE bonds. That'll put a straitjacket on home sales which are already flagging from soaring inventory and falling prices. Higher rates could bring the whole housing market to a standstill.

The Fed's cheap credit policy under Greenspan created an artificial demand for housing which ballooned into the biggest equity bubble in history. Low interest rates are a subsidy which naturally lead to speculation and asset-inflation. At a certain point, however, the endless debt-pyramiding reaches its apex and the whole mechanism switches into reverse. Now the economy has entered deleveraging-hell where everything is primal blackness and the gnashing of teeth, the flip-side of speculative rapture.

By some estimates, Freddie Mac has a negative net-worth of $17 billion. It's basically insolvent, although Paulson would like to see the charade go on a while longer. Investors purchased another $3 billion of the two GSEs last Monday, but the appetite for failing bonds is diminishing? What's certain is that the collapse of Fannie and Freddie would be a watershed event and a mortal blow to the US financial system. $5 trillion in shaky mortgage-debt can't be easily swept under the rug and ignored. Interest rates on everything would quickly rise; credit would become scarcer, economic growth would shrivel, unemployment would soar, and the dollar will plummet. As the two mortgage giants continue to get whipsawed by higher priced capital and waning investment, US government debt will likely to lose its much-vaunted triple A credit rating. On Friday, credit default swaps on government debt doubled, a sign that investors are losing confidence that the US will be able to manage its twin deficits or pay off its debts. It's the end of the road for Washington's free lunch throng and for a paper dollar that isn't backed by much of anything except music videos, fast food and smart-bombs.

PAULSON'S POWER GRAB

What Paulson is really wants is for congress to allow the Fed to regulate the financial system without congressional oversight. Paulson's so-called blueprint for financial regulation is a blatant power-grab meant to expand the authority of the banking oligarchy giving them unlimited power over the markets. Journalist Barry Grey sums it up like this in his article on "US Bailout of Mortgage Giants: The politics of plutocracy":

"The plan outlined by Treasury Secretary Henry Paulson would give him virtually unlimited and unilateral authority to pump tens of billions of dollars of public funds into the mortgage finance companies. At the same time, the Federal Reserve Board announced that it would allow the companies to directly borrow Fed funds... The Democrats...now march in lockstep with the minority party to rush through laws demanded by Wall Street... The buying of legislators and their votes by corporate interests is carried out openly and shamelessly. Members of Frank’s House Financial Services Committee received over $18 million from financial services, insurance and real estate firms this year. Frank himself raised over $1.2 million, almost half of which came from finance and related industries...Senator Dodd’s top contributor in the 2003-2008 election cycle was Citigroup, followed by SAC Capital Partners. He raised $4.25 million from securities and investment firms.
Senator Schumer’s top contributor was likewise Citigroup. He raised $1.4 million from securities and investment firms, his most lucrative corporate sector."

The smell of political corruption is overpowering, and yet, the plan is moving forward regardless. Even if Paulson's plan worked in the short term, the damage would be enormous. It would place the country's regulatory powers and purse-strings in the hands of the same amoral banksters who created this mess to begin with. It is the fast-track to corporate feudalism on a nationwide scale.

PITFALLS FOR THE GSEs

The biggest problem facing Fannie and Freddie is that wary investors will not roll over the debt of the two companies which will precipitate a collapse. This is where it pays to have people who can be trusted in positions of power. Henry Paulson is the worst thing that ever happened to the US Treasury. Paulson is to finance capitalism what Rumsfeld is to military strategy. To say that Paulson is lacking in credibility is an understatement. Nothing he says can be taken at face-value. When Paulson says "the worst is behind us" or the "subprime crisis is contained" or the Bush administration "supports a strong dollar policy"; most people know it is a fabrication. Besides, Paulson is completely out of his depth in the present crisis. His appearances on TV, with the beads of sweat glistening on his forehead, and his foolish repetition of the same stale mantra is eroding confidence in the financial system and sending waves of panic rippling through Wall Street. Enough is enough. He needs to go.

If the administration was serious about changing direction they would dump Paulson and reinstate Paul Volcker. Whatever one thinks about Volcker, his presence would calm the markets and send a message that the adults were back in charge. But that won't happen. The Bush team still thinks they can finesse their way through the thicket of investor skepticism. That means that catastrophe is inevitable as more and more investors pick up their bets and head for the exits.

TIME IS RUNNING OUT

Whatever the administration decides to do; time is short and they have one chance to get it right. The Treasury needs to find a way to ring-fence the garbage bonds and pray that the investing public won't dump their holdings in a panic run on the market. Either way, it's a gamble and there's no guarantee of success. The Wall Street Journal outlined the doomsday scenario if Paulson's plan fails:

"Falling house prices and nonpaying homeowners cause the value of the trillions of dollars in outstanding debt held by these government-sponsored enterprises (Fannie and Freddie) to plunge. Many banks have balance sheets stuffed full of this paper. They face huge losses, which some can't survive. They and other investors, such as foreign central banks, then dump the GSE paper.

Fannie and Freddie would end up unable to lend, or at least to take up anything like their current 80% share of the U.S. mortgage market, further punishing the reeling housing market. This would add another twist to the spiral of falling prices, credit losses and failing lenders.

What should they do? First, devise a plan -- and fast. There is no time to dither." (Wall Street Journal)

If foreign banks and investors ditch their GSE debt; it will send shockwaves through the global economy. But if the Treasury provides unlimited funding for a sinking operation, it's likely to trigger a sell-off of the dollar. It's a lose-lose situation. For now, bond holders are sitting-tight even though the stock is tanking, but for how long? They've already been taken to the cleaners on hundreds of billions of dollars of mortgage-backed garbage; now there are rumors that the US government won't back agency debt. What kind of shabby shell-game is the US playing anyway?

New York Times:

“If people lose faith in Fannie and Freddie, then the whole system freezes up, and nobody can buy a house, and the entire housing market can crash,” said Paul Miller of the Friedman, Billings, Ramsey Group in Arlington, Va. “There’s a fine line between having faith and losing it, and sometimes it’s unclear when it has disappeared. But when investors cross that line, bad things happen very quickly.”

And it affects more than the housing market, too. The bond and equities markets are handcuffed to real estate and they're already listing from the slowdown in investment. The Fed thought they could keep the whole mess from going sideways by opening up "auction facilities" where the banks could get low interest capital in exchange for their mortgage-backed junk. But the banks have curtailed their lending and there's bigger trouble ahead. Bridgewater Associates issued a warning last week that losses to the banking system would exceed $1.6 trillion, four times original estimates and enough to crash the entire banking system. So far, banks have only written down $450 billion, which means that they are only 25 per cent of the way through the current credit storm. Defaults are liable to skyrocket as hundreds of undercapitalized banks turn to a grossly underfunded FDIC ($52 billion in reserves) to cover the losses of their depositors. The prospect of a humongous taxpayer bailout seems nearly unavoidable.

What's most disturbing is that nothing has been done to restore the markets to a functional model. The Fed's strategy is still to try to keep the relatively new "structured finance" model (with all it's bizarre-named debt instruments and derivatives) in place even though it failed its first stress-test and has demonstrated that it cannot withstand even moderate downward movement in the market. The current model is kaput; there needs to be a Plan B or the Fed is just wasting its time.

Fannie's demise comes at a particularly difficult time for the banking system. According to a report by Paul Kasriel, Chief Economist at Northern Trust:

"The sharpest 13-week contraction in bank credit” since data were first available in 1973. Banks simply don’t have the capital on hand to avail “themselves of the cheap credit the Fed is offering to fund them at.”....This is what it means to be in a “credit crunch.” Banks have suffered hundreds of billions in losses, forcing them to pull credit out of the economy. Every time you read an article about banks cutting credit lines, exiting lending businesses, or eliminating mortgage products it represents more bank credit drying up." (Option Armageddon, "Understanding Bernanke")

Bank credit is drying up because the capital is being destroyed (from foreclosures and downgraded assets) faster than anytime in history. We are just now feeling the first stiff breezes from a Force-5 deflationary hurricane set to touch down in 2009. Fannie and Freddie are teetering towards insolvency while the country is entering the most vicious downward cycle since the Great Depression. Higher interest rates, negative home equity, mounting credit card debt, auto loan debt, commercial real estate debt and tightening lending standards will only curtail consumer spending more putting greater pressure on the dollar.

The Fed will have to be selective; not everything can be saved. Significant parts of the financial system will be reduced to ashes. It would be wiser to clear the brush away from as many of the solvent institutions as possible and prepare for the worst. Otherwise, the whole system is at risk of contagion. Hundreds of local and regional banks are expected to go under. (the average small bank has 67% of its assets in real estate) It can't be avoided. They are holding too much bad paper and no way to make up for the losses. They're following the same path as the 250 mortgage lenders that vaporised in the subprime meltdown. They couldn't be saved either.

The bigger investment banks are in trouble too. That's why the SEC has finally decided to act as a regulator and go after short-sellers:

"The Securities and Exchange Commission announced an emergency action aimed at reducing short-selling aimed at Wall Street brokerage firms, Fannie Mae and Freddie Mac, and will immediately begin considering new rules to extend new requirements to the rest of the market."

The SEC never took an interest in naked shorting of stocks (or commodities speculators) while its fat-cat friends in the big brokerage houses were raking in billions. Now that many of these same institutions, including Fannie Mae and Freddie Mac, are in the crosshairs, SEC chief Christopher Cox is rushing to their rescue. It is utter duplicity, but it illustrates an important point; the system is cannibalizing itself just like Karl Marx predicted over 100 years ago. Unchecked greed is inevitably self-destructive.

A growing number of market analysts are beginning to notice the storm clouds forming on the horizon. The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months. The Bank of international Settlements (BIS) made a similarly ominous warning that the credit crisis could lead world economies into a crash on a scale not seen since the 1930s. The bank suggests that government officials and market analysts have not fully grasped the financial turmoil that could result from the mortgage crisis and its effects of the global economic system. The body points out that the Great Depression was not anticipated because people ignored the implicit danger of "complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system."

Ron Paul (R-Texas) is one of the few members of congress who has shown that he has a grasp of the impending economic disaster now facing the country if corrective action is not taken swiftly. In a speech he gave last week on the floor of the House, he said:

"There are reasons to believe this coming crisis is different and bigger than the world has ever experienced...The financial crisis, still in its early stages, is apparent to everyone: gasoline prices over $4 a gallon; skyrocketing education and medical-care costs; the collapse of the housing bubble; the bursting of the NASDAQ bubble; stock markets plunging; unemployment rising;, massive underemployment; excessive government debt; and unmanageable personal debt. Little doubt exists as to whether we’ll get stagflation. The question that will soon be asked is: When will the stagflation become an inflationary depression? "

The troubles at Fannie and Freddie are symptomatic of more deeply rooted problems related to abusive lending and the unsustainable expansion of credit. We've now reached our debt limit and the bills must be repaid or written off. The Bush administration is hoping to reflate the bubble by (stealthily) recapitalizing the GSEs, but it won't be easy. As one blogger put it, we have reached "peak credit" and have nowhere to go except down.

Economist Michael Hudson summed it up like this:

"The reality is that Fannie, Freddie and the FHA gave a patina of confidence to irresponsible lending and outright fraud. This confidence game led them to guarantee some $5.3 trillion of mortgages, and to keep $1.6 trillion more on their own books to back the bonds they issued to institutional investors."

It was a scam of Biblical proportions and now it is all starting to unravel. Bush's "ownership society" was a cheap parlor trick engineered by the Fed's low interest rates to trigger massive speculation and shift wealth from one class to another. Now, the housing bubble has crashed and the excruciating reality of insolvency is beginning to sink in.

Michael Hudson, again:

"All one hears is a barrage of claims that the government must preserve the financial fictions of Fanny Mae and Freddie Mac in order to 'save the market.' The usual hypocrisy is being brought to bear claiming that all this is necessary to 'save the middle class,' even as what is being saved are its debts, not its assets...The “way of life” that is being saved is not that of home ownership, but debt peonage to support the concentration of wealth at the top of the economic pyramid.

Mortgages are the major debts of most American families. In this role, real estate debt has become the basis for the commercial banking system, and hence the basis for the wealthiest 10 percent of the population who hold the bottom 90 percent in debt. That is what Fannie Mae, Freddie Mac and “the market” are all about." (Michael Hudson; "Why the Bail Out of Fannie Mae and Freddie Mac is Bad Economic Policy", counterpunch.org)

The housing boom never had anything to do with Bush's Utopian-sounding "ownership society". It was always just a swindle to enrich the banking establishment and divert middle class wealth to ruling class elites.

[papabear]

http://www.atimes.com/atimes/Global_Economy/JG22Dj01.html
In short, crisis reaches
bedrock level
The jump in benchmark yields on Fannie Mae mortgage-backed securities last week and the tightening of US rules on shorting large financial stocks are not unrelated. With the mortgage crisis reaching the bedrock of the mortgage credit system, any meaningful tightening in conventional mortgage credit would exacerbate already escalating problems.
Doug Noland looks at the previous week's events each Monday.

[papabear]

http://www.atimes.com/atimes/Global_Economy/JG22Dj06.html

Debt capitalism self-destructs
By Henry C K Liu

In a period of less than a year, what had been described by US authorities as a temporary financial problem related to the bursting the housing bubble has turned into a fully fledged crisis at the very core of free-market capitalism.

A handful of analysts have been warning for years that the wholesale deregulation of financial markets and the wrong-headed privatization of the public sector during the past two decades would threaten the viability of free-market capitalism. Yet ideological neoliberal fixation remain firmly imbedded in US ruling circles, fertilized by irresistible campaign contributions from profiteers on Wall Street, methodically purging regulatory agencies of all who tried to maintain a sense of financial reality.

This ideology of "market knows best" has allowed the nation to slip into an unsustainable joyride on massive debt giddily assumed by all market participants, ranging from supposedly conservative banks, investment banks and other non-bank financial institutions, to industrial corporations, government sponsored enterprises (GSEs) and individuals.

The once-dynamic US economy has turned itself into a system in which it is difficult to find any institution, company or individual not over their head in speculative debt. Undercapitalized capitalism, also known as debt capitalism, has been the engine of growth for the US debt bubble in the last two decades. This debt capitalism cancer is caused by a failure of central banking.

In the face of a broad systemic collapse of debt capitalism, where capital has become dangerously inadequate and new capital hazardously and prohibitively scarce, having been crowded out by massive debt collateralized by overblown assets of declining value and with a credit crisis that clearly requires systemic restructuring and comprehensive intensive care, those in the US responsible for the financial well-being of the nation seem to have been reacting tactically from crisis to crisis with a script of adamant denial of obvious facts, symptoms and trends, with no signs of any coherent grand strategy or plan to save the cancerous system from structural self-destruction.

This band-aid short-term approach to artificially pop up share prices in the collapsing equity market and to maintain insolvent financial institutions with technical life-support will lead only to long-term disaster for the whole economy.

Yet this approach is preferred by those in authority, trapped in self deception about unregulated market capitalism being still fundamentally sound. They try to calm markets by asserting that the current turmoil is merely a minor liquidity bottleneck that can be handled by the central bank releasing more liquidity against the full face value of collaterals of declining worth.

The message is that somehow, if easy money in the form of debt is made endlessly available, the economy will recover from this credit crunch, notwithstanding that excessive debt has been the cause of the problem; or bad loans can be made good by Congress giving the US Treasury authority to buy up bad loans with unlimited amounts of taxpayer money.

Yet these incremental measures taken so far by the Treasury and the Federal Reserve make the two government units with direct responsibility on the nation's long-term financial health look like panicky rogue traders trading for the national account in desperate hope to score a win in the next quarter by upping the ante, to contain allegedly isolated crisis hot points. The aggregate effect adds up to a broad stealth nationalization of the insolvent financial sector. Their prescription for stabilizing a debt-destabilized market is more public debt to support corporation socialism.

For years, anyone warning that the government sponsored enterprises (GSEs), namely Fannie Mae and Freddie Mac, should be held to normal capitalization requirements was ridiculed as a fear monger by the powerful lobbying machines these GSEs employed. Capital is considered as superfluous in the new game of debt capitalism held up by complex circular hedging. As a result, the GSEs have become the monstrous tail that wags the dog of housing finance.

The current talk about the need to curb speculation in the commodities and financial markets to stabilize prices is off target, especially for believers of market capitalism. All market transactions are speculative in nature. Speculation can stabilize prices as well as to destabilize them, but only in the short term. Long-term price levels (inflation or deflation), as Milton Friedman aptly observed, are always monetary phenomena. The current turmoil in the financial system, the subprime mortgage implosion, the credit crisis from the seizure in the asset-backed commercial papers market, the undercapitalization of commercial and investment bank, the rating agency dysfunction, the insolvency of monocline (bond) insurers, the massive financial losses by the GSEs and a host of other financial problems percolating under the media radar, are the outcome, and not the cause, of this market turbulence. (See Perils of the debt-propelled economy, Asia Times Online, September 14, 2002.)

Fanny Mae and Freddy Mac, GSEs that have provided mortgage funds for the housing market since 1938, were created as part of the New Deal to help low-income families. They were privatized in 1968 on terms that would alter their social mandate and would inevitably lead them into financial trouble on a big scale. Finally but suddenly, these GSEs find themselves in danger of defaulting on their massive debts, upwards of US$5 trillion, in the course of a single week.

Deeply rooted in US political culture is the view that credit is a financial public utility, much like air and water, and should be equally accessible to all, not just to the rich. Economic democracy has been the core strength of US political democracy. Government loan guarantees for students and home mortgages for low- and moderate-income groups and loans to small business are based on this principle. Yet from time to time, this principle of economic democracy is overshadowed by free-market extremism to push the nation's economy into extended depressions.

The US National Housing Act was enacted on June 27, 1934, as one of several economic recovery measures of the New Deal to get the nation out of the Great Depression. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home-mortgage loans made by private lenders, taking the disaggregated risk in lending to low-income borrowers off private lenders and managing the risk on a national scale with a government agency to take advantage of the law of large numbers, a theorem in probability that describes the long-term stability of a random variable. Title III of the Act provided for the chartering of national mortgage associations by the FHA administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages insured by the FHA under Title II.

Only one association was ever formed under this authority. On February 10, 1938, this association, the National Mortgage Association of Washington, became a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III of the US National Housing Act became a statutory charter for Fannie Mae.

Click on the link to read the rest.

[papabear]

http://www.atimes.com/atimes/Global_Economy/JG23Dj05.html
The death-knell of Bernankeism
The most recent US price data show inflation securely in the 1970s framework. That means it is no longer possible to inflate the money supply by pretending that inflation in the real economy is not a problem. Other means will have to be found to perpetuate the shell-game. - Martin Hutchinson

[papabear]

http://www.counterpunch.org/whitney07232008.html
Mike Whitney, Visualizing Dow 6000

[papabear]

http://globaleconomicanalysis.blogspot.com...sound-when.html
You Know The Banking System Is Unsound When.....

[papabear]

http://www.atimes.com/atimes/Global_Economy/JG25Dj02.html
Bernanke blighted
by tunnel vision
US Federal Reserve chairman Ben Bernanke in his recent testimony to Congress masked a faulty money policy which, if continued, will lead to even deeper economic decay, worsening inflation and financial disorder. - Hossein Askari and Noureddine Krichene

http://www.atimes.com/atimes/Global_Economy/JG25Dj01.html
No bottom for flailing financials
The sell-off of US financial stocks may tempt investors to seek out bargains. That raises the questions of whether the government will be able to underwrite the entire financial industry and what impact its interventions will have on inflation. - John Browne

[papabear]

http://www.counterpunch.org/morici08052008.html
Rear View Mirror Economics

By PETER MORICI

[papabear]

http://www.atimes.com/atimes/Global_Economy/JH06Dj01.html

THE BEAR'S LAIR
The collapse of consumer spending
By Martin Hutchinson

The gross domestic product and employment figures released last Thursday and Friday appeared at first sight to show a US economy that had returned to a measure of stability. However, when examined more closely, they painted a much darker picture, of an economy in which a sharp decline in retail spending is likely to cause substantial overall economic contraction over the next several quarters.

Second quarter gross domestic product (GDP), announced on Thursday, came in at 1.9% growth, which at first sight is an un-alarming number. However, it is questionable both what quarterly GDP measures and whether it measures it accurately. In 2006-08, according to this month's figures, three quarters of sub-par



growth averaging 0.8% (recessionary, given 1% US population growth) were followed by two quarters of enthusiastic 4.8% growth, which have now been followed by another three quarters of growth averaging 0.8%. During the two quarters of enthusiastic expansion in mid-2007, the largest credit crisis in decades exploded. Certainly, nobody noticed this expansion at the time.

The reality is that the current expansion in GDP is caused almost entirely by the inexorable expansion of government and a modest rebound of exports, led by the weak dollar, from their previous abysmally low levels. Real federal government consumption rose 6.7% during the quarter and real exports rose 9.2%. Meanwhile, personal consumption rose only 1.5% in real terms, even though real personal income rose over 4%, all of which was accounted for by the US$150 billion tax rebates, the great bulk of which arrived during the quarter.

The unemployment figure announced on Friday was equally pregnant with meaning. The market welcomed it, as the job total declined only 51,000, but the real situation was demonstrated by the unemployment rate, which rose to 5.7%. While a job loss rate of 50,000-70,000 per month is not extreme, the fact remains that this is the seventh successive month of such declines, during which the employment total has risen by over 500,000, in a country where because of population growth around 150,000 jobs should be created each month to keep the employment percentage stable.

Not every factor in the US economy is negative. House prices nationwide are probably now nearer their bottom than their peak, helped by the huge amounts of money the Fed has pumped into the system. The Case-Shiller house price index announced last week was treated by the market as yet another negative, but in fact the monthly rate of decline lessened, suggesting that the "second derivative" of house prices had turned positive. With prices already down over 20% nationwide, it seems reasonable to assume that we are more than halfway to the bottom - a total drop of 40% would not be consistent with gradually rising nominal incomes and continued low interest rates.

Of course, once interest rates are raised to a more reasonable level, say 2-3% above the current inflation rate of about 7%, house prices will undergo a further decline, but that will be cushioned by the inflation itself. Nevertheless, the drag on the economy that housing has formed will lessen over the next year, if only because housing has become a smaller share of output.

The more difficult assessment is how much construction redundancy has still to be shaken out. Most of the larger homebuilding companies accumulated so much fat in the good years that they are not yet in true financial difficulty. Furthermore, the commercial building sector was strong until the end of last year and so has as yet lost relatively few jobs. Hence, while 550,000 jobs have been lost in the construction sector since the peak, we are likely still to be closer to the top than the bottom in terms of job losses, with multiple major bankruptcies of construction companies and massive redundancies still to come.

Exports also will probably continue to be a positive factor in economic growth, at least while interest rates remain low and the dollar weak. However, US exports tend not to be very labor-intensive, so expansion in the export sector does not produce much additional employment, at least relative to the decline in construction employment. Moreover, the collapse of the Doha round of trade talks suggests that the world is swinging towards protectionism, so that the growth in trade as a percentage of world GDP that we have seen in the last several decades will at least temporarily halt or even reverse.

Thus, while higher global interest rates and slower growth in the US and worldwide are likely to continue narrowing the US payments deficit, it is not at all clear that they will do so by increasing US exports rather than by reducing imports. The export sector cannot therefore be relied upon for much in the way of additional employment.

While the effect of the housing recession may in some respects lessen in the months ahead, difficulties in the automobile industry seem likely to become more severe. General Motors’ second-quarter loss, reported on Friday, of $11 per share is truly alarming for a company whose share price is currently only $10. Ford and Chrysler are in similar difficulties; it would seem that none of the US "Big Three" have sufficient resources to survive a recession lasting beyond the end of 2009. Should the US-owned automobile industry declare bankruptcy, it would doubtless be bailed out by the US taxpayer like everything else, but the effect on business confidence would be severe. In any case, the redundancies caused by even a partial closure of US automobile manufacturing facilities would themselves add very substantially to unemployment, with older workers being particularly badly affected.

There thus remain two vortices sucking the US economy into a pit of depression: employment and retail spending. While output rises so sluggishly and all sectors involved with real estate continue to shed jobs at a rapid rate, it seems unlikely that the US can create significant jobs overall. Hence whether or not there is an official "recession" by the eccentric GDP figures, unemployment will continue to rise.

Since the peak unemployment rate was 6.3% in the 2001-02 recession, it is almost certain that the unemployment rate this time will rise beyond that level (unemployment is, after all, a lagging indicator of economic activity). The peak in 1990-92 was 7.8%; a rise beyond that level is by no means out of the question, although the peak unemployment rate in the 1980-82 recession of 10.8% will probably remain unchallenged unless the US-owned automobile industry is allowed to disappear altogether. Nevertheless even a rise in the unemployment rate to 8%, historically a fairly mildly recessionary level, will cause a huge amount of heartburn among a US working population that has seen nothing like it in more than a generation.

Even more of a downdraft will be provided by retail sales. These have been weak even in a period when they have been subsidized by Uncle Sam. Uncle Sam's wallet is now empty (or, more properly, his banks have taken to making incessant whining phonecalls during mealtimes). Hence retail sales will be exposed to the full force of the current economic situation, which for them is dire indeed.

# First, the decline in house prices and the tightening in lending standards have eliminated for homeowners the possibility of a mortgage refinancing that can be spent on goodies. The decline in home sales has also removed the desire for monstrous and unnecessary home improvement projects, to the great detriment of Home Depot and the like.
# Second, the decline in home values and stock market prices, and the lousy stock market returns obtained since 2000 are beginning to demonstrate to the baby boomers that they are grossly ill-prepared for retirement. This has been true for a decade or more, but the specter of old age is looming ever closer as the largest bulge cohorts near 60. All across America, aging baby boomers are resolving to lead lives of austerity and saving, hopefully with more chance of success than their diet resolutions.
# Third, to the extent redundancies occur in declining industries such as automobile manufacturing, they will be concentrated in the older cohort of workers, who are much less prepared for them than were their depression-reared parents a generation ago. The revival of export industries may offset this to some extent for those blue-collar baby boomers who have managed to hang on to jobs in the right manufacturing exporters.
# Fourth, since returns on saving are so poor, the amounts that must be saved in order to meet retirement or other goals will be substantially greater than expected. Again, this will hit retail sales.

# Finally, much of the retail sales ebullience of recent years derived from the top 1% of income-earners, whose share of national income rose enormously during the loose-money period since 1994. Since these people were earning far more than they had ever expected, and saw no reason why their earnings should ever decline, they saved very little, preferring instead to devote their resources to overpriced homes, expensive toys and bling.

It now seems almost certain that their income share will revert over the next few years to around its 1994 level, little more than half its level in 2006. Over the last year, they have covered their "needs" by increasing debt; over the years ahead their resources will of necessity be devoted to debt repayment and saving, causing an icy winter in the luxury goods sectors of the economy.
The gradual increase in unemployment and decrease in real estate and equity values will be important drags on the economy even while interest rates remain at their current low levels. Needless to say, the resurgence in inflation to which negative real interest rates are already leading will eventually force interest rates to be raised, as I discussed two weeks ago. When that happens, the unemployment effect will be significant, as over-borrowed private equity-controlled companies will find themselves unable to survive.

Conversely, the retail sales effect may be somewhat mitigated, as consumers find they can meet their savings goals more easily in an environment where they are at last granted a positive real return on the amounts they save. Stock market and real estate investments may still disappoint, but at least bank deposits and short term investments will provide a real return much higher than has been customary, restoring some equilibrium to the financial positions of the US public.

While the market is already aware of the gradual increase in unemployment, it has not yet taken into account the effect of the recession on retail sales. Hence we can expect sharp reactions as the full extent of the retail downturn is revealed. Retail sales figures, not GDP, interest rates or employment, are now the economic numbers to watch.

[dave4418]

I'm just wondering. Why are you posting this in Soompi? I don't think anyone's gonna read it let alone understand it.

[siliconrex]

It makes for an interesting read on monetary trends. Other than that, it's probably the longest single poster streak ever.

[sakura_dubai]

I'm just wondering. Why are you posting this in Soompi? I don't think anyone's gonna read it let alone understand it.

well, there are some who read it.. and understand it..
see i'm a business student and i don't like this topics at school.. but still i have to educate myself and update myself because these are things that affects our daily life..
do you know how much problems the dropping of the dollars early this year has caused to many countries.. it's really important to know something about it.. since it affects our life..

think of pricing.. when the oil prices have increased, food prices have increased in my country.. the land prices have been a hill.. everything can change because of one or two factors..

[papabear]

http://www.atimes.com/atimes/Global_Economy/JH19Dj08.html
Aug 19, 2008


The US economy is in a funk
By Peter Morici

Troubles at United States banks are making mortgage, credit card and business loans scarcer and more expensive. Falling home prices, rising foreclosures and high gas prices have stalled home building and consumer spending. These problems are exacerbated by the long-festering trade deficits on oil and with Asia on consumer goods and cars that tap off demand for US-made goods and services.

How the George W Bush administration (and its successor) and the US Congress respond to these challenges will importantly determine how Americans emerge from the current malaise. With the right policies, the economy can grow at 3.5% to 4% a year, perhaps a bit more. Without meaningful reforms in banking and changes in energy and trade policies, the United States is headed for substandard growth and a declining standard of living for many workers.

Since 2005, US imports have exceeded exports by more than US$700 billion or more than 5% of gross domestic product (GDP). To finance the trade gap, Americans sell bonds and other securities to foreigners, including the People's Bank of China and other central banks.

Until recently, money center banks and securities dealers, such as Citigroup and Merrill Lynch, recycled foreign funds to US consumers. Consumers borrowed ever-larger sums to live beyond their means through exotic mortgages, questionable auto loans and lax credit-card rules.

In the housing market, mortgage companies were aided by real-estate appraisers, who juiced estimated home values, and Wall Street bankers, who transformed shaky loans into seemingly low-risk mortgage-backed bonds for sale to insurance companies, pension funds and foreign investors. The bond rating agencies turned a blind eye and blessed these transactions.

These schemes now exposed, banks can't securitize mortgages into bonds and must finance mortgages through more expensive certificates of deposit. US homebuyers must put up larger down payments and pay higher interest rates and fees to get loans.

The result is predictable: housing prices are falling. Builders have a 10-month supply of unsold new homes, and new home construction is down more than 55% since April 2006.

Rising delinquencies and repossessions are making similar abuses apparent in credit card and auto loans. Lenders face difficulties selling bonds to finance new loans and are increasing monthly interest rates and tightening qualifications.

Consumers can't run up debt as easily to boost spending and live beyond their means. Sales are falling at shopping malls and restaurants, and consumer demand for US-made goods is stagnating.

Similarly, banks are making fewer loans to businesses for worthwhile projects, and business spending on commercial buildings and new equipment and software is expected to stall in the second half of 2008 and 2009.

Thanks to this grand deleveraging, economic growth has averaged only 1% a year since the fourth quarter of 2007 and is expected to continue to limp along at that pace until the second half of 2009. It will take that long for the banks to clear out all their bad loans, for most of the expected 2 million-plus foreclosures and resales of homes to be completed, and households, generally, to restore their balance sheets through more conservative spending patterns.
Getting the economy going again will require getting the banks on a sound footing, so that mortgage money and other credit are available on reasonable terms. But if the United States is to grow at a decent, sustainable pace and avoid another credit crisis and deleveraging, it must reduce its trade deficit and reliance on foreign borrowing.

Simply, trade deficits of more than 5% of GDP require Americans to spend more than 105% of what they earn to maintain demand for domestically produced goods and services and sustain GDP growth and employment. Even if foreigners are willing to continue buying US bonds, financing American consumption at that level will require the banks and finance companies to write progressively more risky loans, as they did during the last economic expansion, until debts cannot be repaid.

Inevitably, that would end in another banking crisis and credit shortage, painful deleveraging, and period of slow growth similar to the current slog, or worse.

To accomplish healthy growth, the United States must slash its trade deficit, dramatically, over the next several years. Imported oil, cars from Japan and South Korea, and consumer goods from China account for nearly the entire US trade deficit. No permanent solution to the US quagmire is possible with addressing those issues.

Global oil supply has not kept up with demand in recent years, because several important exporters, including Venezuela, Russia, Nigeria and Mexico, have shunned the investment and know-how Western oil companies can offer to sustain their production.

In recent weeks, crude oil prices have receded, somewhat, but this is because the US, European and Japanese economies are slowing and speculators face more hurdles in financing positions, and not because the basic global supply imbalance has been redressed.

Higher oil prices may be here to stay, but the technologies to reduce US oil imports dramatically are at hand. Hybrids, plug-in electric and even hydrogen-powered vehicles are no longer fanciful proposals. Coal gasification is viable at $55 a barrel for oil, and more-efficient building designs, appliances and heating systems are all possible at affordable costs.

Economists assert that the market will provide, but they fail to reckon with the fact that most epic transformations in transportation technology - canals, turnpikes and national highways, railroads and airplanes - got boosts from the government to overcome the barriers created by habits and costs of switching. For example, the biggest problem getting into production and use of hydrogen cars will be the initial investment in fueling stations and quickly achieving a critical mass of vehicles on the road to sustain them.

Japan, Korea, India and China have promoted their domestic vehicle industry by limiting imports and exploiting the open US market, and now Japan, the most mature producer, boasts Toyota and Honda as the leaders in hybrids and greener vehicles.

The US should not turn to protectionism, but rather, it should use its large market to its advantage. It should require much higher mileage standards for automobiles and offer substantial product development assistance to US-based automakers and suppliers - that includes Toyota and Honda, as well as the Detroit Three, battery makers and other suppliers - to accelerate the build-out of high-mileage innovative cars.

The condition for assistance would be that beneficiaries do their research and development and first large production runs in the US, and share their patents at reasonable cost with one another. The huge US market would attract producers from around the world and rejuvenate the US auto supply chain.

Similarly, accelerating clean coal gasification, nuclear power and the hydrogen transformation, as well as mandating much more efficient buildings and home heating systems and appliances, would propagate exciting new technologies Americans could sell around the world.

Since January 2007, the dollar has fallen 12% against the euro, and a burst of commodity and manufactured exports have helped reduce the US non-oil trade deficit. However, as the dollar has weakened against the euro, China has stepped up its intervention in currency markets to keep its yuan inexpensive and exports growing. Factoring in higher oil prices too, the overall trade deficit is down only about $20 billion.

Although China has permitted the yuan to fall by 17% since July 2005, it has increased purchases of dollars with yuan to $640 billion annually in 2008, up from $462 billion in 2007. This provides a subsidy on exports and domestic import competing products equal to about 17% of China’s GDP, and pressures other Asian nations to pursue similar currency policies lest their industries lose competitiveness to Chinese manufacturers in vital US and European markets.

Moreover, by artificially accelerating Asian growth, this policy boosts Asian oil consumption and provides the hard currency to subsidize oil imports and domestic fuel prices, further exacerbating international oil shortages.

Cutting the US trade deficit with China and other Asian exporters requires that Washington find a way to persuade Beijing and other governments to end their currency market intervention.

Negotiations have not worked. The United States may have to resort to a tax on yuan-dollar transactions at a rate directly proportional to Chinese currency intervention to reduce imports in the near term. This would encourage China to stop intervening in currency markets and redirect investment toward more domestic consumption and investment in schools, hospitals and public infrastructure. Then the tax could be removed.

That may sound radical but redressing the trade deficit with China and other Asian exporters would also require major changes in American habits too.

As China and other foreign governments ended their purchases of dollars, US Treasury securities and private bonds, Americans would have to borrow less, save more and start living on what they earn. The US government would have to cut its budget deficit to near zero, and American households would have to save 5% to 10% of their disposable income, as opposed to the near zero levels accomplished during the recent economic expansion.

Getting through the current crisis requires unusual steps in credit markets. Federal efforts to route capable but currently distressed homeowners into sustainable mortgages and Federal Reserve to help the money center banks and securities firms will help avoid economic Armageddon. The same is true of Federal efforts to assist mortgage guarantors Fannie Mae and Freddie Mac.

However, achieving a sustainable economic expansion requires strong new disciplines, from loan officers on the ground to the executive suites at those New York banks. So far, federal credit market reforms have been focused on mortgage brokers and small lenders, rather than the business models pursued by the large money-center banks and securities dealers that bundle mortgages, credit-card debt and auto loans into bonds. These firms are largely locked out of the fixed-income market for the purposes of securitizing mortgages, owing to the absence of transparency in past practices and the dearth of meaning management reforms.

The Federal Reserve should start conditioning its discount window lending to large money-center banks and securities firms to meaningful reforms in securitization and management practices, or US credit markets will take several years to rebuild.

Regional banks or other financial institutions could emerge as major bundlers of mortgages and consumer and business loans for sale to insurance companies, pension funds and foreign investors, but that would take many months to effect too.

Either way, adequate credit to both home construction and business investment will not be available before 2010. Until then, growth will be slow, and closer to 1% than 3% per year.

At that point, if positive steps have been taken to encourage substantial new investments in alternative energy sources, conservation and transportation, and to substantially cut the trade deficit with China and other Asian exporters, the US economy could grow at 3.5% to 4% for quite a long time.

Otherwise the US economy will grow in spurts above 3%, punctuated by banking crises and periods of deleveraging. In some years, growth would exceed this rate, and for others, it would be less than 1%. Overall, the pattern will be in the range of about 2% a year or less.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the US International Trade Commission.

[bluelily]

These articles are hard to bare. In all aspects of the world, people are refusing to look at the daily signs. Taking it one day at a time is all I can do. Thanks for the post, papabear.

[papabear]

An Interview with Economist Michael Hudson
The Worsening Debt Crisis: Who Got Us into This Mess and What are the Real Political Options?

By MIKE WHITNEY

[papabear]

Numbers racket:
Why the economy is worse than we know

By Kevin P. Phillips

[papabear]

http://news.yahoo.com/s/ap/20080915/ap_on_...jp63zjeDFSs0NUE
Banks roll out $70 billion loan program

By JOE BEL BRUNO, AP Business Writer Sun Sep 14, 10:31 PM ET

NEW YORK - A group of global banks and securities firms announced late Sunday a $70 billion loan program that financial companies can tap to help ease a credit shortage that threatens global financial markets.

The ten banks, which include JPMorgan Chase & Co. and Goldman Sachs Group Inc., said they were committing $7 billion each for the pool. The pool would act as a signal to the marketplace that banks, brokerages, and other financial companies can lean on the fund to take care of borrowing needs.

The banks said the program will be available to participating banks which can get a cash infusion up to a maximum of one-third of the total size of the pool. The size of the loan program might increase as "other banks are permitted to join."

All participating banks intend to use this facility beginning this week, the statement said.

The banks also include Bank of America Corp., Barclays PLC, Citigroup Inc., Credit Suisse Group, Deutsche Bank AG, Merrill Lynch & Co., Morgan Stanley and UBS.

The banks made the announcement to try to head off market disruptions after the possible failure of investment bank Lehman Brothers Holdings Inc. Lehman was expected to file for bankruptcy by Monday after succumbing to dwindling investor confidence due to losses from its real estate holdings.

[papabear]

http://news.yahoo.com/s/ap/20080912/ap_on_...LJfAoIqQ.iyBhIF

Japan reports economy shrank 3 percent April-June

By YURI KAGEYAMA, AP Business Writer Thu Sep 11, 10:09 PM ET

TOKYO - Japan's economy shrank at a 3 percent annual rate in the April-June quarter, the government said Friday in a lowered revision of an already pessimistic reading for the world's second biggest economy.

Fears about a global downturn have been growing amid soaring prices of gas, steel, food and other goods. Signs of a slowdown in the U.S., Japan's major trading partner, have added to the worries.

Tatsushi Shikano, senior economist at Mitsubishi UFJ Securities Co. in Tokyo, said the pessimistic revision had been expected, given recent indicators that show declines in corporate investments, exports and consumer spending.

"Our view of a weak economy was once again confirmed," he said.

The economy was expected to stay sluggish for the next few months, staying flat at best, and may continue to contract, Shikano said.

The Cabinet office reported Japan's gross domestic product — a measure of the value of its goods and services — contracted 0.7 percent in the second quarter from the previous quarter.

That was steeper than the 0.6 percent contraction given in a preliminary report released August. For the annual rate, Japan had said the economy contracted 2.4 percent in its earlier report.

Since the "bubble" economy of overspending burst in the 1990s, Japan had been eking out moderate growth in recent years.

But some Japanese officials are now seriously worried about a possible recession because of emerging risks largely outside Japan's control.

The lagging economy is expected to be a key issue in the ongoing campaign to find a new prime minister after Yasuo Fukuda abruptly announced his resignation earlier this month.

The ruling party is selecting its new leader later this month among five candidates. Partly because of the growing worries about the economy, former Foreign Minister Taro Aso, who is promising more stimulus spending to wrest Japan out of its doldrums, is widely viewed as the likely victor.

[papabear]

http://www.atimes.com/atimes/Global_Economy/JI13Dj02.html
Pareto's Bazooka
By Chan Akya

Have you heard the one about the French army rifle for sale on eBay? It is advertised as "Never fired, dropped only once". The reason to think about this item is not to make fun of the French again, but to ruefully consider the metaphorical bazooka that US Treasury Secretary Hank Paulson holds; and wish as a free market agent that it had never been removed from its holster, let alone fired.

For those of you who skipped financial newspapers over all of the summer - admittedly not a bad idea in itself - the reference here is to the infamous July speech when Paulson said, "If you have a squirt gun in your pocket you may have to take it out. If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out."

The context was the Treasury grabbing power from the US Congress by insisting on greater powers to deal with the crisis cutting across the entire financial sector. Proving the rule that a fool and his money are soon parted, Paulson last weekend had to fire that bazooka after all, in his rescue of failed mortgage giants Freddie Mac and Fannie Mae; which followed the March takeover of Bear Stearns by JP Morgan at the insistence of the Fed and US Treasury.

On the face of it, these events are only loosely related in the bigger framework of the credit crunch. However, that ignores the key aspects of behavioral finance - the application of psychology to financial behavior - a subject that is far more relevant today than at any other time in financial markets. While this subject itself has multiple branches, I am here only looking at the most simplistic framework, ie, how do finance professionals behave in given situations.

The larger framework for studying the interplay of governments with financial markets in crisis situations is defined in the rules of Pareto Optimality. Simply put, a Pareto optimal situation is one in which all players in the game get efficient outcomes. An external agent, like the government, that seeks to influence the outcome can either create a higher chance of such an optimality (a Pareto Improvement) or more likely, not.

Dialing back
First, let us dial back a bit: under "normal" situations, a financial institution such as a commercial bank operates on the basis of trust. Wafer-thin capital is intended to support gargantuan balance sheets on the notion that the incidence of losses through defaults and the like are both miniscule and spread out over a long period; so ongoing earnings can replenish the capital base. As I have written before, banking isn't exactly rocket science, though - for all the wrong reasons - it does tend to attract the world's best brains.

Investment banks - like the dear departed Bear Stearns - had a slightly different business model, wherein investors depended on their ability to continuously undersell their positions to investors, or they were paid to distribute risk. This is like the children's game of passing the parcel, except of course that something a lot more incendiary than a Barbie doll is being passed around. Traditionally, investment banks relied on getting the parcel as far away from themselves as possible, and it would hopefully blow up some distant investor.

However, as of three years ago, investment banks changed their business model. The usual phrase that can describe this is unfortunately a bit too racy for an Asian newspaper; so let us just call it "gun envy". As the old firm of Goldman Sachs went from strength to strength, other investment banks like Bear Stearns and Lehman took it on themselves to bolster their own standings. This they did by boosting proprietary trading, the business of trading on their own account, and something that Goldman excelled in consistently - providing billions of dollars of income every year.

Now, the thing with proprietary trading is that while conceptually it looks similar to investment banking, it is actually the exact opposite as it involves brokers buying up their own produce. If you have ever come across the sickly pig farmers gorging on their own produce in Italy, you would begin to appreciate where I am going with this. Anyway, to fund the book - remember the wafer thin capital holding up the assets - the brokers increasingly used short-term "cheap" money.

When the first Special Investment Vehicle (SIV) went kaput last summer and was swiftly followed into the breach by the money market funds that lend in the short-term markets, this access to financing quickly disappeared.

This is when all financial institutions turned to "repo financing", or pledging collateral to each other to get cash. Typically, this works as follows: bank A sells a security to bank B at say 98, and promises to buy it back after a month at 100. The difference of two is the interest cost associated with the financing. For bank A, the process is good because it gets 98 immediately, and for bank B, it gets a security that is worth a 100 for 98, so if bank A doesn't honor its agreement to purchase the security back, bank B can sell it in the open market for 100.

Dr House maxim: Everybody lies
By now, astute readers would have guessed the fundamental flaw with the above setup, which is, to use the maxim of television's Dr House: "Everybody lies." The investment banks bought assets that they should have sold on but instead held on their books to eke out marginal gains, all the while funded by short-term markets.

As the price of these financial assets started falling, brokers and their customers soon found an inexorable volume of losses hitting their accounts. This was only in the most liquid assets though, leaving the issues of less liquid assets to be sorted at a future date. Like a man with a limp who hides a serious flatulence problem by pretending that the squeaks emanate from his cane (and I will leave the Dr House analogies alone after this), brokers and other financial players preferred to conceal the losses they were running up on their illiquid assets like Collateralized Debt Obligations (CDOs).

When you think about CDOs though for a few minutes, the idea of funding long-term assets with short-term liabilities starts looking awfully familiar - it is in fact a mini-version of a bank. And as with bank runs, the idea of suddenly removing the availability of funding for these asset vehicles causes a plunge in the value of the assets they hold.

To complicate matters, all brokers (and their biggest customers including the hedge funds) held the same kind of assets - see my previous comments on the general lack of smarts in the banking world. Thus, whenever the weakest link of the chain cracked, these assets were sold forcibly. Soon, the declines in value were so perceptible across the whole chain that the haircuts being demanded by potential lenders on the repo market soon started creating their own set of headaches.

Even as brokers and others increasingly depended on the repo markets, the volatility of asset prices was also rising dramatically, thereby forcing greater care in lending based on such collateral. Worse, by opening the Fed window (as well as the European Central Bank and Bank of England windows) to brokers, the day of reckoning was essentially postponed.

This is always the problem with imposing moral hazard on the markets: someone eventually calls your bluff.

Paulson is not Pareto
By rescuing Bear Stearns in March and Fannie and Freddie last week, Paulson probably tried to assure holders of long-term debt that the outlook was not all that bad. However, by doing so he scared the holders of equity and those holding short-term debt; because a continuous decline in the value of assets meant that the coverage for short-term borrowing was absent and capital was meanwhile being wiped out.

By creating a misalignment of interests between different types of creditors - long- and short-term - and shareholders, in effect Paulson unleashed an untenable timetable for a turnaround of the financial sector. Effectively, his strategy to save Bear would have worked had US financial markets enjoyed a prolonged upturn.

Instead, all players focused on surviving the immediate short term, thereby pushing more firms to seek securitized financing from the repo market. In turn, this left firms with both a funding and a capital problem whenever asset prices fell - Paulson's moves effectively made the US financial system a leveraged bet on investor optimism.

Stepping away from the rescue of private firms like Bear Stearns though would have necessitated a quick self-sale of smaller firms like Lehman, even as greater clarity on asset prices would have followed. However, by saving the long-term unsecured creditors of Bear Stearns, Paulson set in motion a precedent that was to cause greater volatility in the financial system.

More pointedly, the interest of long-term unsecured creditors, ie, the people who had the most capital at risk (given the amount of leverage that Wall Street firms, banks and agencies had relative to their capital) were frequently against those of investors in other parts of the capital structure or equity and holders of short-term secured debt. These investors had only one proven way of getting their money back and that was to secure government backing for the debt issued by these private companies.

This was the main "cost" of the rescue of Bear Stearns, it became imperative for holders of long-term debt to actually push large financial firms towards bankruptcy to force the government to rescue them. In effect, the arbitrage so created, that is buying long-term debt for extremely wide spreads that then tightened when the government took over the firms, became the new mantra for such investors. This is the exact opposite of Pareto optimality and the blame for that can be laid straight at the feet of Paulson.

The bigger cost is for the US government. Already, the total debt load has doubled since the absorption of Fannie and Freddie into the government balance sheet last weekend (See Paulson placates China, Russia - for now Asia Times Online, Sep 10, 2008). Now to add the likes of other troubled firms would be to push the overall debt burden well over 100% of gross domestic product, at which level it becomes unthinkable that the US government itself will retain its Triple A rating.

What Paulson may have forgotten though is that for all their mismanagement and so on, the two agencies actually held the best assets in the US mortgage space. If they needed to be rescued by the government, investors could easily work out what the fate of other US institutions holding lower-quality instruments would be. Three in particular entered crisis mode this week: Lehman Brothers, Washington Mutual and AIG (American International Group). All three were being quoted at distressed levels in the credit markets on Thursday.

Market reaction after the Fannie-Freddie rescue is where the behavioral finance aspect that I described in the beginning of the article began to bite. The rally on Monday quickly gave way to circumspection as investors worried about which was the next shoe to drop. The near-term experience of seeing capital wiped out on Fannie and others meant that there was no capital to be had from equity investors, even as the repo market was shut down for the affected firms by lenders afraid of being caught with either counterparty exposure or worse.

All of that meant that capital was pulled out of the affected firms at exactly the time when they needed it the most: a classic instance of herd behavior, and one that has become depressingly familiar in the global financial system of late.

Stung by the market crisis from the beginning of this week and the failure of Korea Development Bank to top up its capital (about the smartest thing that an Asian investor has done of late, in my opinion), Lehman advanced its earnings call to September 10 from September 16. But the announcement proved problematic as while losses of nearly US$4 billion were confirmed, the management could not identify the path of any turnaround, nor could it shed light on future sources of capital.

Lehman's share price continues to fall, and opened under $5 on Thursday in New York, a quarter of the value on July 1 and just a tenth of the highest price reached after the rescue of Bear Stearns.

Instead of one single rescue - of Lehman - US authorities are going to have to think of at least three institutions. A forced sale such as Bear could well work again, but that still leaves two big institutions in the lurch as of Monday morning. The number of companies which can potentially bail out these firms is fairly limited to start with.

It looks to me like the US government and its agencies will have to make some painful decisions about who to let go by Monday morning. It would be better for them and global investors if they left the decision to the markets instead. Essentially, someone has to take the bazooka of intervention from the trigger-happy US Treasury secretary.