Is the Securitization Crisis Driven by Non-Linear Systemic Processes?

Posted: 12 May 2008 07:00 AM CDT

Reader Richard Kline, who provides regular, sophisticated comments, was
keen to continue the discussion provoked by a post last wee, "Hoisted From
Comments: Greater Liquidity Produces Instability." An anonymous reader
offered a complex systems theory view of our modern financial system. The
opening paragraphs:
Perhaps a lesson to be learned here is that liquidity acts as an efficient
conductor of risk. It doesn't make risk go away, but moves it more quickly
from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do
if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex

system is promiscuity of information (i.e., feedback loops but in a more
generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing
its non-linear behavior is to divide it up into little boxes and use them to
compartmentalize information so signals cannot easily propagate quickly
across the entire system.

I hope I am not oversimplifying what either the anonymous reader or Richard

intend to convey, but the non-linear issue is not trivial. Processes that are
described by non-linear equations are unpredictable. That is why, per above,
inducing or enabling non-linear behavior is Not A Good Idea.

Worse, non-linear math is really hard, so while lots of mere mortals can model
linear processes, it takes high powered skills to deal in non-linear modeling.
And you therefore get a second problem: due to computational convenience,
most practitioners will try to describe a system using linear models, and if it
works well enough in most cases, it gets a go. To illustrate: pretty much every
mainstream financial model (Black Scholes, for instance) assumes continuous
markets, which simplifies the math. This, for instance, is the origin of the
classic fat tails problem. Pretty much everyone knows that models that use a
normal distribution underestimate tail risk (the odds of outliers, which in this
case is dramatic price rises or falls). Yet the flawed models are still consulted
out of convenience (note I am not saying other models aren't used, but the
reliance on models known to have fundamental shortcomings is considerable).

Richard has provided a through, thoughtful exploration out of some of the

issues. After a general discussion, he sets forth five questions and works
through the first one. on innovation (note the discussion ranges far beyond
the financial markets). Recall that one of the defenses of our current financial
mess is that the products were innovative and hasty regulation will curtain
other useful advances (this argument is that the products weren't the
problem, it was the practitioners, or in popular terms, "guns don't kill people,
people kill people"). But as Richard illustrates, that level of discussion is
simplistic; there are ways to parse the problem that can lead to better
thinking about possible remedies.

His ideas on issues 2-5 will come in later posts in this series.

Your comments very much appreciated. I've edited his piece slightly to make
it a bit less formal.

Now to Richard Kline;

To what extent have nonlinear processes promoted the Securitization Bubble,
precipitated its collapse, or prolonged the resulting instabilities in the financial
system? I'll keep the discussion non-technical, i.e. non-mathematical. While I
have an informed opinion, I don’t pretend to expertise, and hope to elicit
further comment and debate.

While there is evidence for most of my contentions, it isn’t conclusive;. I raise

ideas more than offer conclusions. Some general, but valuable, further
reading is suggested for those interested. Comment by those with technical
background in nonlinear complex systems, especially economic systems, is
welcome---but I’m not holding my breath. Though nonlinear dynamics in
financial markets received no little initial research ten years ago and more,
many of the specialists involved have since been hired into the hedge fund
industry where their work has presumably become proprietary. Not only do we
not know what they are doing, we don’t even know what they know now;
there has been little recent publication of consequence.

To delve into this issue, then, let us first briefly consider financial markets as
systemic phenomena. Given their inherent complexity and diversity of inputs,
modern financial markets are inherently complex systems with numerous
nonlinear phenomena embedded within their actions, that is phenomena
whose transformations are not smooth, not continuous, or both. Such
overlapping dynamical phase spaces appear less complex than they are
because salient stable equilibria within them are defined by firm, cohesive,
and above all observable parameters such as priced units of exchange,
transaction terms, regulatory limits, and the like. Such firm parameters do
typically though not invariably have the virtue of precluding overtly chaotic
behaviors in their respective financial event-spaces, and to a degree in the
larger interaction systems which contain them. Indeed, while complex
systems will often self organize with emergent properties developing within
them in consequence, the intervention of human participants in these markets
tends to limit or swiftly capture observable systemic properties---or at least
that is the idea.

Since these defined and manipulated parameters are of lower dimension than
the market processes to which they map, they give the illusion to the
observer that markets themselves are more solid and of lower dimension than
is really the case, like skin on hot chocolate. This illusion is compounded by
the fact that the very large volume of quantitative data regarding finance and
markets, including trend analyses beloved by academically trained
economists, are presented in linear analytic terms; ants crawling on that skin,
if you will. Such linear models tell something regarding ‘what dwells below,’
but less then we often lead ourselves to believe.

Bear in mind, though, that such linear models only map to the nonlinear
trajectories and higher dimensions of the underlying event-spaces, if with fair
reliability, rather than fully describe them. These are fuzzy, noisy spaces in
that they largely describe human behavior which is intrinsically inexact,
information which can be imperfect and/or corrupt(ed), and rule-parameters
which are not always followed and which do not capture all relevant
processes. Phase spaces and their properties are best described as geometric
structures with a time dimension which describe relationships whereas our
analyses in a modern educated context are overdefined by linear
mathematical methods which abstract fixed values. The present conceptual
mismatch of methods to phenomena further leads to an insufficient cognitive
engagement with systemic and nonlinear processes on their own terms, in
economic behavior and elsewhere:

Our tools are yet poorly matched to the natural phenomena we wish to
understand. I will pose it as a truism that processes which appear disjointed or
broadly nonlinear do so when they are viewed from perspectives which are or
lower dimensionality than are the structures observed; Flatland views of
Squareland trajectories. Tensor analysis may prove sufficient to effectively
analyze some complex processes; perhaps. Since most of us cannot execute it
competently, nor are the guidelines clear by which to operationalize available
data into tensor matrices, we will have to sharpen our ‘complex reasoning’ to
make heuristic judgments better suited to the data-events instead. This
exercise is valuable in and of itself. It is even more true in considering
complex systems than otherwise that as you define your questions you
describe the parameter space of your possible answers. So, let’s build some
better questions.

From that position, here are five questions recently and variously posed which
I find personally interesting:
Does innovation require untrammeled information flow across social/
economic event spaces?

Is the crisis in securitized debt the result of a ‘black swan’ event?

Was the creation of the Securitization Bubble the result of nonlinear processes
in the financial markets?
Is a financial event-space optimized for propagation desirable?

If not, what structure or process parameters might improve process

outcomes?

Innovation: Does innovation require untrammeled information flow

notwithstanding any potential costs to an economy or society of undampened
interactive trajectories? Not . . . quite.

The stated assumption that innovation requires untrammeled flows of any

kind embeds two misconceptions. First, there is an implied confusion between
discovery and innovation. Discovery is just that, finding something not
previously understood to exist. Exposure to large bodies of information may
raise the probabilities of discovery, but so may improved observation of
putatively well-known information. Either way, discoveries are comparatively
rare; significant discoveries rarer still.

Second and more fundamentally, the stated assumption conflates innovative

design and innovation diffusion. The popular belief is widespread that
innovative design results from ‘throwing many ideas up against the wall and
seeing what sticks;’ that no one really knows what they are doing so
innovative ideas and designs are both essentially fortuitous and random. And
certainly fortuitous and random innovations do occur. What is required, then,
from this perspective is the largest possible supply of things to throw up
against the wall. In fact, much the opposite is the case. To site Edison’s well-
known dicta as a benchmark, “Genius is 1% inspiration and 99%
perspiration.” This overstates the case, but innovative design tends to happen
in small environments which can be effectively modeled to the point where
changes from shifts in composite parameters can be approximated
hypothetically, additional variables or inputs can be added to the context in a
controlled fashion, or both.

Engagement with those environments---i.e. knowledge and skill---tend to

improve the frequency and coherence of designs, to which quality of outcome
correlates. Fortuitous manipulations do happen, yes; information putatively
extraneous to context can provide valuable guidance or comparison, again
yes. Innovative design does not necessarily flourish in noisy environments
maximally in flux. There, relationships can be hard to grasp, and innovations
may soon be suboptimal in ever changing contexts; indeed, conservative but
stable designs may better reward success. In brief, innovative design occurs
best in the enriched niche, not in the middle of a crossroads.

Innovation diffusion, by contrast, occurs best where information and

adaptation are minimally constrained across a context. Consider the adoption
of mobile phones in Europe or Korea, where a single technical standard was
publicly designated, adoption of mobiles was rapid and deep, and use-driven
development burgeoned. In contrast in the US, competing technical
standards and incompatible service provider networks slowed adoption, and
have left services fragmented. Diffusion is a process which implies point
autonomous use of what is adopted or put to use. In contrast, propagation is
more nearly a spread whose nodes remained linked.

Consider Linux an example of diffusion and Windows an example of

propagation. Linux point sources can transform or adapt independently, while
Windows point sources are under heavy systemic pressures (incompatibility
drift) to transform in relation to nodal (i.e. Redmond) based changes. It isn’t
commonly understood that many innovative designs are effected well before
they diffuse (or are propagated), perhaps because salient fads can diffuse
with great rapidity in modern societies. A typical example is the Internet,
which was functionally extant well before software refinements turned it into a
mass medium, a medium whose greater scales drove product and
organizational developments thereafter. The adoption trajectories of
innovations most typically are logistic functions in form, but with longer low
adoption under-the-radar initial tails then considered, even much longer.
Whether relatively rapid diffusion is a social version is debatable, but it is
certainly an economic gain if only for implementation investment.

There are two points to making this distinction between innovative design and
innovation diffusion (or propagation). First, the two processes can be
facilitated or inhibited separately. For example, a society with low barriers to
diffusion may still be the one to capitalize upon innovations, regardless of
source, because they scale the markets and formalize product parameters.
Second, large profits come to those investing in innovations which diffuse due
to market scale-ups, while huge profits come to those investing in innovations
which propagate since they remain substantially intermediated in subsequent
capital flows. The arguments one typically hears for lowering barriers to
innovation diffusion and damn the consequences are from those hoping that
their innovations or the industries tied to them will get the market scale-up
opportunities. ‘Pro-adoptionists,’ to give them a name, typically have a stake
in the outcome so their perspective is not disinterested (presuming that
anyone else’s could be, either). To get innovative designs we need enriched
niches whether or not we have low barriers to innovation adoption. We can
have rapid adoption without being particularly innovative. Societies can, in
fact, deliberately choose whether or not to have rapid adoption.

Moreover and more importantly societies can deliberately choose which

innovations to rapidly adopt (within limits); consider China in the latter regard
of selective adoption. Choices about which innovations to permit rapid
adoption are choices about who will get very rich, however. Much of the
shouting about innovation is, at its base, concerned with the last proposition.

Further reading:

Nebojsa Nakicenovic and Arnulf Grübler. 1991. Diffusion of Technologies and

Social Behavior.
Jacob Getzels and Mihalyi Csikszentmihaliy. 1976. The Creative Vision.

[Respectively the best texts on technological innovation and the creative

process I have ever
found. Of course they are the least known.]

"The global slump of 2008-09 has begun as poison spreads"

Posted: 12 May 2008 04:31 AM CDT
Uber-bear Ambrose Evans-Pritchard waxes apolyptic this week, after finding
that Standard & Poors issued a report that was even more pessimistic than he
is.

From the Telegraph:

The avalanche of bankruptcies has begun. Six US companies of substance
have defaulted on bonds over the past fortnight, against 17 for the whole of
last year.

As a "non-believer" in the instant rebound story, I am not easily shocked by

gloomy reports. But the latest note by Standard & Poor's - The Bust After The
Boom - gave me a fright....

As the Fed's latest loan survey makes clear, lenders have dropped the
guillotine. With the usual delay, the poison is spreading from banks to the real
world.

Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the
rate of past downturns. "Companies are heading into this recession with a
much more toxic mix. Their margin for error is razor-thin," she said.

Two-thirds have a "speculative" rating, compared to 50pc before the dotcom

bust, and 40pc in the early 1990s. The culprit is debt. "They ramped it up in
the last 18 months of the credit boom. A lot of deals were funded that should
not have been funded," she said.

Some 174 US companies are trading at "distress levels". Spreads on their

bonds have rocketed above 1,000 basis points. This does not cover the
carnage among smaller firms outside the rating universe.

The California city of Vallejo (117,000 inhabitants) has just made history by
opting for Chapter 9 bankruptcy, the result of tax erosion from a 26pc fall in
local house prices. Half Moon Bay may be next.

"This is the tip of the iceberg: everybody is going to line up for Chapter 9 in
California," said John Moorlach, Orange County board chief.
US consumers are juggling plastic to put off their day of reckoning. The Fed
survey said credit card debt had jumped 6.7pc in the first quarter to $957bn,
or $6,000 per working American, despite usury rates near 20pc.

"My guess is that many Americans continue to run up massive credit card
debt because they have little intention of paying it off," said Peter Schiff at
Euro Pacific Capital. Quite.

Thankfully, the Fed's monetary blitz has averted a depression. Emergency

lending under the "unusual and exigent circumstances" clause of the Fed Act -
the nuclear Article 13 (3), unused since the 1930s - has put a floor under the
banking system.

There will be no "reset Armaggedon" as rates vault on honey-trap mortgages.

Drastic Fed cuts - to 2pc from 5.25pc in September - have conjured away that
disaster, at least....

Despite the rescue, US house prices are likely to fall 25pc from peak to trough
(Lehman Brothers, Goldman Sachs). We are barely half done, yet 10m-12m
households are in negative equity already.

The bears at Société Générale are going into Siberian hibernation, issuing an
"Ice Age" alert. They have slashed exposure to global equities to a minimum
30pc for the first time ever.

Their weighting of super-safe "AAA" government bonds has been raised to a

maximum 50pc. This is a bet on gruelling "Japanese" deflation. The bank
expects equities to fall by 50pc to 75pc.

"Nowhere and nothing will be immune. We are on the cusp of an equity

meltdown that will slash and shred portfolios," said Albert Edward, SG's global
strategist.

"We see a global recession unfolding. Liquidity will drain away and crush the
twin emerging market and commodity bubbles. The recent hope that 'the
worst might be over' is truly staggering. Profits are disintegrating," he said.

Today's "bear rally" may live on into June. Don't count on it. Global bourses
are no longer rising hand-in-hand with oil in exuberant celebration of liquidity
relief (US, UK, and Canadian rate cuts).

Crude ceased to be a friend of equities when it reached around $110 a barrel.

At last week's close of $126, it became an outright threat. The Bush rescue
package - $600 in rebate cheques per household - has been rendered null and
void by the latest spike. The average US home is now spending over 8pc of
income on energy or fuel.

OPEC is playing with fire by refusing to pump more oil to offset rebel attacks
in Nigeria. The cartel's output drop of 350,000 barrels a day in April is a
hostile act at this point.

But there again, why should Middle Eastern states help America as long as the
White House keeps filling the US petroleum reserve to prepare for war with
Iran? Bush is playing with fire, too.

The oil spike will burn itself out. China has hit the buffers. With inflation at
8.5pc, it risks political turmoil. Moreover, it has repeated Japan's mistakes in
the 1980s, building too many factories shipping too many goods at slender
margins into a crumbling export market.

Lehman Brothers' Sun Mingchun says China will tip over in the second half of
this year. "With so much latent overcapacity, an export-led slowdown could
trigger a chain reaction which, in the worst case, could threaten the stability
of [its] financial and economic system," he said.

Britain, Europe, Japan, and China will go down before America comes back up.
This is turning into a synchronised bust, after all. The Global Slump of 2008-09
is under way.
Bottom Testing in Mortgage Land
Posted: 12 May 2008 02:38 AM CDT
The Financial Times has a long analysis, "Value to Unlock," on how various
financial players are starting to pick and choose among distressed mortgage
assets. This may prove to be premature (recall how Wall Street firms eagerly
bought subprime brokers through January 2007) and the housing market itself
appears unlikely to hit its floor before 2010, but even at this stage, there may
be pockets that are so cheap that the downside is (or appears) modest.

Note this seems to be a theme du jour: Calculated Risk also saw signs of
buying in some distressed markets, and too is cautious about reaching
conclusions.

The set up is that the Mortgage Bankers Association, a sober and sparsely
attended affair this year, is galvanized by the report that a BlackRock fund will
buy $15 billion of UBS's subprime debt for 75% of face (UBS is a minority
investor in the fund; query whether there was more than meets the eye here).

The piece comments on various players buying servicers allegedly to gain

expertise. Maybe I am talking to the wrong people, and Tanta et al will correct
me, but my sources tell me servicers are factories, and don't have skills that
are relevant to evaluating mortgage pools. Remember, the credit decision was
made long before the securitized mortgage got in the hands of the servicer
(and in the recent environment, calling them "credit decisions" is generous.
More accurate might be "handing out cash to anyone who had a pulse and
could fill out a form"). I'm a little perplexed that this factoid, while narrowly
accurate, keeps being bandied about uncritically.

From the Financial Times:

Policymakers, bankers and investors all want more buyers like BlackRock to
emerge for mortgage securities and other risky assets, to provide a tipping
point that ends the credit crisis. Yet thus far there has been only patchy
evidence that this healing wave of purchases is under way.

Certainly, the market for corporate debt has shown some positive signs. The
$23bn buy-out of Wrigley by Mars, agreed two weeks ago, involved more than
$10bn of debt - although less than $6bn of that debt came from investors,
with the rest provided by Warren Buffet's Berkshire Hathaway.

The debt capital markets, which last year made possible deals that were twice
that size, still have a long way to go before they recover fully.....Banks are so
desperate to rid their balance sheets of these loans that they are offering
their best clients sizeable discounts and lots of leverage to sweeten the
sales....

Investor fear of buying distressed assets too soon and catching the "falling
knife" is even more intense in the mortgage market, where premature buyers
have been badly burnt by plummeting asset prices...

Nevertheless, BlackRock's deal with UBS represents one of the more

significant examples of a small but growing number of contrarian bets on
distressed mortgage assets by opportunistic buyers. Goldman Sachs, TPG and
other investment banks, private equity firms and hedge funds have also
started looking to buy portfolios of mortgages - in some cases reversing
bearish bets made last year.

Indeed, in the past 10 months more than 80 funds have begun raising money
to buy bad mortgage debt on the cheap, including Marathon Asset
Management, GSC Group, Pimco and Fortress Investment Group. Goldman is
trying to deploy around $4.5bn to invest in mortgage assets...

Placing values on distressed mortgage assets remain an enormous problem

for both buyers and sellers, in part because it is hard to predict the full extent
of the continuing slide in US home prices and the accompanying level of
mortgage defaults and foreclosures.
Part of the difficulty is that faith has been lost in the measures of probable
losses on which lenders used to rely, such as credit ratings and historical data.
For pools of subprime mortgages, guides such as loan-to-value ratios, used to
compare the size of a loan against the value of the property on which it is
secured, have proved unreliable.

Mark Fleming, director of economics at First American CoreLogic, a research

provider, says that while reported loan-to-value ratios for many subprime
mortgage pools had been around 100 per cent, the existence of unreported
"piggyback" loans meant that in some instances the ratio could be as high as
160 per cent.

"The problem is that while market-based pricing is not necessarily

commensurate with the true risk, it's still hard to measure the mismatch
between pricing models, rational pricing opinions and prices driven by fear,"
says Mr Fleming.

The valuation problem is worse for more complex instruments, for which there
are still no buyers, particularly if these fall under fair-value accounting rules
that require securities to be "marked to market" - priced on the books at no
more than what is achievable. Susanna Kondraki, vice-president at Risk Span,
an advisory firm, says one client spent $250,000 on valuation services for a
$1bn portfolio of collateralised debt obligations backed by mortgages, only to
discover that the portfolio had to be valued at zero.

James Fratangelo, head of whole loans sales and acquisition at Bayview

Financial, says snags like this are why many parts of the mortgage market are
yet to establish clearing prices. "There is plenty of liquidity for distressed
assets but there is still a huge gap between where buyers want to buy and
where sellers want to sell," he adds - with the gulf between bids and offers
remaining as wide as 20 cents on the dollar for many assets.

Robert Gaither, head of the secondary marketing group for mortgage

securities at Bank of America, illustrated this problem at last week's
conference. He described receiving bids for a portfolio of so-called "Alt-A"
mortgages, between prime and subprime, that the bank had marked down to
91 cents on the dollar. After a series of bids from prospective buyers at 50
cents, he finally received one at 86.5 cents. Yet the bank's pricing model said
the mortgages should be priced in the mid-90s.

The bank decided to hold on to the portfolio, even though it was forced by
mark-to-market accounting rules to write down the mortgages to match that
86.5 cent bid.

Many European banks are also refusing to sell at prices that they consider to
be artificially depressed....

She says European banks' belief that such asset prices have fallen too far has
been bolstered by a recent Bank of England report suggesting that triple-A
tranches in particular were mispriced......

Still, there are signs - including UBS's sale of loans to BlackRock - that some
higher quality assets are beginning to move...Traders say the scale of buying
generally remains small, however. In the European markets, buyers are
placing orders of just €20m (£16m, $31m), far below the €500m orders that
were normal before the crisis broke.

Many funds say they remain constrained in the volume of deals they can do
by the sheer difficulty of raising finance. Others fear this means there is too
little capacity to absorb the volume of distressed assets in the market.

"What worries some people is that you have seen a few people fill up but it's
not clear whether there will be more buyers after that - it could just be one or
two groups that are ready to buy," says one London-based hedge fund official.
"The market is so thin and prices are so volatile that if they stop buying, we
could go back down again."....

One of the biggest problems facing prospective buyers of distressed mortgage

assets is that US house prices continue to fall and the flood of late mortgage
payments and foreclosures shows few signs of abating. Unless the rising tide
of losses in the housing market can be stemmed, establishing a floor under
asset values may be difficult, writes Saskia Scholtes.
Mark Kiesel, a portfolio manager at Pimco, the big US bond investor, says: "We
may need housing prices to bottom for this entire process to trough and for
most markets to rebound."

Links 5/12/08
Posted: 12 May 2008 02:01 AM CDT
Is divorce bad for the parents? PhysOrg

British Gas fights Accenture over billing Times Online. A world class IT mess.

Shipping rates near record levels Financial Times

The case for invading Myanmar Asia Times, Mirable dictu. The Asia Times,
which is is pretty unsparing in taking the US to task, is calling for a US foray
into Mynanmar. This would be a "humanitarian intervention" but I wonder
what the subtext is. Does this mean they don't trust the locals (China, India.
Thailand etc.) to do in with UN coordination and blessing?

When to ‘have a go’ Willem Buiter

Capital market deals raise $20bn FT Alphaville

Oil Nonbubble, Paul Krugman, New York Times. Krugman argues (as he has on
his blog) that the lack of inventory buildup means that there is no oil bubble.
The problem I have with that argument is we cannot be certain of the
supposed lack of inventory increases. The New York Times, in a recent story
on the runup in agricultural commodity prices, discussed how some farmers
who cannot sell to elevator companies and are frustrated with the ways the
options and futures markets are misbehaving are doing deals outside the
exchanges, directly with sponsors of commodity funds such as AIG. AIG, which
runs commodity index funds, buys the commodity, the farmer stores it for a
fee, and the farmer buys it back later at a pre-set price. Again, does the
inventory held with the farmer by a commodity index fund get recorded
anywhere? And note further (if the author got it right): commodity funds are
not supposed to buy commodities. But AIG, the fund manager, apparently did.
If this is somehow to AIG's advantage (certain) it's a no-brainer that Goldman,
which manages about 60% of the GCSI funds, is doing similar moves on a
greater scale. And if private deals of the sort depicted in the article aren't
recorded, we could indeed have more inventory that is widely recognized.
(And remember, even if inventories are actually growing, bubbles can go a
very long time before they burst).

Bottom line: more deals are being done OTC, and physical trades related to
them may not be fully captured. Anyone with knowledge is encouraged to
comment.

NAR President-Elect Brays About Banks Bank Lawyer's Blog. Amusing.

Two Posts Everyone Needs to Read Angry Bear

Antidote du jour:
Waldman: Halt the Fed's Mission Creep
Posted: 12 May 2008 12:26 AM CDT
Steve Waldman has a typically top notch post at Interfluidity,"Let's not write
the Fed a blank check," in which he dissects the implications of the Fed's
request to Congress to pay interest on bank reserves.

Waldman explains the technical workings and the pros, and gets to the real
issue. This represents a change from a fractional reserve banking system to a
so-called channel or corridor system. Fixed reserves become incidental and
might be dispensed with, since the Fed would manage interbank rates directly
by setting what amounts to a bid and offered price (a bit simplified, see
Waldman for details).

Now the Fed did not just wake up and decide in a fit of housekeeping to adopt
this practice, which has been road tested by other central banks. The
problem, as has been clear from the when this idea first surfaced, is that its
main objective is to allow the Fed to circumvent its balance sheet constraints
in salvaging the financial system. The method open to it now, of simply
issuing liabilities so it could take on more dodgy assets, is tantamount to
printing money and inflationary.

Aside: you thought the credit crisis was over? This proposal says the Fed is
afraid it isn't. Per Waldman, the Fed has already used $475 billion of balance
sheet capacity and has another $300 billion to go. As he points out, the
amount already loaned to Wall Street equates to $1500 per person in the US;
use of the additional $300 billion would bring it to $2500. Don't kid yourself; if
these loans go bad, they come out of the public purse. The Fed wants
approval for a mechanism that allows it to go even higher.

The Fed's mission creep is yet another sorry Greenspan era development.
Earlier central banks understood their mission: to provide a stable price of
money, preserve the soundness of the banking system, and promote full
employment. Greenspan took an unprecedented interest in the stock market,
which has never been any central bank's responsibility (a May 8, 2000 Wall
Street Journal cover story discussed this at some length, although predictably
not in disapproving terms). Even worse, Greenspan's predilections seemed a
prescription for moral hazard: minimal regulation and a "let a thousand
flowers bloom" approach to new products, no matter how geared, combined
with aggressively backstopping the industry at any whiff of trouble.

Much has been written about the Greenspan put; less has been said about his
Fed's other moves that extended the Fed's purview without any formal
approval. The biggest, the one that set the stage for the Fed's current
expansive view of its role, was the bailout of LTCM. Although the Fed did not
broker the deal, it did review LTCM's books before calling 24 firms, most of
which it did not regulate, to meet at its offices. While that intervention has in
retrospect been presented as a success, it wasn't clear then, and cannot be
determined now, whether a LTCM failure would have been a systemic event.
However, at the time, it was quite controversial, precisely because the Fed
was extending its reach to areas that were not part of its charter.

The problem, as Richard Sylla points out in the Palgrave Dictionary of Money
and Finance, is that
.....the Fed was a compromise between two central banking traditions in
America. Each was tried for extensive periods and then rejected. The first was
the tradition of the corporate central bank, chartered by the State but owned
wholly or in great part by private investors...After the corporate central bank
was rejected, the US flirted for seven decades with a second central banking
tradition, namely having the the government's fiscal authority, the US
Treasury Department, serve also as the central bank.....The Federal Reserve
Act rejected the earlier traditions of monetary policy controlled by bankers or
the Treasury, but it gave each of these interests a voice in central bank policy
formation.

Fast forward 95 years, and we are coming to the limits of this model. Not only
have private interests managed to co-opt the central bank, as opposed to
have a voice in monetary policy, but they have the Federal government
apparently ready and willing to give the industry an unlimited, unconditional
guarantee. Retail deposit insurance is capped; why should professional
investors, shareholders (who unless they work for Bear, know to diversify their
holdings) and incumbents, who created this mess, get a far more generous
deal?

Remarkably, and sadly, Congress had the chance to rein in the Fed during its
hearings on the Bear rescue. Indeed, I thought that was the point of that
exercise. But having given the Fed a free pass, there is zero possibility that
the legislature will leash and collar the Fed as Waldman recommends below.

From Waldman:
As long as the Fed is conducting ordinary monetary policy, switching to a
channel system offers modest benefits at a modest cost to taxpayers. But the
Fed's monetary policy has not been ordinary at all lately. In fact, it's been
quite extraordinary....and it is in the context....that we must consider the
change.

The core of the Fed's new exuberance is a willingness to enter into asset
swaps with banks.... In doing so, the Fed puts taxpayer funds at risk. If a bank
that has borrowed from the Fed runs into trouble, the Fed would face an
unappetizing choice: Orchestrate a bail-out, or permit a failure and accept
collateral of questionable value instead of repayment. Either way, taxpayers
are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will
soon have dwindled to $300B, give or take. The difference, about $475B,
represents an investment by the central bank in risky assets of the US
financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more

than $1500 from every man, woman, and child in the United States, and
invested that money on our behalf in Wall Street banks that private financiers
were afraid to touch. For bearing all this risk, if things work out well, taxpayers
will earn about what they would have earned investing in safe government
bonds. If things don't work out well, the scale of the losses is hard to predict.
The Fed will claim to have done "due diligence" on its loans, to have valued
collateral conservatively, and will point to strength of bank guarantees and
the enormous diversity of collateral assets to convince us that its actions are
safe and prudent. But rating agencies made the same claims about AAA CDO
tranches, and turned out to have been mistaken. Correlations often tend
towards one when asset values fall sharply. Central bankers struggling to
manage day-to-day crises in financial markets might cut corners when trying
to value complex securities. They might find it convenient to err on the side of
optimism, as the ratings agencies did, albeit for very different reasons. And
even if the Fed is cautious and sober-minded, are we sure that central bankers
can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it
would have invested more than $2500 for every man, woman, and child in
America. Public investment in the financial sector would have exceeded the
direct costs to date of the Iraq War by a wide margin. Would that that be
enough? If not, how much more? Just how large a risk should taxpayers
endure on behalf of companies that arguably deserve to fail, to prevent
"collateral damage"? Have we considered other approaches to containing
damage, approaches that shift costs and risks towards those who benefited
from bad practices, rather onto the shoulders of taxpayers and nominal-dollar
wage earners? Does this sort of policy choice belong within the purview of an
independent central bank?....
I don't love the decisions that were made, but decisions did have to be made,
and there weren't very good options. But now we have a moment to reflect. If
the credit crisis flares hot and bright again, how much more citizen wealth
should be put at risk before other policy options are considered? That's not a
rhetorical question: We need to choose a number, a figure in dollars. My
answer would be something north of zero, but not more than the roughly
$300B stock of Treasuries that remains on the Fed's balance sheet....

.....suppose Congress gives the Fed the authority to pay interest on reserves.
Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for
troubled assets..... Since interest rates can be held to any level by adjusting
the "corridor", the Fed would retain the flexibility to respond to inflation. At
the same time, it would be able print cash in any amount that it pleases — "to
infinity and beyond!" — in order to fund asset swaps (or outright purchases)
at taxpayers' risk. This strikes me as a delegation of Congressional authority
that would not only be undesirable, but arguably unconstitutional......

I think that Congress should grant the Fed's request, but it should
simultaneously impose constraints on the composition of the Fed's balance
sheet that cannot be violated without express legislative consent. This will be
a complicated exercise, unfortunately. Besides government debt, central
banks quite ordinarily hold precious metals and foreign exchange, and
limitations on non-Treasury assets will have to take this into account. Plus,
restrictions would have to be written carefully to apply to off-balance sheet
arrangements such as TSLF, and contingent liabilities like the insidious
reverse MBS swap proposal. Finally, Congress must consider restrictions on
the Fed's ability to enter into derivative positions, whether directly or
indirectly via special purpose entities, including how the bank's existing
derivative book should be managed and whether the bank should or should
not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be
permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary
monetary policy, exchanging government debt for cash and vice-versa. But if
the central bank wants to put ever greater quantities of public money at risk,
it will have to accept a lot more public supervision. If the prospect of intrusive
oversight is too much for the Fed, then, as James Hamilton hints, perhaps the
roles of central bank and macroeconomic superhero should be moved to
separate boxes on the organizational chart. If we are not careful, the next
bank requiring a taxpayer bailout may be the Federal Reserve system itself.

Downtown LA Package for Sale at 35 Cent on the Dollar

Posted: 11 May 2008 08:42 PM CDT
Bloomberg reports that the company that is the biggest property owner in
downtown LA, with concentrated holdngs in the Little Tokyo section of Los
Angeles is trading at a deep discount to book value minus borrowings. The
reason? The company may not be able to refinance debt coming due.

Now one may legitimately take book value with a handful of salt, and my dim
recollection of LA is that Little Tokyo is adjacent to rather than in the business
district. Another factor is that this stock probably trades by appointment:
market cap of $142 million, with 45% held by the CEO. Nevertheless, this is
yet another manifestation of the credit crunch.

From Bloomberg:
A package of Los Angeles real estate on sale for 35 cents on the dollar is
attracting investors to the depressed shares of Meruelo Maddux Properties
Inc., the biggest private landowner in the city's four-square-mile downtown.

The stock has plummeted 85 percent since an initial public offering 15 months
ago as the global credit crisis threatens to disrupt refinancing of $200 million
in mortgage debt coming due in the next 12 months, as well as completion of
the city's tallest downtown residential tower.
Meruelo Maddux owns or controls 80 acres including the Little Tokyo Shopping
Center, home of the country's largest Japanese supermarket, as well as
warehouses and buildings used in Tom Cruise's action film ``Mission
Impossible III.''

``It sure looks like a cheap way to play the downtown L.A. market,'' said Mike
McGarr, a portfolio manager at $2.4 billion Becker Capital Management in
Portland, Oregon, which has added shares this year and owns 1.55 million.
``You're not hanging your hat on a few properties. You've got about 50
properties in various states of development or redevelopment.''....

Loan payments and maintenance consume $500,000 a month more than the
company takes in, eroding the developer's $13.5 million in cash.