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Sunday, November 16, 2008




The Behavioral Revolution

Another wave of deleveraging is hitting the US, this time it's the consumers.

Suddenly, our consumer society is doing a lot less consuming. The numbers are pretty incredible. Sales of new vehicles have dropped 32 percent in the third quarter. Consumer spending appears likely to fall next year for the first time since 1980 and perhaps by the largest amount since 1942.

With Wall Street edging back from the brink, this crisis of consumer confidence has become the No. 1 short-term issue for the economy. Nobody doubts that families need to start saving more than they saved over the last two decades. But if they change their behavior too quickly, it could be very painful.

The truth about the current crisis is that despite a storm of accusations and fingering directed at Wall Street, Wall Street was by far not alone in its addiction to operating on very risky leverages. In the last decades the saving rates in the US were steadily declining reaching their historical lows amidst exuberant celebrations financed through overdraft and abuse of credit cards. Neither the government with its budget, nor the fed's monetary policies were really falling behind. In this sense it's possible to say that in the years preceding the crisis, the whole society, and not only Wall Street, was recklessly and dangerously leveraging up. This points to a possible cultural component among many factors behind the collapse. The current crisis is just as much about culture as it's about loose monetary policies, subprime mortgages and structured investment vehicles. This crisis is very much a cultural event and as such it may have very far reaching consequences.

As Joshua Shapiro of MFR, an economic research firm in New York, puts it, the American consumer has quickly gone from being the world economy’s greatest strength to its Achilles’ heel. “Everything has changed,” he says. “The financial sector is deleveraging. Credit availability is severely constrained. Asset prices are deflating. And household balance sheets are severely stressed.”

It would be silly to insist that a few terrible months meant the end of American consumer culture. But it would be equally silly to assume that culture could never change. It might be changing right now.

Source

The Treasury is now planning to spend the rest of the bailout package on boosting consumer spending. However, one would think that its efforts will meet with a limited success just as it happened with the banking industry. Of course, both institutions and ordinary Americans are now frenetically deleveraging themselves to reduce their exposure to market risks out of the expectation for things to get much worse and soon. However, there should be also no doubt that the culture is changing and in this sense there is not so much Paulson and Bernanke can do about it. They are just trying to stop the inevitable. It's not for nothing that in his appearance before the senate committee, Greenspan thought it right to make the following comment:

"Whatever regulatory changes are made, they will pale in comparison to the change already evident in today's markets," he said. "Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime."

Source

Ironically, the only sector still defying the deleveraging trend is the state and the regulators. At the current rate soon even dogs and cats will be targeted by the regulators with their bailout packages.

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Sunday, November 2, 2008




How to regulate unregulation

Last updated: November 4, 2008

November 2, 2008


I would say that it's now getting really hard to fail to notice how much the policies adopted by the fed in the wake of the crisis are similar to those that have created the bubble in the first place. The interest rate is down to 1% and concerns for deficits and debt ratio have been all thrown over the board as the US is trying to reflate its way out of a deepening recession.

A few days ago the current fed chairman has had the following to say about the situation of the housing market:

Speaking about the credit crisis that started in August 2007, Bernanke said it began with the end of a prolonged housing boom in the U.S. that exposed "serious deficiencies in the underwriting and credit rating" for mortgages, particularly subprime mortgages, loans made to borrowers with weak credit histories.

Banks and thrifts are still making new mortgage loans during the current credit squeeze but have tightened terms considerably, "essentially closing the private market to borrowers with weaker credit histories," Bernanke said.

. . .

He did say that private companies have basically stopped all of their activities to purchase mortgages and collect them into large pools to be sold as securities, something now only being done by Fannie, Freddie and Ginnie Mae. By contrast, private companies accounted for half of the market for mortgage-backed securities in 2005 at the height of the housing boom.

"That experience suggests that, at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages," Bernanke said.

Source

What it basically means is that the US economy is back to the square one as the financial system is largely back to its previous shape that prevailed until the regulators moved in to unleash the lending binge. The private sector has all but abandoned the MBS market leaving Fannies and Freddies to fight their lonely battle for expanding home ownership. The banks have also recovered their past prudence and right now the regulators have no chance to force them back into reckless subprime lending even if they legislate another ten CRA acts.

In view of the above, questions arise regarding the policies adopted by the fed. For starters, there may be no liquidity crisis as such or it may have reasons different enough to justify calling the actions taken by the fed misdirected. As always the regulators are now way too late to the party. The problem has already transformed itself from one of lack of regulation or self regulation so famously decried by Greenspan in front of the Senate committees into one of a massive over-self-regulation by the private sector. While the politicians-regulators are promising to introduce the world to a new era of enlightened state regulation, there's very little left now that can or should be regulated. In fact, it now comes all down to just the very opposite of it, namely, how to unregulate the beast out of a corner into which it threw itself after the housing market had collapsed taking on its way down banks and funds all across the country.

So we are now having the following situation. All talks about the end of capitalism and return of regulation notwithstanding, hardly any of the incoming regulation will have any practical effect on or relevance to the situation. Regulating some of the more exotic among derivative markets is not necessarily a bad idea, but for a few next years any person brave enough to call CDS and CDO by their names, will be at risk to be shot up right in front of the executive board. On the other hand, all the pumping of the financial system currently under way may fail to unlock the credit gates and unless the fed is ready to nationalize the entire banking industry to force open credit lines, it should better come to terms with the situation. The dollar's status of the world's reserve currency is not guaranteed to the US for eternity. Unless the fed wants to see its country finally going bankrupt or washed away by the tsunami of returning dollars, it should better temper its enthusiasm for its current methods.


November 4, 2008

AIG and its swaps

The story making rounds in the last days in the US media is about AIG having essentially run through all 100 something billion dollars provided to the company by the fed in emergency lending. Both the Washington Post and New York Times were running stories on this as well as some others. The details are not clear but it appears that the bulk of the rescue package was wasted by the group on posting more collateral on its troubled credit default swaps. Derivative contracts are at the heart of the group's meltdown.

When AIG went down, the Economist said that one of the great mysteries had been resolved, namely who was taking on the risk banks and investors were shedding so massively in the recent years. At the peak of the boom the spread between the t-bonds and private bonds has shrunk to a mere shadow of its former 3%, as the bulk of private bonds had been underwritten by somebody. AIG collapse has prompted some like the Economist to say that they saw the light and know the answer.

However that was a double sided mystery. Its other side was the existence of an absolutely huge CDS market exceeding the size of the whole US economy. This means that however well everything around was underwritten in the recent years, the actual amount of CDS contracts by AIG and its likes should be even bigger. Another thing is that the enthusiasm of AIG, Lehman Brothers and others for CDS contracts should have been equally matched by the enthusiasm of their counterparties to these contracts. Who are they and where most of this stuff is hiding now should be another mystery of our time. On several occasions defaults were accompanied by claims that surpassed the value of actual assets by orders of magnitude. This points to the possibility that a significant portion of these contracts are a pure speculation by those who were smart enough to anticipate the incoming crash. Unfortunately neither article has any information to share on who are the counterparties to the AIG CDS.

Back to the rescue package, one question that sure troubles many now is how much of the financial system can be salvaged and if beyond the escalating debts and deficits, the massive rescue packages unleashed by the fed and Treasury are actually achieving something. The Economist claimed that a catastrophe has been averted, but many are begging to disagree saying it was only delayed. It may well be the case that the props provided by the fed and treasury to financial institutions have only served to suspend the system in an uncertain situation of neither full bankruptcy nor really functional state the AIG style. The regulators may hate to consider more radical approaches such as collapsing the bulk of the financial system in a controlled manner, or taking some drastic action on all these credit default swaps and their friends, up to annulling a good part of them altogether by decree, but the currently adopted methods of prolonging this agony indefinitely are risking to spread it over the whole next decade, turning it into one to be wasted in a slow and painful stagnation.

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