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Credit Crisis for Kindergarteners

Credit Crisis for Kindergarteners at Interfluidity.

David Leonhardt notes that it’s pretty hard to explain what’s going on in the financial world these days (ht Felix). Here’s how I’d tell the tale to a child:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn’t like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn’t like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn’t looking.

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They’ve each promised to give away some marbles too, but they don’t think about that, they can keep their promises later, after they’ve had time to play with what’s coming. For now, each is eager to hold all the marbles they’ve been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, “That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me.”

But there are still only 10 marbles.

Suddenly, when Bob doesn’t want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue’s broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem. Spoons are placed where forks should be, and saucers used for dinner plates, because Alice really is hopeless in the kitchen. Mom is cross. Dad is cross. Everyone is cross. “But you promised,” is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now the lawn is overgrown, broccoli rots on mismatched saucers, and no one trusts anyone at all. It’s all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is…

I love parables. The rest is at the Interfluidity.

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US trains extremists

“It is long time past that one important piece of fantastical rubbish be finally sent on its way: this is the idea that neo-cons maintain some kind of fastidious ethic and theological democratization when it comes to who they’re willing to work with on killing people.” -rdan, March 20, 2008

The US plays the ‘game of houses’ with determination, some skill, and lots of resources as every power has. We as an electorate do like to believe we are also enlightening and freeing others. Sometimes we actually do.

The US trains and funds extremists to send into Iran. But I also remember other places closer to home. And it was not to free people.

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Iran trains extremists

Al Qaeda in Iran July 16, 2007 on Michael Totten’s site.

“It is long past time that one important piece of fantastical rubbish be finally sent on its way: this is the idea that Islamists maintain some kind of fastidious ethnic and theological separatism when it comes to who they’re willing to work with on killing people.” – Noah Pollak, July 16, 2007

True or not in the aggregate? True or not in particular to certain entities?
Paskistan and Iranian intelligence work together on some things. Kashmir rebels sometimes vet candidates that go to Pakistan. Saudi Arabia helps first the part of the royal family in charge, and many others. Syria, Hizbullah, Hamas can live together sometimes.

So what is the question our answers want to fit?

Update: I am asking a question, links required, and am not sneaking in a hidden answer. If I wanted to say McCain was right, I would. What do you know about terrists?

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Inflating pizza costs…

The BBC had a note about food prices rising.

And given that global wheat prices are so high, it is tempting for farmers to borrow more in their hope that their gamble pays off with a bumper harvest.

“It really is back to the bank manager,” says George, explaining how that conversation will now go: “‘OK, this is THE crop. Everyone is talking it up. Let’s have a go at it.’

“But it’s borrowed money that’s doing it. And if it doesn’t come off and there are too many more [poor years], then you have to sell the farm.”

But who is going to buy the farms?

“There are already two or three farms in the district which are up for sale and should have been sold. But people just don’t have the money to buy them,” explains George.

With global wheat prices at record highs, one bumper crop would alleviate much of the financial burden and help many local farmers pay off their debts.

But their hopes have been dashed before.

Last year saw one of the best starts to a growing season for years, but dry weather in recent weeks has forced the Australian government to slash its crop forecasts by 30%.

It struck me that unlimited credit expansion has an appeal because it will be successful for awhile, even a few years for the players, but HAS TO fail in any one year when market forces somehow come together to restrict the three laws of unlimited credit expasion Old Vet proposed.

Farmers gamble also, but the market has more limits and is not as elastic. But farmers also fail sometimes. There is just no glamor, and the pizza you order is pretty mundane looking…unless you can’t get one.

If you are going to invest, take a look at CommunitySupported Agriculture (CSA’s) to take on a portion of the risk to feed your family. It might even be healthier for you. There are two locally I know of, but you need to look around in your own locality.

And why is it farmers have no status?

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Old Vet looks ahead for more action

Trying to get beyond today’s headlines, and the moves and countermoves in today’s markets, is difficult. However the future beckons, and it’s looking a lot more “deflationary” than “inflationary” which is the exact reason the Fed is throwing around the power of the “lender of last resort.” Don’t want a Depression, do we?

The great de-leveraging of 2008 continues, in which credit market expansion reverses due to excessive credit extended to a myriad of parties who now have trouble paying. One aspect that is now rising to prominence in the banking and non-banking financial world are financial derivatives and counterparty risks borne between parties like banks, hedge funds, brokers, and securities dealers.

In 1996 the US banking system hardly knew derivative financial instruments, but these have proliferated through the following decade to the present day. Think of “vanilla extract” or condensed essence of the vanilla bean. Vanilla extract is the kitchen equivalent of financial debt derivatives to their underlying financial products such as mortgage debt, automobile debt, credit card debt, corporate bonds, interest rate contracts, foreign exchange contracts, over the counter or listed contracts of various kinds. Most derivatives are not traded in public markets but sold in private deals, which makes them hard to track and to evaluate.

Notional values are not actual cash values. The premise of derivatives transactions is that a small amount of real cash can be used to gain exposure to a large amount of notional dollars. Hence the leverage. The movement in the notional values ultimately determines the profit or loss of the underlying derivative contract. Therefore the cash risk exposure of the banks listed below indicate RELATIVE rather than absolute cash exposure.

Trillion $ of notional derivative exposure

JP Morgan $91.7
Citicorp $34.0
BofA $32.1
Bear Stearns $13.4
Morgan Stanley $7.1
Wachovia $5.2
Merrill $4.6
HSBC $4.4
Goldman $2.0
Wells $1.0
Bank Of NY $1.0
Lehman $0.7
(10-K data)

In the US banking system, exposure to financial derivatives proliferated but was then reduced by “laying off” or sharing risk with counter parties. It is called “bilateral netting.” The rough amount of derivatives laid off to counterparties rose from 45% of derivatives in 1996 to 85% in 2007. Thus counter party risk is the issue in the mysterious world of derivatives. How solid are your counterparties?

Bilateral netting is essentially the degree or magnitude of financial risk exposure laid off to counter parties. Counter parties such as other banks, perhaps a hedge fund or three, an insurance company, and even a broker such as Bear Stearns. Wait a minute, Bear Stearns? One and the same.

The financial derivatives world is held together by three critical assumptions:

1. Always available liquidity (meaning plenty of cash in the hands of buyers),

2. 100% solvency of counter parties (meaning capacity to pay debts), and

3. A continuous market (no freezes, breaks, or discontinuities please)

Oops. All three of these assumptions have been violated recently in one degree or another, and the Federal Reserve Bank has stepped in.

Up until now we have seen many a “temporary” liquidity or asset swap action on the part of the Fed. Next up in this ongoing chain of events should indeed be some type of Fed sponsored monetization (the true printing of money, so to speak, which really has not yet occurred in its most pure form and in magnitude). As of today, the money printing sequence has not yet blossomed in full form as apparently the Fed is scared of nearer term dollar and global commodity price consequences. That may be changing if “runs” on financial institutions continue, as they must in order for the great Credit Cycle to turn towards less leverage.

Consequences ahead? Maybe a bailout fund, or using Fannie and Freddie as bailout funds, or the Fed simply buying crappy financial derivatives and “products.” Replacing them with cash to insolvent institutions, something well beyond merely increasing liquidity (cash) in the system. It’s what markets really want, Big Daddy to come in and take away their cares, and tell them their sins of greed and extravagance will be lifted away.

I really don’t know what that means for stocks, the US dollar, for prices of anything we buy, or anything we sell. But I’m sure that it will become clear if the Fed takes the next step, which is a doozy.

(There are plenty of experts who read this Blog and they should correct me as needed. But people need to look ahead, not in the rearview mirror.)

This one by Old Vet.

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Another viewpoint on Bear Stearns and the FED

Reader sammy sends this link from the WSJ editorials page:

Thebest thing about Sunday night’s Federal Reserve-inspired sale of Bear Stearns to J.P. Morgan Chase is the price. At $2 a share for a total of $236 million, this was less a “bailout” than a Fed-mediated liquidation sale. Bear wasn’t too big to fail after all, though there’s still the issue of the Fed expanding its own moral and financial hazard in the form of $30 billion in guarantees on Bear Stearns securities.

Bear shareholders will essentially be wiped out in this close-out sale, with British billionaire Joseph Lewis alone reportedly enduring paper losses of $800 million on his 9.6% stake. Even on Wall Street, that’s real money. Jimmy Cayne, the Bear Chairman and former CEO who supervised this disaster, will lose a bundle on his nearly 5% holding. This makes the Bear sale different from the Fed-managed Long-Term Capital Management rescue of a decade ago, when investors were left substantially intact. We doubt many bankers will look at Bear’s fate and claim there’s no punishment for financial error.

Bear employees, who hold about one third of its shares, are angry and grousing that they could get more cents on the equity dollar in Chapter 11. Some may even be inclined to vote against the sale, but then they’d have to find a market for that $30 billion in mortgage securities that no one wants to finance.

The hard capitalist truth is that Bear’s most senior managers have mainly themselves to blame. They bought their second or third homes with fabulous bonuses during the good times, and they must now endure the losses from Bear’s errant investment bets. Bear took particular pride in its risk management, but it let its standards slide in the hunt for higher returns during the mortgage mania earlier this decade. There’s no joy in seeing a venerable firm expire, but it has to happen if financial markets are going to have any discipline going forward.

As for J.P. Morgan and CEO Jamie Dimon, remind us to have him negotiate our next contract. He gets Bear’s best assets, including a Manhattan building said to be worth $1.4 billion by itself. Meantime, he gets the Fed to backstop Bear’s riskiest paper. We don’t know the quality of that paper — and we hope the Fed has done its due diligence — but taxpayers are now on the hook for future losses. Some previous Fed officials might have told Mr. Dimon to take all of Bear or nothing at that $2 liquidation price, but Ben Bernanke and Tim Geithner of the New York Fed seem to have been desperate to get a sale announced before markets opened on Monday. Mr. Dimon took them to school.

The Fed is also opening its discount window even further to non-deposit-taking institutions, and for an open-ended amount of lending and mortgage-based collateral. We endorsed this last week as a way of reviving a frozen market in mortgage-related securities. But with its Sunday move, the Fed is going all in. This raises genuine issues of moral hazard. Commercial banks traditionally have access to the discount window — that is, to public money — because they are regulated and have certain reporting and capital obligations.

Will investment banks and securities dealers now have to meet similar obligations if they tap the window? If they don’t, then it’s unfair to the banks that do, not to mention the taxpayers who are lending them the money. Goldman Sachs or Lehman may not want to meet those terms, but they should be asked to do so.

This new risk-taking is an extraordinary expansion of the Fed’s traditional crisis role, and not one to be taken lightly. In talking to central bank veterans yesterday, we were told the Fed has never taken a material loss. Even as a lender of last resort, the central bank has always made sure it had appropriate collateral.

If this latest effort does help to revive the mortgage credit markets, then the Fed’s potential losses may never be realized. On the other hand, no one knows how far housing prices will fall, and steeper declines in home prices will mean steeper losses in mortgage-backed securities. Moreover, if this doesn’t work, Wall Street pressure will build for the Fed to buy up mortgage securities wholesale. This could end up ruining the Fed’s balance sheet, and ultimately its credibility as the lender of last resort.

The Fed is making these commitments under the authority of a Depression-era statute that has rarely, if ever, been invoked. While Congress will tread warily while the financial crisis lasts, hoping the elixir works, you can bet it will eventually investigate this brave new Fed world. Let’s hope the biggest losers are Bear Stearns shareholders, not American taxpayers.

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American Peso


“We want to support your American peso with our strong Canadian dollar.”-Pink Eyes, lead singer for the punk band Fu***d Up

As we all eagerly await the Fed’s decision on what Fed rate to set today, after taking crud as collateral from Bear Stearns on a non-recourse basis, and opening unlimited lending against further crud mortgage backed securities from everybody and his brother except Cactus and me, I have been looking for fresh ideas. Here’s an idea I found on the Web in a comment:

“The banks forgive part of the principal and in return they receive a like percentage share of the equity. Forgive 10% of the principal and own 10% of the housebuy cheap gorilligans island . This wouldn’t help them raise any cash, and the house sale could be years off. So maybe they could aggregate all their equity shares and then sell them to investors. They could call these, say, “Phantom Equity Securitization Obligations,” or PESOs” for short.
“Now, what could these investors do with their new PESOs? Maybe they could sort of dice them up into differing quality levels and sell some sort of pieces of them. They could have say, three different levels and sell their “Pieces of Three,” or POT, shares.”

This one by Old Vet

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This time it is different-honest.

…the 4 most dangerous words on wall street are “this time it’s different.”

If anyone dealing with securitized mortgages believed that because it was real estate, it would never go bad, they should have been fired long ago; after decades in which the norm has been that housing matches inflation, anyone who believed that this time it’s different deserves whatever criticisms we throw their way.

comment by howard
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The yield curve doesn’t matter anymore”—

“There’s no more business cycle.” —

“Taxcuts pay for themselves”.—

“Too big to fail”. —

“Real estate is ALWAYS a great investment.”—

“Deficits don’t matter”. —

and, my personal favorite . . . “Beijing won’t let anything happen until after the Olympics.”

comments by DOR

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(Comments re-arranged for easier reading, all words intact)

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I haven’t done anything wrong

The WSJ online reports the following about our discussion of domestic NSA surveillance:

Largely missing from the public discussion is the role of the highly secretive NSA in analyzing that data, collected through little-known arrangements that can blur the lines between domestic and foreign intelligence gathering. Supporters say the NSA is serving as a key bulwark against foreign terrorists and that it would be reckless to constrain the agency’s mission. The NSA says it is scrupulously following all applicable laws and that it keeps Congress fully informed of its activities.
According to current and former intelligence officials, the spy agency now monitors huge volumes of records of domestic emails and Internet searches as well as bank transfers, credit-card transactions, travel and telephone records. The NSA receives this so-called “transactional” data from other agencies or private companies, and its sophisticated software programs analyze the various transactions for suspicious patterns. Then they spit out leads to be explored by counterterrorism programs across the U.S. government, such as the NSA’s own Terrorist Surveillance Program, formed to intercept phone calls and emails between the U.S. and overseas without a judge’s approval when a link to al Qaeda is suspected.
The NSA’s enterprise involves a cluster of powerful intelligence-gathering programs, all of which sparked civil-liberties complaints when they came to light. They include a Federal Bureau of Investigation program to track telecommunications data once known as Carnivore, now called the Digital Collection System, and a U.S. arrangement with the world’s main international banking clearinghouse to track money movements.
The effort also ties into data from an ad-hoc collection of so-called “black programs” whose existence is undisclosed, the current and former officials say. Many of the programs in various agencies began years before the 9/11 attacks but have since been given greater reach. Among them, current and former intelligence officials say, is a longstanding Treasury Department program to collect individual financial data including wire transfers and credit-card transactions.
It isn’t clear how many of the different kinds of data are combined and analyzed together in one database by the NSA. An intelligence official said the agency’s work links to about a dozen anti terror programs in all.
A number of NSA employees have expressed concerns that the agency may be overstepping its authority by veering into domestic surveillance. And the constitutional question of whether the government can examine such a large array of information without violating an individuals reasonable expectation of privacy “has never really been resolved,” said Suzanne Spaulding, a national-security lawyer who has worked for both parties on Capitol Hill.
NSA officials say the agency’s own investigations remain focused only on foreign threats, but it’s increasingly difficult to distinguish between domestic and international communications in a digital era, so they need to sweep up more information.

There apparently is no oversight of data kept and data used. The NSA is extraordinarily secretive currently. The DOJ also has its own agendas it appears. And the truth-imploda-meter appears to be having a difficult time keeping up with the times. ‘Trust me’ is actually making me quite worried as a reasonable response.

Who is in your wallet or bedroom? Is a Democratic Rove possible? Looking for you when needed.

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Point Counter-point

Reader JPKK says:

JP Morgan Buys a Bear and the Fed Cleans Up the Woods

How did Bear Stearns (BSC) go from planning to report decent earnings for the current environment to being hours away from filing? It all comes down to keeping liquid in an illiquid market.

Last week starting late Wednesday and through Friday BSC experienced a run on the bank when several European banks stopped acting as Repo counter parties, this resulted in numerous institutions beginning to add a premium charge for anyone else who was going to use BSC as part of a transaction the institution was going to be a counter party in, which resulted in more counter party agreements being canceled, withdrawal of credit lines and Hedge funds who used BSC’s prime brokerage business drawing down their balances.

BSC had the weakest liquidity position of the major brokers and couldn’t raise cash fast enough and was rapidly approaching the point where counter parties would likely seize and fire sale collateral, which would have resulted in a massive unwind as others become forced sellers or faced margin calls due to mark to market. Probably the biggest fear of the Fed was what would happen from the massive forced unwind from hedge funds due to the size of BSC’s prime brokerage business.

So the Fed stepped in to try and insure an orderly liquidation rather than a meltdown and unwind that would have spilled over. JP Morgan and JC Flowers showed up, looked at the books JC walked away and JP told the Fed it needed to do something about $30B of assets that JP didn’t want, as no surprise to many apparently a Bear doesn’t just sh*t in the woods it also has a balance sheet for that.

So the agreement they came to was the Fed would take the $30B in assets at a 50% hair cut and make it non-recourse. So there isn’t a $30B bail out, the Fed gave JP a $15B loan for the assets, which was about the fair market value of the assets, for which only the Fed has downside, thus the max bail out is $15B and could end up being $0 in the end, the more probably max down side is a $9B bail out since the estimated fire sale/liquidation value of these assets was $6B. However, JP does have the option to pay off the loan and take the assets back in the future, meaning JP has all the upside on the assets as well.

As to the $2 price that many are claiming is a pittance, its essentially the equity holders being offered the option to collect the saving on legal costs from bankruptcy instead of going through bankruptcy and likely getting $0 down the road. If shareholders reject the deal we go back to fire sale of seized collateral that will in the end leave equity holders underwater.

But Bear’s building is worth $1.8B, and its free and clear…Well bear has $81B in unsecured debt outstanding, and in a bankruptcy proceeding a long list of counter parties and clients it would likely owe even more.

I think in the end this was the Fed doing a good job of ensuring the orderly functioning of financial markets instead of a massive meltdown on technical factors, while not truly bailing anyone out the Fed made sure BSC was liquidated in an orderly manner and offered some protection to the bank willing to take on the risk on short notice.

As to rumors and speculation about when Lehman(LEH) will following those seem to be greatly exaggerated, LEH is twice the size of BSC, has twice the liquidity as a percent, is significantly less dependent on Repo financing ($19B vs $74B outstanding) and has been a better risk manager. Also LEH has the new lending facility the Fed has extended to primary broker dealers to provide liquidity if it there is a run on the broker.

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This one by Reader JPKK

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