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How did Lehman manage that ?

Robert Waldmann

A commenter over at naked capitalism notes that

$110b of senior LEH debt went from trading .95 to .12 in a matter of days …. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.

Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.

Now I may be crazy, but I think that the idea that accounting fraud is required to achieve this is old fashioned and out of date. I think it can be achieved without breaking the laws, such as they are.

Lehman could have made their senior debt worth 12 cents on a dollar in case of default by selling CD insurance on their own debt — lots of it. This would not require any false accounting as they are not required to report this fact.

Now I would be reluctant to believe that a bank could insure its own debt if it hadn’t already happened .

The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.

Who would buy a CDS on Lehman from Lehman ? Only a fool ? Well I have another candidate — someone who had bought lots of cash settlement CDSs on Lehman debt from a third party. The payout on a CDS depends on par value minus settlement value. A huge amount of Lehman insurance of Lehman is not very useful to someone who wants to hedge, but it is very useful for someone who wants Lehmen to settle for as few cents on the dollar as possible because, he or she has bought Lehman CDSs from a third party.

Now to Lehman, insuring their own debt is a very very attractive proposition. It is money for nothing unless they go bankrupt and if they are bankrupt well they are bankrupt. The whole source of moral hazard and adverse selection in credit markets is that it doesn’t matter to the debtor how much he goes below zero.

A positive price for Lehman insurance of Lehman makes sense (algebra will be after the jump when I type it up). There was money to be made at the expense of holders of Lehman debt who didn’t think of the possibility of over-insurance.

Is this what happened ? I have no idea, but I guess we will find out fairly soon.

update: My claim about reporting requirements has been contested. I should stress *again* that I am not an expert and add that I know jack about accounting standards.
I have learned a lot from comments here and at crooked timber. I reply at tiresome length in comments at crooked timber and at my home blog.

As far as I can tell firms must report the total fair market value of CDS written as liabilities, but this is not what matters to bond holders. To them liabilities matter only to the extent that they cause bankruptcy and/or affect the value of liabilities or assets in case of bankruptcy. Knowing the expected value of a liability which is worth zero the 99.9 % of the time in which bond holders just get interest and principal and a whole lot the 0.1% of the time in which Lehman brothers is liquidated is of little use to bondholders. Also, as John Quiggin notes, accounts are not published continuously and our latest information on Lehman Brothers appears to date from May 31 2008 which was a while ago.

First a CDS on LEH issued by LEH is definitely not worthless. It can’t possible pay out as described in the terms of the contract, because it only pays when Lehman defaults, but it can pay its stated value times the cents on a dollar payout ratio found by a bankruptcy court. Even in the case of LEH,this will be positive.

Now algebra. I will assume all debt is equally senior. The par value of LEH debt is 1 (for simplicity). They go under with assets equal to y (which must be less than 1 for them to be bankrupt). the payout ratio phi is equal to assets over total liabilities. However the liabilities are not just debt. They include self CD insurance for x units of par which, in theory shold pay x(1-phi). Actual payment on the CDSs is .

phi is given by
1) phi = y/(1+x(1-phi))

Note that phi is not zero, so the CDS has positive value — you don’t have to be crazy to buy it.

This gives a quadratic equation with one solution to phi between 0 and 1

2) phi = (1+x – ((1+x)^2-4yx)^0.5)/(2x)

phi is definitely real and positive. 2 can be rearranged to

3) phi = (1+x – ((1-x)^2+4(1-y)x)^0.5)/(2x)

And y
taking a first order approximation alpha is approximately equal to

4) phi is roughly equal to y/(1+x)

Which is positive.

So total payouts on CDSs are

5) x(1-phi)phi= xy(1+x-y)/(1+x)^2

And the ratio of the payout to the face value is

6) payout/x = y(1+x-y)/(1+x)^2

oh this is odd. take the derivative of the payout/x with respect to x

7 d(payout/x)/dx = y[(1+x)^2-2(1+x)(1+x-y)]/(1+x)^4 = y(2y-1-x)/(1+x)^3

So the payout per unit of self CDS increases in units of self CDS outstanding until the number of units, x is equal to 2y-1. For LEH senior debt, imagine the accounts were accurate (as far as they were supposed to go) and y = 0.95, the value of LEH self insurance would increase in LEH self insurance outstanding until the amount was equal to 90% of total LEH senior debt. That seems to me to be an unstable market.

Now how high would it have to go before it stops making sense to buy CDS from LEH ?

Well that depends on the price doesn’t it. If normal investors like Janet Tavakoli won’t touch it, the price could be very low, say one tenth as much as third party insurance. That would make it optimal to a price taker so long as alpha is greater than 0.1. Obviously I chose 0.1 out of my hat, because it is close to current market estimated phi of 0.12.

Could this have happened ? I don’t see why not. As far as I know it was all legal and profitable to both parties in the contract.

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Financial Arsonists ?

Robert Waldmann

Many people are using the term “arsonists” as a loose metaphor for people who share the blame for the current financial crisis. They aren’t suggesting that anyone actually wanted a financial crisis. Cocking my tinfoil hat I will note that it is entirely possible that someone has been making out like a bandit — and might even be one (as far as I know almost legally). I stress as I have in these posts that I am ignorant and might be totally confused.

I remember when arson was a big profit center in New York. Many buildings in crime ridden neighborhoods were grossly over-insured, so, in case of fire, the owners received much more than the value of the building. Oddly there were many many fires.
The burning of New York was brought under control when the over-insurance was eliminated.

Currently, credit is a bit over insured. The amount to be paid if all insured debtors default is over $ 50,000,000,000,000 which is much greater than the total face value of insured credit.

Now the most likely explanation for this is that credit default swaps are an unregulated form of gambling which appeals to arrogant people who are convinced that they can beat the market — that they are side bets by people with different optinions on the probability of default or, more likely, future assessments of the probability of default.

However, over-insuring against risk can be very profitable.

Consider the partners of a partnership Bandit, Arsonist and Thief. What if they buy 2 dollars of credit default insurance on their bonds for every dollar of equity (note no regulation no disclosure requirements) then enter chapter 11 ? They make out like bandits. Now entering chapter 11 for no good reason creates suspicion, but, if you want to go bankrupt there are always people eager to help.

Or how about an evil banker who buys credit default insurance on a client firm having some difficulties then calls its loans and shuts off lines of credit ? I’d say there are a fair number of bankers who can force a fair number of firms to default.

Finally best of all, how about Bandit, Arsonist and Theif’s banker ? Working together they can create a cash flow problem, a chapter 11 filing, a big payout and a workout so Bandit Arsonist and Thief keep their firm and make out like bandits.

Unregulated insurance is a license to steal.

Does this explain the odd behavior of Bernanke Paulson and the Big Bad bankers ? Bernanke and Paulson have been arguing that they have to entice banks into agreeing to a bailout. Huh ? Could it be that the banks in question have bought so much credit default over-insurance that if one of them fails the total capital of all of them increases, because the disruption would be less than the value of over-insurance ? Or how about officers of the banks whose wealth is in blind trusts ?

Now a lot of these credit default policies will never be paid up, because the insurer will be bankrupt, but a lot will be and there is no limit (of which I know) on how much banks and their officers can legally buy and they can afford a huge amount.

Recall Ben and Hank have opened an $85,000,000,000 credit facility for AIG. Is it possible that, in the absence of the bailout, all of that money will go to owners of AIG credit default swaps ? Can the US Federal Government really put a subsidiary into chapter 11 ? If that is inconceivable the logic would be “better to pay 700 billion for stuff worth 650 billion than $85 billion for nothing.”

update: I am trying to follow the White House meeting bailout circus. It is obvious that McCain and the House Republicans kicked over the negotiating table proposing a magic free lunch plan at the last minute so they can vote no on an unpopular bailout and claim they could have saved the financial system a not cost. It is clear that McCain is an unpatriotic totally selfish reckless egomaniac. In fact, I doubt that Paulson is used to dealing with such a totally selfish reckless egomaniac given his background as an investment banker (and I never expected to write that).

However, it took me a while to figure out just how flaky the House Republican pony plan is. Of course they want to cut the capital gains tax and deregulated more (I think they didn’t put in drilling in ANWR or threatening to bomb Iran). However their main idea is that what the US financial system needs is *more* credit default insurance, since $ 50 trillion isn’t enough !!!

On Thursday, a small group of conservative House Republicans — including Texas’ Jeb Hensarling and Virginia’s Eric Cantor — offered their own alternative to the Bush proposal. Focused on mortgage insurance, the one-page alternative plan was presented to reporters at a briefing.

The plan calls for the U.S. government to offer insurance coverage for the roughly half of all mortgage-backed securities that it does not already insure. The Treasury Department would charge premiums to holders of the securities, under the plan.

OK now explain to me how that would have saved AIG ?รน

I don’t know if financial arsonists are a significant factor in the crisis, I don’t even *know* that any exist. However, there is no doubt that political arsonists are a huge problem.

update II: Look I’m ignorant. I don’t know anything about new financial instruments. However, I can’t manage to find any reason to doubt that the House Republicans’ plan would destroy the US financial system. If all mortgage backed securities are insured by the US government, which will not go bankrupt any time soon, many many agents will be over-insured so that they would benefit from defaults and some will be in a position to cause defaults. They will have to cause huge transfers among private agents and huge financial distress costs in order to get their public money and that won’t stop all of them.

Also, as with buying assets, the problem is the price, in this case the premium. If it is vastly less than the probability of default, the House Republicans have found a way to throw money at bankers and financial arsonists instead of just bankers. If it is actuarily fair, it will force liquidity constrained firms to unload the securities — they could wait and hope for no default, but they can’t pay actuarily fair premiums. When you are insolvent, risk, variance, double or nothing is your only hope of survival. Thus aside from the contribution to financial arson (which I guess will be huge) the plan would also force distressed banks etc to unload mortgage backed securities at fire-sale prices. Now I don’t think the current problem is mainly due to systemic margin calls due to mark to market and capital requirements, but making that problem vastly worse would hasten the collapse of the US financial system even without financial arson.

Vladimir Lenin is kicking himself in his grave for not thinking of such a simple way to destroy capitalism.

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If Warren Buffett can do that why can’t we X 100 ?

Robert Waldmann’s Pony Plan.

This plan is modeled on Buffett’s deal with Goldman Sachs. It is also based on arguments by Doug Elmendorf and Luigi Zingales. I may show how good ideas from smart people can be sliced and diced to make toxic foolishness.

One reason the deal had an impact is that it was a signal that Buffett thinks that Goldman Sachs was, at most, $ 5 billion in new capital short of sound. The remaining banks in trouble are less sound (I assume Buffett knows what he is doing) and those who participate in my plan will be the least sound banks.

That said, I think that a lot can be accomplished by issuing new preferred shares to the Treasury.

I’d say the deal is
1) banks can issue preferred shares to the Treasury worth up to 1% of their total assets.
2) These shares pay a 10% annual dividend.
3) the Treasury gets an equal number of warrants to buy common stock at its price as of when the bill passes.
3) At any time t, the bank can buy back any or all of the preferred shares for the original price plus interest equal to 2% per year plus the linearly interpolated average of the treasury bills issued when this bill passes and maturing just before and just after t
4) While any of the preferred shares are outstanding, for each employee, consultant or person who provides any service for pay, the bank must transfer to the treasury the greater of $0 and half of the difference between that person’s total compensation and $ 400,000.

Why would this work? The new equity would improve banks’ capital ratios. Given the law as it is and should be, capital is assets minus debts and equity doesn’t enter.
The risks to the Treasury are 1) that the bank will fail and 2) that it will never pay dividends so the preferred shares are worthless.

Probably, few banks would pay the huge dividend, therefore they would not be allowed to pay dividends on common stock. The 10% dividend is a price the bank has to pay to the treasury for the privilege of paying dividends on common stock. Even the most impatient shareholder must understand that it would be better to buy back the preferred stock first. Thus, while wholly voluntary and using a standard instrument (preferred stock) the plan would discourage banks from paying dividends causing them to build up capital.

Clause 4 is not populist vengeance. My guess is that even investment bankers trust each other enough to keep track of unofficially assigned bonuses, so that when they are finally free of the preferred shares, they will get bonuses based on performance during the period clause 4 applies. This has the effect of making officers of banks loan money to the bank when the bank really needs money. It also penalizes them for not repurchasing the preferred shares. In particular, informal promises to pay are attractive to corporate predators who profit by violating implicit contracts. The combination of no dividends on common shares and implicit debts to managers would make the banks very attractive takeover targets. This would create an incentive to buy back the preferred shares.

The 2% extra interest which must be paid no matter who is secretary of the treasury is partly to cover the losses from banks that fail and partly to get all that the market will bear for the Treasury.

The phrase Pony Plan TM belongs to Atrios. Illustration after the jump.


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The Buffett Buffer

Robert Waldmann

Major financial crisis news.

Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett’s company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.

Look $5 billion is not just a vote of confidence.
Goldman Sachs is in good shape *now*. Goldman’s balance sheet just improved, because they have $5 billion more in assets and no more debt (Buffett bought equity).

update: I should have noted that $ 5 billion increases G-S total equity by about 10% as you can guess from the details of the deal.

Goldman Sachs
47,563.75 Market Cap(Mil)

That would be about 0.5% of total assets.
hardly just a pat on the back.

Via Kevin Drum

Rabid Buffett envy below the fold. I did say there was a killing to be made saving banks.

My guess is that he will make a killing (again) as G-S equity was already underpriced (panic you know) and is now worth more, because of him.

And what a deal he drove

The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on “perpetual” preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05.

Wow 10% plus warrants. Now G-S won’t go bankrupt, as they have no legal obligation to pay a dividend on the preferred shares, but they can’t pay a dividend on common stock until Buffet gets his $500,000,000 a year.

OK so now Morgan Stanley. They are probably in worse shape than G-S but I’m sure a deal can be made. Problem is that there is no one with as much free cash as Buffett and as much brains (maybe or not and). Still I think he might tell his friends Bill and Melinda that there is money to be made saving Morgan Stanley from itself.

If there not interested Morgan Stanley’s hopes of independent survival are Slim.

My guess is that he looked at the killer deal Ben and Hank made with AIG and said to himself “I can do that too”.

This also relieves Paulson’s conflict of interest. I wonder if his attitude will change.

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Credit Default Swaps Again

by Robert Waldmann

My post on “what the hell are credit default swaps for” got lots of comments and I learned a lot from the comment thread.

I continue my effort at remedial education via blogging.

First a very simple article by Martin Hutchison

Does this guy know what he is writing about ?

Key quote

Banking regulations and the lack of funding requirements for CDS: Banks are required by law to hold a certain amount of capital for loans they make – about 8 cents for every dollar in principle, but there are a number of loopholes that allow it to be less for certain types of loans. But there are very limited capital requirements for CDS, so banks and other CDS market participants can take on much more credit exposure through CDS than they could directly.

Oh my. So entities which are not allowed to invest in bonds other than high rated bonds can do that by buying credit default insurance from a firm which absolutely won’t be able to cover a wave of defaults. Craaaaaaazy

In my state of pure tabula rasa ignorance, I have been googling and I haven’t found anything on US regulation of CDSs. However, European banks warn that they won’t be able to keep up with US banks if they are regulated

Banks oppose plan to raise capital requirements on CDS

SIFMA Global SmartBrief | 09/10/2008

The European Commission’s proposal to increase capital requirements on instruments, such as credit-default swaps, is facing heavy opposition from the financial industry. SIFMA and the European Securitisation Forum, an affiliate of SIFMA, were among a group of banks that issued a letter saying the plan’s “fundamental flaws” will hurt risk management and put a crimp on financing. “It will damage the competitiveness of Europe,” the groups said in a letter to Charlie McCreevy, European commissioner for internal market and services. Bloomberg (07/17)

Poor boring European banks can’t have all the modern with it US excitement. If that is a smart brief I sure don’t want to read their dumb briefs.

I am trying to find out what CDS exposure does to a firm’s credit rating.

Unsuccessfully trying.

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Fannie and Freddie Capital Requirements Lowered in March

by Robert Waldman

I missed this at the time.

* MARCH 19, 2008

Fannie, Freddie Lending Power May Rise

The regulator for Fannie Mae and Freddie Mac is expected to announce a plan this morning that will give the government-sponsored mortgage investors more scope to prop up the home-mortgage market.

The plan involves a reduction in capital requirements for the companies and a promise by them that they will each raise several billion dollars of capital this year, likely through a sale of preferred shares, according to several people familiar with the situation. As a result, they are expected to be able to provide additional funding of as much as $200 billion for home mortgages and related …

That was bright. Now I know that Fannie and Freddie aren’t the heart of the problem, but McCain claims otherwise. I wonder why he had no problem with this one (actually I don’t think he knew about it either but he’s the one who says he knows how to solve the financial crisis).

Via OptionArmageddon who called it right at the time.

Oh and remember, I found this photo for Paul Krugman

banking regulators and bankers

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Paulson’s Skin in Paulson’s game

Henry Paulson promises that he will spend the 700,000,000,000 of our dollars over which he wants total control wisely. I say he be required to put his money where his mouth is. Ask him how much he expects them to be worth after he has spent them on mortgage backed assets and tell him he pays 1/1,000 th of losses beyond that up to 10 million (he has them) and gets 1/1,000 th of all profits (that is if we end up with more than $ 700 billion he keeps one one thousandth of the difference.

He would get even paler if his money were on the line.

Also, I think if any firm sells stuff to the treasury, the officers of that firm should be required to put up 1% of the money and get 1% of the revenue generated by the assets their firm sold and 1% of proceeds from sale of those assets.

That way, if they are good stewards of their shareholders wealth, they will still dump their worst junk on the treasury (and pigs will fly). Otherwise they will try to unload at fair value (if they make a profit they get sued. If they make a loss for the treasury they hurt their pocket books).

over at dailykos you can vote on this proposal.

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Toxic Sludge Inc

There are three reasons that the give Paulson $700,000,000,000 to play with plan might save world finance

1) the value of a pool of all the mortgage based assets is easier to determine than the value of particular assets — making a huge pool of all the toxic sludge will cause it to melt, that is be liquid (check the metaphor is not mixed).

2) If all claims on a mortgage belong to one legal entity, that legal entity can renegotiate the terms of the mortgage and avoid foreclosing. This is often good for creditors as a group, but when they are many, each one benefits if the others renegotiate and he she or it demands full payment. Thus reassembling sliced and diced mortgages will reduce the number of foreclosures with associated legal costs, delays and distress sales of foreclosed properties.

3) by paying more for mortgage based assets than they are worth, Paulson will re-capitalize banks and insurance companies.

Paulson obviously doesn’t stress the third aspect, and, to the extent that he admits it might happen, would like to present it as an inevitable side effect of the first two.

It is not at all. All the gain in liquidity and ability to renegotiate which can be achieved with toxic sludge pool belonging to the treasury can be achieved with a new private entity toxic sludge inc whose shares belong to the banks that contributed the sludge.

If we want to give Paulson a huge amount of authority, we can let him negotiate the price in shares of toxic sludge inc for particular assets. That would be crazy of course, but not as crazy as letting him spend our money as he pleases.

I think a reasonable plan is to require all banks and insurance companies to pool all their claims on mortgages in exchange for shares proportional to the most recent market price. The revenue from the mortgages pays them dividends, people can buy and sell shares of toxic sludge inc which is easy to price as it is a claim on a huge pool of mortgages some of which were reasonable business propositions to begin with.

Now a problem with this approach is that with an accurate valuation of shares of toxic sludge inc. many banks will be obviously insolvent (they are already but it isn’t obvious).

That is a separate problem — recapitalizing banks. That can be done by having the treasury buy an equity stake (as proposed by Doug Elmendorf) so that the treasury shares the upside as well as the downside.

More arguments after the jump.

One problem is that mortgage based assets are currently illiquid, because no one knows what they are worth, and, especially, because their current owners have a better idea than possible buyers. They are hard to price in large part, because the underlying mortgages are varied. To own a claim on the proceeds of liars loans is not the same as owning a claim on mortgages whose borrowers documented their income. Current owners don’t know as much as they should, but they know more than non-bank investors. Thus there is a market for lemons/adverse selection problem. The solution to adverse selection problems is a mandate. All mortgage based assets must be sold to participate (or x% of such assets on the books of participating firms). This was obvious to my dad and Mark Kleiman , who are real smart but not economists. I’d say that participation in the scheme can be voluntary, provided that participating means selling all or a multiple of the portfolio of mortgage based assets with no picking and chosing. Non participating financial institutions are not likely to survive long.

Paulson proposes solving the problem by having the treasury, which has poor information perverse incentives and no accountability, buy the assets for inflated prices. That is a huge transfer from the public to shareholders and officers of banks.

A huge pool would be easier to price as the nationwide mix of securitized mortgages, bad as it is, produces a revenue stream which is relatively predictable.

Now recapitalization is all well and good, but normally the people who put up the money get an equity stake in exchange. Recapitalizing by having people deliberately make bad deals on behalf of the public is first a transfer and second a way to guarantee corruption (even if you don’t count it as corruption in the first place).

There is no logical link between pooling mortgage based assets and nationalizing them. The only point of creating that link is to privatize public money.

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What is the point of credit default insurance ?

I stress again that I am technically an economist, but I have focused on everything except for money and banking (OK everything but money, banking and Neo-Austrian theory) so I am ignorant on this topic.

I am interested in understanding why financial innovation is profitable. I can think of two key reasons for new instruments. One is that they make risk diversification possible, the other is that they enable regulated entities to evade prudential regulations.

I would tend to guess that the second is the more important.

My thoughts on Credit default insurance.
1) You can hedge against default on bonds by buying a diversified portfolio of bonds
2) Prudential regulations do not take account of this fact, but rather include restrictions on total assets as a function of capital and on the types of assets which entities can own.
3) Credit default insurance makes it legal for regulated entities to own bonds whose rating is low.
4) it is no more effective in avoiding risk than is plain diversification, because a nationwide crisis will bankrupt the insurer.
5) it exists as a means of evading prudential regulation.

If I am right, the smart guys on Wall Street are similar to smart corporate lawyers who made their money by finding ways of evading regulation. That lowers my opinion of them (I thought they were partly gambling and mostly fleecing individual fools who should blame themselves).

Thoughts on other innovations after the jump.

Does anyone else remember when money market funds were new ? Anyone else vague on the difference between a money market fund and a money market account ?

Now I understand that the point is that, theoretically (and not just theoretically any more) the balance of a money market fund is a number of shares each of which is always (almost always now) worth exactly $1, but which does not have a guaranteed price.

Thus, it seems to me, the balances do not count as liquid liabilities of the banks (deposits) for the purposes of reserve requirements, and the assets (commercial paper IIRC) does not count as an asset of the bank. Officially, the bank is just like a broker.

However, the instant that there is a significant risk of breaking the buck, the treasury jumped in to protect them.

The Treasury also said on Friday that it would siphon up to $50 billion from a fund established in the 1930s to conduct foreign exchange market intervention to backstop the rattled U.S. money market mutual fund industry.

This long-safe corner of financial markets, home to some $3.5 trillion of deposits, has increasingly appeared at risk of falling victim to the year-old credit crunch. Money market fund assets dropped by a record $169.03 billion in the week ended September 17 as jittery investors pulled money out.

The Treasury said it would back money market funds whose asset values fall below $1 a share. Separately, the Fed said it would lend money to banks to finance purchases of certain assets from money market funds

This means that banks have avoided paying dues to the FDIC and relaxed capital and reserve requirements in exchange for … an empty threat, since money market funds are too big to fail.

What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ? If the original pools were already well diversified, they would be almost perfectly correlated so all tranches of the pool of pools would be middling risky (mezzanine). Were the original pools poorly designed or was the aim to get an AAA rating for a risky asset ? Even assuming the bond rating agencies are honest, they must work according to rules. I think it very likely that everyone knew that the senior tranches of pools of pools were risky (they paid higher than standard AAA rates) and that entities which weren’t allowed to buy risky bonds didn’t care.

That this was not a way of diversifying risk but a way to evade prudential regulations.

I suspect that financial innovators not only undermined the US financial system, but did it on purpose, creating instruments whose only role was to technically comply with prudential regulation while making a crisis inevitable sooner or later.

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More on the McCain Health Care Plan

I have posted a deliberately unsophisticated discussion at my other blog

After the jump, I try to add something to Tom Bozzo’s post below (which you should read first because he actually knows something about the issues).

Here I take as fact Buchmueller et al’s assertion (as summarized by Bozzo but at least I admit it) that a typical family health plan costs employers $12,000 and a similarly generous plan costs $14,000 on the individual market.

I think about how employers might respond to the McCain plan.

First I’m sure many will just keep on keeping on providing health insurance to employees with the same limited range of options (maybe one size fits all, definitely “no thanks, I’ll get mine on the individual market” is not an option). The plan will simply be a tax increase for their employees*. I think the McCain team sincerely thinks this is no big deal, because they think tax treatment is the real reason for employer provided health care, so they assume few employers will be so dumb and no one will want to work for them unless they increase wages to bear the cost of the tax and that would drive any really stubborn firm bankrupt.

Basically, I think they assume that either employers will have nothing to do with health insurance or, at least, they will give employees the option of taking the benefit as cash instead of health insurance.

I think that this is about the same thing, to a rough approximation. The advantage to insurance companies of selling insurance to employers is that the employees don’t have a choice and so the insurance companies don’t have to market or, more importantly, worry about adverse selection. I think that, quickly if not immediately, insurance formally provided by the employer but with an opt out, will vanish as the important lasting difference from the individual market will just be the $5,000 credit.

OK so why did I slip in the weasel word “lasting”. Well given how scared people are of the individual market, I think it would take a long time for the more healthy to all opt out of employer provided coverage, so the adverse selection in the employer provided pool will only slowly become as severe as that in the individual market.

So I claim an either/or either a lot of people will have employer provided insurance whether they want it or not, so the plan is a tax increase on them, or the plan will, for practical purposes, eliminate employer provided health insurance.

Now, assuming the extra $2,000 calculation is accurate, where does the money go ?

I’m sure only a small part of it goes to health insurance company profits. I would guess that the individual health insurance market is quite competitive and the profit rate, while probably higher than in group markets due to bargaining power, is nowhere near 28% of sales higher.

Some goes to increased marketing administrative and screening costs and amounts to pure inefficiency.

Some goes to the free riders who get a (partially) free ride. That is the other side of adverse selection is that some healthy people benefit by not having insurance. If they are insured they subsidize the less healthy. If they are not they get some health care without paying for it (if they go bankrupt or if the provider gives up on chasing after them to pay the bill).

If Buechmuller et al are right then, there is another either/or.

Unless the McCain plan increases the number of uninsured, it would cause the US to waste about $2,000 per family that currently has employer provided coverage. Not as huge a waste as the Iraq war but well over $100,000,000,000/year (way more than total earmarks which aren’t pure waste).

The actual waste will be lower as part of the cost to (employers + the treasury + the insured) will be an increased transfer to the increased number of free loading uninsured. It will also be lower as some people will stick (or be stuck) with employer provided insurance with no opt out and so they will just pay more in taxes.

But the plan is partly a tax increase, partly a windfall for freeloaders and partly increased waste.

Importantly, the McCain supporters argument that the plan will benefit tax payers is based on assumptions about responses such that it will reduce tax revenues. It is typical Republican logic to assume that cutting taxes gives benefits to taxpayers at no cost to anyone ever, but it is still nonsense.

Now what is the logic of serious economists who helped design the McCain plan (Douglas Holtz-Eakin is, for all I know, not the only serious economist on the McCain team, and he is serious or, at least, he was, when they were working on the plan).

The argument is that, on the individual market, people will purchase plans less generous than the one they get from their employer. That their having skin in the game will make their health care consumption choices more efficient and that this outweighs the increased costs of marketing, administering and screening. Basically I find this argument absurd, because it if it were true one would imagine that the US health care is more efficient that that of other developed countries and it obviously isn’t. But that is very crude data. To get more micro (much more micro) I suspect that underuse of health care (statins, oral anti-diabetics, insulin, anti-hypertensives, antacids that actually work and prevent ulcers, cancer screening etc etc etc) is more costly than overuse (even though the cost of accelerated morbidity is just interest on the cost of people getting deathly ill as most do before dying). Experimental evidence (the RAND study) suggests that copayments reduce demand equally for necessary and un-necessary treatment.

* and update: I was totally confused about the McCain plan. Sorry. Should have done my homework. If one still gets insurance from one’s employer, the change is pay income tax but get the $2,500 or $5,000 for a family. For most people, this is a tax cut. It is a tax increase only for people in the 33% bracket (over $200,000/yr if married filing jointly) with more costly than average insurance. The way McCain manages to cut almost everyone’s taxes while giving a lot to those with low incomes and/or without insurance is by adding 1.4 trillion More to the 10 year budget deficit.

He’s addressing the problem by throwing money at it.

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