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…abandon claims that they had been sold trash

Via Benzinga, L. Randall Wray notes more of the same for socializing the costs of our financial woes:

In truly depressing news, Secretary Treasury Geithner announced he was funneling $2.8 billion more bail-out funds to Bank of America. In the deal, Fannie and Freddie would agree to abandon claims that they had been sold trash in fraudulent “mortgage backed securities” by the BofA. (A similar deal was provided to Ally Financial.)

As I have written, holders of the securities have gradually realized that the securitizations did not meet the “reps and warranties” asserted by the banks that pooled mortgages. A growing number of investors have demanded that the originating banks take back the fraudulent securities, including Fannie and Freddie, as well as the NYFed and PIMCO. But true to form, Timmy prefers to backstop the control fraud banks rather than forcing them to bear the costs of their frauds.

The actual losses that Freddie and Fannie will take on the toxic waste sold to them by Countrywide (absorbed by Bank of America, which is now responsible for the put-backs) will undoubtedly be much larger than the $2.8 billion they received in the settlement. And guess who will suffer that extra loss? You betcha: Uncle Sam. As always, Geithner instinctively socializes losses to protect Wall Street’s private bonuses.

Flashback: How Donald Luskin Earned His Title

Max Sawicky, on his Twitter feed, sends us to this classic piece from Donald Luskin

Believe me, if we raise taxes on hedge-fund managers we’ll get fewer hedge-fund managers. Today, with lots of hedge-fund managers trading all the time and keeping markets efficient, stocks are at record highs around the globe and markets are deeper, more liquid and less volatile. With fewer hedge-fund managers, markets would shrink, become more volatile and more costly, and tumble from their present highs.

The date on the piece is 20 July 2007. Just over three months later—pretty much exactly three years ago—the IB-sponsored MBS origination market effectively died, having taken much more value than was produced by the underlying property and placed it firmly into the pockets of traders and originators who knew that the present value they were claiming was—let us be nice—overoptimistic.

Does anyone wonder why Brad DeLong designated Donald Luskin “the Stupidest Man Alive Emeritus“?

Senate passes HR 4173 finance reform conference report

by Linda Beale
crossposted with Ataxingmatter

Senate passes HR 4173 finance reform conference report
[updated to add information on Geithner’s opposition to Warren 7:12 pm]

On a 60-39 vote, the US Senate passed the Dodd-Frank H.R. 4173 financial reform conference report today. While the bill imposes some new restrictions and creates a consumer protection agency, most of the impact will come (if it comes) through regulation as the new systemic risk council oversees bank issues and decides whether activities of banks pose sufficient risk to be regulated or eliminated. Capital requirements and leverage requirements, for example, are not directly set in the bill. The US is likely to settle with the capital and leverage standards set by Basle III, the discussions going on now at the Bank for International Settlements regarding updating of the 2004 standards. In those talks, thje banks lobbying are making inroads on the fairly tough standards originally proposed in December, as officials yield to fears (cited by the banks) that tough capital and leverage requirements will dampen the economic revival. See, e.g., Damian Paletta and David Enrich, Banks Gain in Rules Debate: Regulators Seen Diluting Strictest New ‘Basel’ Curbs; Credit Crunch Fears Remain, Wall St. Journal, July 15, 2010, at A1.

Query whether we have learned anything from this crisis at all. Officials remain at the mercy of banks–bailing them out, providing cheap cost of funds through implicit and explicit guarantees, and letting, even encouraging, them to get back to the old securitization games that allowed them to generate liquid and easy credit without adhering to prudential banking standards since the lender was not the one holding on to the loans over the long term. Banks argue for remaining entangled with their profitable proprietary trading and derivatives businesses, since they know that the synergies of being able to use cheap depositor funding for their investment-banking activities means high profits for them, even if it may mean socialization of losses down the road. See Simon Nixon, Barclays Capped by Regulatory Risk, Wall St. J., July 13, 2010, at C10

Interestingly, Tim Geithner has come out against having Elizabeth Warren appointed as head of the new consumer protection agency created by the reform bill. Nasiripour, Tim Geithner Opposes Nominating Warren to Head new Consumer Agency, Huffington Post, Jul. 15, 2010. Having watched Prof. Warren in action and read the scathingly honest output of her term at the head of the bailout watchdog commission, I can’t think of a better person to head the agency. One suspects that Geithner is concerned about a gradual erosion of the power of the Wall Street clique (Geithner, Summers and Bernancke) with the forceful Warren on the job with the ear of the President. Personally, I think that power needs to be eroded, so Geithner’s concern makes Warren an even better choice.

What Works About the FDIC?

reads Ezra Klein and Matt Yglesias (between the two of them they have more years than I do).

Klein thinks the FDIC works well. Yglesias notes that it keeps eating banks every Friday and has doubts about the quality of its prudential regulation. I will argue that the FDIC has more of an incentive to make banks prudent than the SEC, the Fed, the Treasury or the comptroller of the currency.

The key point is that the FDIC has a trust fund and wants to keep it. This is the reason that Stiglitz, Sachs, and Krugman were totally wrong and the PPIP was not a huge give away (Tom Bozzo and I explained it to them at the time but they don’t read this blog). So long as the FDIC doesn’t run out of money, it doesn’t have to go begging to Congress.

Robert Waldmann

The SEC and the comptroller don’t put their own money on the line. They regulate but they don’t bail out. Failures mean they have more egg on their face but no less cash on hand. The Treasury has broad responsibilities and has to explain economic policy to Congress in any case. The FED can just print all the money it wants. The FDIC is independent so long as it stays within its means.

This makes a difference. It is true that the FDIC has had to spend some of its money lately. IIRC it hasn’t had to ask congress for any extra appropriations – at all. This in spite of the fact that the FDIC agreed to insure money market funds which therefore got insurance without paying for it. The scale of failures of FDIC insured institutions are tiny compared to the scale of failures of non FDIC insured institutions.

See the secret is to have an intertemporal budget constraint. That tends to cause forward looking behavior.

Say It Ain’t So

NBER paper of the day:

We analyze asset-backed commercial paper conduits which played a central role in the early phase of the financial crisis of 2007-09. We document that commercial banks set up conduits to securitize assets while insuring the newly securitized assets using credit guarantees. The credit guarantees were structured to reduce bank capital requirements, while providing recourse to bank balance sheets for outside investors. Consistent with such recourse, we find that banks with more exposure to conduits had lower stock returns at the start of the financial crisis; that during the first year of the crisis, asset-backed commercial paper spreads increased and issuance fell, especially for conduits with weaker credit guarantees and riskier banks; and that losses from conduits mostly remained with banks rather than outside investors. These results suggest that banks used this form of securitization to concentrate, rather than disperse, financial risks in the banking sector while reducing their capital requirements.

UPDATE: If anyone knows of Tom points us to an “ungated” version from three weeks ago, please mention it in comments or e-mail.

The Meaning of "Monty Python and the Meaning of Life"

Robert Waldmann

Barry Ritholtz argues that the problem with mortgages was underwriting standards and not securitization. He appeals to the very great authority of Monty Python. Click the link.

Ritholtz seems not to be familiar with this new idea in economic theory called “Nash equilibrium”. Over -rated yes. Totally irrelevant not so much. One can not assume that underwriting standards are exogenous. If there had been no MBS, no firm would have underwritten those mortgages. It was exactly because it was possible to blend them, and then sell them to people who didn’t spin the mortgage tapes before buying, that the mortgages existed in the first place.

Let me work with his analogy. First, while I have great respect for the Monty Python team, few people have been killed by canned Salmon. Even blended into mousse, it kills fairly quickly and can be tracked back to the canner. The way bacteria work is that if you mix some contaminated stuff with other stuff you have trouble for sure. It doesn’t work that things seem fine until people notice.

At a way lower cultural level than Ritholtz I appeal to road runner cartoons. Wile E. Coyote runs along in mid air until he notices. Then he falls. As noted by everyone, this is the way financial markets really work. The non Monty Python quality humor is based on the fact that gravity doesn’t really work that way. Neither do bacteria. Analogies between rotten mortgages and rotten Salmon fail for this reason.

Notably, the ingredients in the Salmon mousse are few enough that the dead diners immediately know what went wrong when death points at the mousse. That’s not the way MBS work let alone CDOs of MBSs or CDOS of tranches of CDOS.

A better analogy would be making hamburger. Bits from hundreds of steers end up in the same package at the supermarket. If one bit has E. coli on it, you can get sick. If they tried to sell you that bit, you wouldn’t buy it because it would stink. However, mixed in with hundreds of uncontaminated bits of beef, it doesn’t stink.

Is there a hamburger problem? Yes there is. One is much more likely to get food poisoning from hamburger than from unprocessed meat. Is the solution special regulation of hamburger? It sure is.

Thought-Experiment: Assets and Securities

Ken Houghton

wants to sidebar today into looking at the general application and implications of an Accounting Identity:

Assets = Liabilities + Equity (A=L+E, or the ALE Rule).

Let us assume that, since the housing bubble burst, I believe that my house has fallen in value by too much. I would understand a 20% decline, but the “market price” that the experts (realtors) tell me I can get is 40% below the price of the last “comparable sale” (a smaller house in perfect condition).

But there are ancillary factors—proximity to NYC, good public transit infrastructure, good schools, convenience to the airport and major roadways—that I believe the market is undervaluing. So I “carry” the house in Quicken at 80% of the last sale.

Since I refinanced a couple of years ago, someone out there owns the Mortgage-Backed Security that was formed from that refi. Let us pretend it is Citibank, who are carrying that security on their books at 80, even though the last similar trade in the market was 60.

I think you can see where this is going.

So along comes the U.S. Treasury to “fix” the crisis and Get Banks Lending Again. (Apparently, they can’t lend because the market values their assets as being less than their liabilities plus their equity.)

In doing so, the Treasury will supply so random number—say, 85%—of the capital required so that a Private Investor can swoop in and Save Citibank’s Securities, by buying them “closer to their real value.”

So the Private Investor says, “Yo, Big C! I see you own the MBS that covers Ken’s house. Even now, his house is worth more than he owes on it, so I want to buy that security from you.”

Big C says, “I’m carrying that security on the books at 80. And there are a few billion others just like it.”

Private Investor: “Well, the market says all those securities are worth 60.”

Big C: “I can’t sell it at that level. I would have to mark down everything else, and people would see that my liabilities exceed my assets, leaving me with negative equity. And everyone is still pretending that my equity shareholders should not be revealed to own bupkus.”

PI: “Well, I’ll tell you what. Since we can foreclose on Ken for more than the amount owed, I’m willing to pay a little more.”

Big C: “I need you to pay something close to 80, or The Truth will out.”

PI: “Well, since the U.S. taxpayer is going to support 85% of my purchase in the worst of scenarios, I can pay you–how about 76?”

Big C: “Make it 78 and you have a deal.”

PI: “All right; I’ll do that. After all, I’m only having to put up $11.70 of that.”

Big C: “And I’ll be able to pretend we’re solvent. After all, we have some Inside Investors who need loans, and the Fed wants us to loan more.”

But wait a minute: the real value of that security is supposed to be the cash flows from The Underlying Assets. In short, it’s based on my (and others) ability to pay the mortgage. So let’s look at the other side.

I carry my house in Quicken at 33% (20/60) over what the realtors tell me it is worth. So Quicken shows me that cool Net Assets thing, and I have a Net Asset Value $30,000* higher than “the market” believes.

But it’s not liquid, and I don’t run a Treasury operation, nor am I necessarily required to abide by the ALE rule. So in general I feel more solvent, but may not (or may, but let’s assume not) change my behavior because of it.

So tomorrow I have a heart attack and can’t work for a while.** And my wife needs to help me with recovery, as well as keep the kids going to school and activities, so we spend six months to a year living on savings and whatever safety net there is. And finally we realise we have to downsize our life and move to Northern Indiana where my family can help us out for a while.

So we put the house on the market, at the price the realtors said it was worth.

But—as happened last summer—there are no bidders. And when there might be a bidder, they can’t get a bank loan from The Big C.

Eventually, we realise we’re not going to move back and stop making payments on the property, which stays on the market until it is foreclosed. And then the bank that owns the mortgage sells the house short to a developer who pockets a quick few bills.***

We file for bankruptcy.

Now, in the real world, the Securitized Asset that looked so great above is now a losing proposition. But in GeithnerWorld, the asset is secured by the U.S. Treasury, and the “investor” takes no hit at all; indeed, Private Investor is made whole with…taxpayer funds!

In short: Debt that my child will have to pay.

The Geithner Plan is the ultimate in Financial Reality. Derivatives were at least based on underlying assets; if the five-year Treasury price fell, the five-year swap was worth more.**** GeithnerBuys have no relation to the “securitized” asset at all, except to add to the expenses of bankrupt taxpayers.

It is the final Decoupling of Wall Street and Main Street, so while Arlen Spector makes certain that workers can’t organize and Ellen Tauscher ensures that mortgages can only be reset to market value if it is a Vacation (or “second”) Home (despite an earlier agreement), Tim Geithner and Larry Summers—with the support of Some Economists who Should Know Better—are ensuring that any damage to the real economy is not felt in the financial sector.

Welcome to Brighton Rock. Or maybe Faust.

*Possibly not the real number.

**Knock wood, this is not real either.

***Anyone got the link on this one? Saw a piece earlier today about Citi selling a foreclosure for $131K to a developer who flipped it, doing nothing, for $249K.

****Reminder: lower price = higher yield.