Wednesday, October 29, 2008

The election in a nutshell

I can boil this election next Tuesday down to one question for you:

Do you believe that life should be difficult if you are on welfare?

For me, the answer is easy. Yes, life should be difficult for those who are on welfare. Every person should have incentive to not be on welfare. It's that simple.

Now, do not be confused: I am not saying that there should not be welfare. Life is certainly cruel, and events conspire against well-meaning people such that they are not able to take care of themselves. It is incumbent upon us to take of them in such circumstances.

However, in my opinion, it is also incumbent upon us to give those people both the incentive and the means to better their lot. If we make their lives comfortable, they will do no such thing.

If you disagree with me, if you believe that life should be easy for those on welfare, then you should vote for Barack Obama.

Because that's what he believes. He believes that the Constitution should guarantee each and every one of us a certain standard of living, regardless of what we do to earn such a living. He would enact such a guarantee by taking hard working people's money and redistributing to others, some of whom may not be working quite so hard.

In fact, if he had his druthers, even the judiciary would get involved in the act. He has implied that he is disappointed that the Supreme Court has not broken "free from the essential constraints that were placed by the founding fathers in the Constitution..." That the Constitution "doesn't say what the federal government or the state government must do on your behalf."

What the government must do on your behalf?! What ever happened to "ask not what your country can do for you, but what you can do for your country"?

If adopted by a majority in a democracy, Obama's politicial philosophy is insidious. In its fullest implementation, it has the ability to destroy us from within.

Here are the words of science fiction author Robert Heinlein from To Sail Beyond the Sunset (1987):

The America of my time line is a laboratory example of what can happen to democracies, what has eventually happened to all perfect democracies throughout all histories. A perfect democracy, a "warm body" democracy in which every adult may vote and all votes count equally, has no internal feedback for self-correction.... [O]nce a state extends the franchise to every warm body, be he producer or parasite, that day marks the beginning of the end of the state. For when the plebs discover that they can vote themselves bread and circuses without limit and that the productive members of the body politic cannot stop them, they will do so, until the state bleeds to death, or in its weakened condition the state succumbs to an invader — the barbarians enter Rome.

Two Reasons Why Polls May Be Misleading

Two quick notes about the polls:

1) Most analysts, when they describe how the polls might be underestimating McCain's strength, point to the possible "Bradley Effect", which states that certain people who tell pollsters that they are going to vote for Obama, in fact are not, because of racial bias.

It's possible that there will be some Bradley Effect, especially in the kinds of places that Murtha denigrated last week.

However, there may be another effect which is also underestimating McCain's strength. In places with an educated, politically correct electorate, people might have a lightly considered, visceral inclination to back Obama (and thus tell pollsters that they intend to do so), because it seems like the right thing to do. The New York Times sure seems to like him ... I'm going to support him, too! Supporting Obama is the politically correct thing to do. I am quite sure that there are a number of dinner parties on the Upper Westside that people would not get invited to if it were generally known that they were McCain supporters. Again, these are not heavily researched, deeply held convictions, but rather lightly considered, visceral feelings.

But is it not possible that the doubts that McCain has tried to plant in people's minds might actually be working, and some of these people might end up pulling the lever for McCain because, in the end, when they actually get to the voting booth, they view him as the safer candidate? In fact, my gut tells me that this effect could be as large (on national vote totals) as the Bradley Effect, although it will have less of an effect on the election itself, since it would tend to be felt in the blue states rather than red ones and therefore may not effect electoral college math. If big enough though, it could make a difference in certain towns like Philadelphia, Minneapolis, Charlotte, etc, which could be important at the margins.

2) People are simply not paying enough attention to how charged up the Republican base is because of Sarah Palin.

George Bush beat John Kerry, in large part because the conservative base showed up in numbers heretofore not seen in a national election.

This could happen again. Ironically, many of the polls which show large national advantages for Obama do so because they calculate huge voter turnouts from younger, black and hispanic voters.

Wouldn't it be interesting if that effect was cancelled out by the huge, Sarah Palin influenced turnout of the Republican base?

Tuesday, October 28, 2008

A Whole New Constitution

If you weren't spooked by Obama before, these comments from a radio talk show in 2001 ought to do it:


If you look at the victories and failures of the civil rights movement and its litigation strategy in the court, I think where it succeeded was to vest formal rights in previously dispossessed peoples. So that I would now have the right to vote, I would now be able to sit at the lunch counter and order and as long as I could pay for it I'd be okay.

But the Supreme Court never ventured into the issues of redistribution of wealth and sort of more basic issues of political and economic justice in this society. And to that extent as radical as people tried to characterize the Warren court, it wasn't that radical. It didn't break free from the essential constraints that were placed by the founding fathers in the Constitution, at least as it's been interpreted, and the Warren court interpreted it in the same way that generally the Constitution is a charter of negative liberties. It says what the states can't do to you, it says what the federal government can't do to you, but it doesn't say what the federal government or the state government must do on your behalf. And that hasn't shifted. One of the I think tragedies of the civil rights movement was because the civil rights movement became so court focused, I think that there was a tendency to lose track of the political and community organizing and activities on the ground that are able to put together the actual coalitions of power through which you bring about redistributive change and in some ways we still suffer from that.


Obama strongly implies that he would like to "break free from the essential contraints that were placed by the founding fathers in the Constitution."

I am constantly having arguments with various people about whether Obama is really as radical as I think he is, or whether he is the moderate that he portrays right now on the national stage.

How can one read that sentence and not conclude that he is a dangerous radical? To break free from the essential contraints that were placed by the founding fathers in the Constitution? Doesn't that sound like a pretty good definition of a radical? These are his words! When are people going to wake up!

Tuesday, October 21, 2008

Is Obama's Poll Strength a Chicken or an Egg?

The overwhelming consensus suggests that as the financial crisis has unfolded, and as the stock market has tanked, Obama has gained substantially in the polls.

There is certainly a great amount of truth in the analysis, especially in the early days of the financial crisis. But that may not be the entire story. As this financial abyss widens, and as I sit here today watching the Dow fall yet again by hundreds of points, I am beginning to wonder if there is not also something else going on.

I would suspect that a great percentage of people and institutions who are causing the fall of equity markets today are reasonably sophisticated financially. This is especially so if a good portion of the movement in equities is, as has been suggested in many financial publications, due to massive redemptions in hedge funds.

The implications of Obama's "spread the wealth" philosophy are anathema to the health of corporations and the robustness of financial markets. The implementation of Obama's worldview would result in the institutionalization of high unemployment and low growth rates.

Is it not possible that we are seeing, right now in the equity markets, a reaction to a general consensus that Obama is going to win this election? The market may be tanking because it thinks Obama's going to win. While Obama may have benefited from the beginning of this financial mess, we are all suffering greater financial distress because of Obama's benefit.

What cruel irony!

Monday, October 13, 2008

The Great, Shrinking Income Inequality

Caution, Blog Post Wonk Index: High

Not many themes have recieved more airtime in the Obama repertoire than the issue of widening income inequality in the United States over the past eight years. He doesn't really talk about the data explicitly, but the idea forms the foundation of many of his most forceful arguments. The issue has been smoldering in the more thoughtful left-leaning press for the past several years. With each passing year, new data seem to add fuel to that fire. More than any other, the issue seems to fill Obama with an almost saintly glow, as he rails about the unfairness of it all.

First, let me state unequivocally my belief that income inequality, in and of itself, is no vice. If, by virtue of the policies we choose to add dynamism to our economy, we end up with a very high income inequality, but also have the richest poor people in the world, that is an end which should be pursued under all circumstances. The opposite, low income inequality, but poorer poor people, might somehow seem more fair, but is clearly less desirable for everyone. One day I'll expound upon this at length. I'd like to do some country-by country comparative income distributions by decile, and regress the slope of the curve to something like a Freedom Index, and then determine how much purchasing power each of the countries has at the lowest decile. Maybe the study is out there somewhere already, but I haven't seen it.

But now to the issue at hand. My gut tells me that the party is over at the top of the income distribution. We've just lost, over the course of several weeks, many trillions of dollars of wealth because of stock price declines. Perhaps another couple trillion of equity in real estate has vanished. Finally, something like 100,000 bankers and Wall Streeters are out of work. The ones that remain are working in a very different world, where compensation expectations have declined precipitously as financial institutions are in need of deleveraging in order to stay afloat. Anecdotal evidence suggests that the current financial mess is something akin to nuclear winter in the most high-flying of locales like Greenwich and Darien, CT.

The vast majority of this loss of wealth and income has obviously hit the top of the income distribution. We may find that when all is said and done, we're back to normal with regard to the slope of the curve. After all, people have been saying that the early part of the 21st Century has been an anomaly with respect to all sorts of measures, from the use of leverage to savings rates to real estate values. Why should not the increasing income inequality also be an anomaly?

Of course, it will take many years for the results of this mess to show up in the official, published statistics. In the meantime, Obama will continue to glow when he talks about fairness, even though income inequality may have already reverted to its historic norm.

Sunday, October 12, 2008

Is Logic a Heritable Trait?

I was disappointed to read that Christopher Buckley had come out for Obama yesterday. I met the man at at a National Review party at his parent's Park Avenue apartment a couple of years ago. He seemed a nice and thoughtful guy, and his demeanor seemed in keeping with his self description in the Obama endorsement as "a small-government conservative." Although he writes in National Review from time to time, I do not profess to know much about his political thinking.

In his endorsement, Buckley makes an assertion that I've now heard from several different people who are uncharacteristically backing Obama: that Obama is smart enough to know that he will be unable to implement much of a liberal agenda because there's just not enough money right now. From the endorsement:


But having a first-class temperament and a first-class intellect, President Obama will (I pray, secularly) surely understand that traditional left-politics aren’t going to get us out of this pit we’ve dug for ourselves. If he raises taxes and throws up tariff walls and opens the coffers of the DNC to bribe-money from the special interest groups against whom he has (somewhat disingenuously) railed during the campaign trail, then he will almost certainly reap a whirlwind that will make Katrina look like a balmy summer zephyr....

...Necessity is the mother of bipartisanship.


My goodness. What does this mean? Would Buckley be supporting McCain if we were not in the midst of a financial crisis? Why would the current mess change anyone's thinking about who to support for President?

Furthermore, and more important, just listen to Obama talk for a minute or two. It seems blindingly clear to me, at least, that Obama thinks that a liberal agenda is precisely the remedy for what ails us. He's going to tax us, redistribute the wealth, and make us all better off.

Being a good politician, Obama has dressed up what is essentially additional welfare (tax credits) in the cloak of tax relief for lower income people, and he's tricked people like Buckley into believing that he thinks like a small government supply-sider. But a tax credit is not a tax cut. It's a payment of cash from the Federal government. Most of the people receiving Obama's tax credits will not have even paid any Federal income tax.

People, this is the most liberal person in the United States senate. There is no bipartisanship in Obamaland! Mr. Buckley, if Obama is elected, you can kiss your small government goodbye. We had better hope that the Dems don't end up with filibuster proof majorities!

Wednesday, October 8, 2008

The Regulations are Done!

From time to time, I venture on over to the other side to see how the thinking is going over there. Who was it that said "know thine enemy"? Sun Tzu? Did he use the word "thine"?

But I digress (and I joke).

I did venture over to The Nation, and read this fluffy piece of wonderbread (Born Again Democracy). It's all about how the federal government needs to take over the economy, and it's filled with all sorts of vapid proposals. At least at the end, the author admits that "These ideas and many others are in gestation." If there ever was a need for abortion, this may be it...

Anyway, it reminded me of a thought that I'd had recently, and that is this: we don't need to regulate, because it's already been done for us!

Consider: Set aside the rating agencies (and the complicit federal government) for a moment. Whose behavior was the most damningly irrational in getting to the present mess? Is it the people who took advantage of aggressive mortgages when they were available? Was it the mortgage bankers who swam in fees? The investment bankers?

No, each of those people had their own (albeit selfish) reasons for doing what they did. The most irrational among all of the players were the fixed income managers who bought all of the toxic mess which had been packaged up into CDO's. What were they thinking? Didn't they do any due diligence?

We don't really need to go into it, because that's history, but one thing is for sure: private markets are very good at recognizing mistakes like this and correcting for them. You can be sure that fixed income portfolio managers won't be buying a lot of CMO's with dodgy mortgages in them any more.

It's very hard to regulate an industry that isn't there. The recent troubles have effectively killed the CMO market - it doesn't exist! The regulation has already been done for us!

Monday, October 6, 2008

Tax Rates for the Unemployed

I find it almost counter-intuitive that Obama's lead in the polls has been growing over the past few weeks as the financial crisis enveloping our nation has deepened.

Republicans have always been the business friendly party. Why now, all of a sudden, is it the Democrats who are going to come to the rescue of the nation? I can only surmise that most people are just simply confused. They are tired of the barrage of financial news, and they think that any change is good.

Well, that's just sloppy thinking. Take one look at Obama's prescription for our country, and his philosophy of entitlements, and one can only conclude that an Obama Presidency would only make things worse, not better. It's simply infuriating.

Obama likes to point out (misleadingly) that he will lower tax rates for the middle class. Well, it doesn't make any difference what tax rate you pay if you don't have a job!

A Scared Accountant is a Dangerous Thing

Alright, ladies ‘n germs, you might as well settle in, because this is going to be a long one. If you’re a pro in the financial world, you might want to skip to the end, where I describe the hellfire wrought by mark to market accounting. For others, the good news is that by the end of this post, you will understand, or at least know about, most of the salient aspects of the recent financial crisis. More important, you will understand why this particular financial dislocation has been so severe.

Here’s the part you probably already know: this financial crisis has been created, in large part, by a bubble in asset values and the underlying financing for those assets. In this case, the assets concerned were real estate assets, and the financing were residential mortgages, for both first homes and investment properties.

Now, economies suffer bubbles in asset values all the time. We had the stock market bubble in 2000. We had a similar real estate bubble in the 1980’s. There was the quintessential tulip bubble in Holland in the 1600’s. Often, these bubbles were accompanied by “easy money”, which led to the proliferation of unsustainable financial contracts like we have seen in this most recent bubble.

However, most of the bubbles in history did not cause the extinction of the investment banking business. This bubble has been markedly different in the severity of the liquidity crisis which has unfolded, and its effect on financial institutions.

What caused this crisis in the first place? Well, there are a lot of people who have been keen to point the finger at one particular thing or another. It was either the “predatory lenders” or the easy money of Alan Greenspan which caused it. Barney Frank is my favorite bogeyman.

In reality, there were a number of trends which, together, created this mess. Then, there was one thing which made it much, much worse than any other bubble we’ve seen, possibly since the Great Depression.

Very quickly, let me explain the conclusion, and then I will give you details later in the post.

The Things Which, Together, Contributed To The Bubble:

Relaxing of mortgage underwriting standards
Very efficient, but complex, capital markets
Low interest rates

The Thing Which, in Turn, Caused the Wholesale Destruction of the Financial World:

Mark to market accounting

Without this last item, mark to market accounting, in my opinion, we would be facing issues in our financial system not much more severe than that which we suffered during the Russian debt crisis or any number of other financial dislocations over the course of the last century.

Instead, this time, Merrill Lynch is gone. Goldman Sachs has converted itself into a commercial bank. Lehman Brothers has been liquidated. After two hundred years of being in business, Wall Street is simply gone.

If you’d like to know why, read on.

First, the bubble itself.

The Things Which, Together, Contributed To The Bubble:

Relaxing of mortgage underwriting standards: For most of recorded history, the mortgage business has been quite mundane. Banks had rules of thumb, developed over decades, which determined how large a mortgage a person could secure, given his particular financial situation. They used a ratio of mortgage payment to total monthly income, a ratio of downpayment to total value, and various other measures, and were generally quite inflexible. At some point in the 1990’s the federal government got involved in a crusade to increase home ownership, particularly among the poorer, which often meant minority, populations. In the course of doing so, the government applied pressure to financial institutions, often in the form of regulations and pressure to meet requirements of the Community Reinvestment Act of 1977, but also by simply urging financial institutions to relax their underwriting standards for minority populations. A very hot smoking gun can be found here (, a 1998 manual printed by the Federal Reserve of Boston specifying the ways that banks might do such a thing, including overlooking those old standards I mentioned. The result was that banks began to relax those standards, and people who previously could not qualify for a mortgage became able to do so. In addition, truly creditworthy people started being able to get more aggressive mortgages, including no downpayment, interest-only, etc. This trend was magnified by the actions of Freddie Mac and Fannie Mae, which could (and did) purchase or guarantee the payments on certain qualifying mortgages and resell them to investment banks or other institutions.

Very efficient, but complex, capital markets: This one is little more difficult for those not in the financial industry to understand, but the development of the collateralized debt obligation (“CDO”) and collateralized mortgage obligation (“CMO”) massively increased the scale of the financial difficulties associated with the real estate bubble. In developing a CMO, an investment banking firm would purchase a great number, say 5,000, mortgages, and pool them together, creating a massive set of cash flows from the payments on the combined mortgages. Then, they would take these cash flows and divvy them up into slices, some of which were senior to the others, and thus more secure, and others of which were junior, and thus more risky, but which would pay higher interest rates. All of the slices would be rated by the rating agencies and sold to institutional investors of all stripes. The development of these financial instruments is a wonderful idea, and they will be permanent parts of our financial industry for years to come, but they added several elements of risk to the financial system which helped to create the current mess:
Complex and opaque financial instruments: CMO’s are inherently complex. Any analysis of the cash flows underlying such securities is time consuming and difficult, since the securities are an aggregate of hundreds and sometimes thousands of other financial contracts, each of which has its own particular complexities. While it is possible to estimate certain risks associated with such securities, such analysis is, at best, a guess, especially when unexpected events occur (like economic cycles or, as in this case, a housing bubble).
Distance between the originators of mortgages and the ultimate owners of mortgages (the “agency” problem): With the advent of the CMO, the entity which ended up holding a mortgage was very rarely associated with the entity which originated the mortgage. In fact, mortgage bankers, operating by themselves instead of on behalf of banks, started gaining market share in the mortgage marketplace. These mortgage bankers were incentivized solely by the number and amount of mortgages that they originated, rather than the quality of those mortgages, since they generally sold them very quickly to investment bankers eager to pool them into CMOs. The problem with this scenario is that it tended to magnify the shortcuts that mortgage originators took in the due diligence they performed on their borrowers, since they would not be the ones to suffer if the mortgage became impaired at some point in the future.
Low interest rates: With the advent of the CMOs, the increasing aggressiveness of mortgage bankers, and the ubiquity of financial information on the internet, it became increasingly easy to obtain an aggressive mortgage starting in the late 1990’s, a trend which increased into the early 2000’s. In addition to these trends, the United States (and the world) saw a very low interest rate environment early in the 2000’s as the federal reserve attempted to jump start the US economy after the recession of 2000-2001 associated with the collapse of the dotcom equity bubble. With low interest rates, borrowers started to be able to obtain even more aggressive mortgages, since there is an inverse relationship between interest rates and the amount that someone could borrow, given their income. “Mortgage Calculators” became ubiquitous on the internet, wherein a person could input various financial figures, and then, based on the prevailing (low) mortgage rates, figure out how much he could borrow to purchase a home. As people were given more and more money to purchase a home, not surprisingly, home prices continued to rocket skyward.

The situation was a bit like the old snowball rolling down the hill. Sometime in the 1990’s a bit of snow got kicked of the top of a mountain and started rolling down the hill. The federal government added a bit more to the snowball in the 90’s and into the 2000’s as it encouraged the loosening of credit standards for mortgages. It continued to get bigger and bigger as Wall Street developed fancy new ways of packaging mortgages and selling them to unsuspecting institutional investors. Finally, as interest rates achieved new lows in the 2000’s, and consequently home prices began to surge, the snowball was by now huge, and flying down the hill, approaching the bottom. People and events started to get in the way of the hurtling snowball.

Sometime in 2006, people started to notice that the default rates on the most aggressive mortgages (mostly what they call “sub-prime”) started to creep up. There are reasons why the default rates were higher than in days past, but we shall not go into them here, because it is not particularly germane to the discussion. But business continued as usual. In fact, people were so pleased with the surging housing markets, that normal Joe Sixpacks were buying up real estate on speculation, hoping that they would make a killing when they resold the property six or nine months later.

By August of 2007, however, the snowball really started bashing into things at the bottom of the hill. Default rates on mortgage portfolios had started to climb to almost unprecedented rates. Because of the opacity and complexity of the securities which actually held most of the aggressive mortgages, people in the financial world had a hard time even figuring out which securities would be affected, and by how much. In that month, trading of most types of these securities ceased altogether for a period, as people backed off to try to understand what was happening.

Investment banks, which had put together billions of dollars of these types of securities in hopes of selling them to long-term institutional buyers, were caught with illiquid securities on their balance sheets. Nobody would buy them, because nobody knew what effect the surging default rates would have on the complex cash flows of these securities. Banks could neither originate, nor package new mortgages into new CMO’s.

At the same time, the freezing up of the mortgage origination marketplace started to affect home prices. For the first time in ten or fifteen years, home prices were starting to drop, furiously in some places. The snowball was now massive, and crashing into the entire housing marketplace with a fury.

This was the situation in the winter of 2008. No bank or financial institution had yet failed, but people were getting increasingly concerned about the amount of collateralized debt obligations sitting on the balance sheets of financial institutions. In the quarter ended September 30, 2007 and December 31, 2007, banks, investment banks, insurance companies and other financial institutions started trying to estimate their financial exposure to the worsening housing crisis, and started taking charges, aggregating into the hundreds of billions of dollars by early 2008.

Trading in the most exotic of collateralized securities had virtually ceased. Since nobody had the time to figure out what they were really worth, nobody would bid for them. Rumors started to fly to the effect that certain institutions were more exposed to losses than others, and people and institutions started pulling their money out of the accounts of certain institutions. There was a run on Bear Stearns, one of the most aggressive banks, in March, and it was swallowed up by JP Morgan over a tense weekend.

Then, it just kept getting worse. By September, the federal government had to step in and save both Fannie Mae and Freddie Mac, the entire investment banking industry was gone, and Congress was forced to provide up to $700 billion for a bailout of the world’s financial institutions.

How did we go from having an asset bubble, which may have been no more significant than others in history, to the extinction of the investment banking business and governments around the world having to commit hundreds of billions of dollars to prop up failing credit markets?

In my opinion, there is one overriding reason, and that is mark to market accounting.

The Thing Which, in Turn, Caused the Wholesale Destruction of the Financial World:

Mark to market accounting:

First, let me do a little bit of back of the envelope mathematics for you. Currently, in October 2008, the aggregate default rate on mortgages in the United States is about 6%. Most people, even though they may even have a home which is worth less than the amount outstanding on their mortgage, are still paying their mortgages, because they don’t want to default! Now, 6% is a very high default rate given historical averages. It’s scary high, but let me continue, because it’s not as bad as you may think. Let’s make some obscenely aggressive assumptions. Let’s say that 100% of the defaulting mortgages are foreclosed (it would never happen…). Further, let’s assume that the original loan to value ratio of all of those mortgages is 100% (again, absurd). Finally, let’s assume that the actual market value of the homes underlying those mortgages is only 70% of the mortgaged amount (likewise, absurd). The lenders on those homes will loose 30% of their principal, ignoring transaction costs. OK, so now let’s do the math. The total value destruction so far should be the total mortgage market times 6% times 30%, or 1.8% of the total mortgage market. The total mortgage market in the United States is about $10 trillion. 1.8% of that number is $180 billion. A big number, to be sure.

But, as of today, the financial industry has taken something like $800 billion worth of write-downs, and still the carnage continues. When it’s all said and done, people are estimating that the problem might cost well in excess of $1 trillion in aggregate, and possibly many trillions.

What gives? How can $180 billion of possible losses translate into a $1 trillion of actual losses?

Well, by an accounting adjustment.

Remember those opaque CMOs that nobody could figure out? Well, those securities are holding all of the defaulted mortgages. But since they’re so complicated, and since the housing market is so dynamic at the moment, nobody can really figure out which CMOs are going to be affected in what amounts. So nobody will buy them. They sit, illiquid, on the balance sheet of the institution which happened to own them when the music stopped.

Excluding Fannie Mae and Freddie Mac, financial institutions might have several trillion dollars worth of these securities sitting on their balance sheets, and, as we have calculated before, there may be something like $200 billion of real losses hiding in there so far.

But how do these financial institutions value these complex securities which sit on their balance sheets? Do they make a bunch of assumptions about the economy and housing markets, and analyze the resulting cash flows and pick a discount rate and assign a value to them?

As of the last several years, the answer is no. Because of increasingly aggressive accounting policies which finally resulted in the adoption of something called SFAS 157, financial institutions have been required to value those securities at the price which others in the marketplace would be willing to bid for them. This is called “mark to market” accounting. When markets are liquid and functioning properly, and when institutions hold securities primarily to sell them or trade them, mark to market accounting makes a lot of sense. It is the most appropriate measure of value of a security which is held for sale.

But, didn’t we just conclude earlier that the market for these securities has become almost illiquid? At what price would people be willing to purchase complicated securities with unknown values in an illiquid marketplace? At the very least, someone would have to be given a very substantial discount to a security’s true value in order to induce them into a trade under such circumstances.

In fact, this has been the case. Whatever trading has occurred in the marketplace has been at severely discounted prices, for all of the reasons that we have discussed. The most talked about example has been the $30.6 billion worth of CDOs which Merrill Lynch sold to a private equity investor called Lone Star Financial for approximately 22% of the stated face value of those securities.

If we had to value all of the CDOs sitting on the books of financial firms at those kinds of discounts, there would be paper losses at those firms amounting to many hundreds of billions of dollars, maybe even trillions of dollars.

In fact, this is exactly what has happened, notwithstanding the likely fact that the real losses which will be incurred because of the housing crisis will be much, much less. All of this would be fine if financial institutions did not have capital requirements (regulatory, in the case of banks, and simply as a matter of creditworthiness for everyone else). Mark to market accounting has created its own, self-fulfilling prophecy. Because accountants have marked these securities down to a value far below their true, intrinsic value, credit markets have seized up as nervous institutions have stopped lending to other institutions with suspect balance sheets.

And, since institutions are not being able to borrow, based on paper losses, they are forced into liquidity crises. Often, those liquidity crises force the institutions to actually sell their suspect securities at firesale prices, well below their true intrinsic values, thereby turning paper losses into permanent reductions of capital.

This is how Bear Stears, Lehman Brothers and the others disappeared on various Sunday nights. A simple accounting treatment has outrageously caused a crisis of confidence which has resulted in an historic credit meltdown and the extinction of the investment banking business.

And it did not have to happen.

When I catch my breath, on another post I will describe how all of this could have been avoided.

PS: Understanding all this, if you want another villain, how about the trial bar? Here’s how it goes: Enron -> trial lawyers -> collapse of Arthur Anderson -> Sarbanes-Oxley -> proliferation of outrageously, ridiculously conservative accounting principles -> SFAS 157 -> extinction of the investment banking industry.

I am only half-kidding.

Wednesday, October 1, 2008

Burning Down the House

Anyone who's on this blog has probably already seen this video, but if not, please take a look:

I don't know who produced this video, but it is extroardinary, and it tells the whole truth about the current financial crisis unfolding around the world.

Viral marketing on the web will change forever the way politics works. In two week's time, I would not be surprised if John McCain were back on top in the polls...