Redstate

No one really knows how bad mortgage defaults will get. One of the key ideas in structured finance is to wrap up the ugly details of the underlying asset market using a variety of techniques. In the current environment, no one is trusting that any of that stuff (or the ratings generated by agencies like Moody's) is what it seems to be.

In conditions like that, you'd rather be out than in.

Now that I'm thinking about your point, I can see some merit to it. There's no way to legally require transparency, especially with international institutions. But the market handles this quite nicely on its own, which is what it's doing.

In the absence of full portfolio transparency, you just don't do as much business with as many people. What happened after the 1998 Long-Term crisis was that every decent-sized institution started enforcing daily or several-times-daily marks to market against their counterparties.

But as I said, that's hard to do with mortgage-backs because there is no secondary market.

Before making a deal, you could simply say "open the kimono and show me what you've got." That would of course rule out deals among firms that occasionally compete, which is just about all of them.

The only way out that I can see is what will probably happen: credit markets will remain depressed until the mortgage portfolios run off a few years from now.

Most of the big banks are putting them on their balance sheet - they don't really mark to market but mark to model and are classified (for Fair Value purposes under FAS 157) Level 3 assets, and occasionally Level 2. As of yet, there is little evidence that investors are strongly questioning the models themselves but the uncertainty rests in the market conditions themselves rather than non-transparent disclosures.

As an example of the deatil banks are giving here is part of Merrill Lynch's Q3 footnote:

U.S. sub-prime residential mortgage-related and ABS CDO activities

During the third quarter of 2007, Merrill Lynch recorded a net loss of approximately $7.9 billion related to U.S. ABS CDO securities positions and warehouses,
as well as U.S. sub-prime mortgage-related assets including whole loans, warehouse lending, residual positions and residential mortgage-backed securities.
These losses primarily related to assets and liabilities recorded at fair value on a recurring basis and are included in principal transactions losses in the table
below. At September 28, 2007, the remaining net exposure for these positions was approximately $21.5 billion. This $21.5 billion net exposure includes:
• Assets and liabilities, including derivative positions, that are recorded at fair value on a recurring basis of $5.0 billion (includes Level 2 and Level 3);
• Assets that are recorded at fair value on a non-recurring basis of $2.3 billion (i.e., loans recorded at lower of cost or market);
• Additional off-balance sheet exposures on derivative positions (i.e., notional amounts) of $13.6 billion; and
• Additional off-balance sheet exposures on loan commitments of $0.6 billion.

Hope I did it right.

Risk is usually about something that is known and usually quantifiable, for example driving at 100 mph is risky and can be quantified in terms of potential damage to you and your vehicle. Uncertainty would be driving at 100 mph around a bend and not knowing what might be there.

Another example is the next president. There is almost no risk that we will not have a new CEO, it is uncertain who it might be.

Both your examples have quantifialbe risk probabilities. Risk is unknown but qunatifiable in probabilistic terms and does not contain no uncertainty but includes the uncertainty in the model. If I understand blackhedd correctly he is using the term a little bit loosely and it might be best understood as having an extremely large range for say your 90th percent confidence interval that makes any model of the risk too volatile to be useful.

An example might be modeling the risk of precipitation tommorrow, which we can't do perfectly but can do well enough to let me know whether I should take an umbrella versus the risk of precipitation on February 13th, any attempt at that would have such a large variation as to be useless for me to make a decision on.

...mathematical finance (sometimes called neo-classical economics). You generally compute risk by reference to stochastic models of the prices of various asset classes, and you express it in statistical terms. For example, "Value at Risk" (VAR) is a way of stating to some statistical confidence level that you stand to lose up to x dollars on any given day.

You hedge risk by constructing portfolios with exposures to multiple asset classes that have different risk profiles. And you use mathematical models to establish the co-variance among the risks.

It all works fine in normal times. In times of stress, all the covariance matrices break. That's one source of uncertainty.

Another source comes from how securities are priced in the first place. You basically compare the expected risk of an asset class with that of a benchmark asset (like a 30-year US Treasury bond) or of the market as a whole. And the equations assume liquidity and rapid price-discovery, which are things that don't exist in the mortgage-backed asset market. So no one is really sure what their portfolios are worth.

I hope that helps. I really oversimplified this. A whole raft of Nobel Prizes went to the guys who originally figured this stuff out back in the Sixties.

I've done stats (BS in CS and Math), but never finance. You confirmed my best guess at what you meant.

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NARF

The Depression: the monetary contraction that precipitated the financial crises basically started in late 1928, and was caused by the Fed. (At a reception for the late Milton Friedman shortly before his death, then-Governor Bernanke apologized tongue-in-cheek to Friedman for this failure.)

FDR began taking the steps that relaxed the contraction immediately on taking office, most importantly by reversing a dollar-gold overvaluation that had existed since the mid-Twenties. Interestingly enough, FDR's first month in office (March 1933) was the turning point in the Depression as measured by economic output, although the financial panics persisted until that summer.

However, plenty of analysis shows that bankers responded to the extreme liquidity conditions of 1930-1933 by changing their behavior in ways that constrained business development almost until the war started. Risk aversion is something that government, even an over-ambitious government like FDR's, can't do anything about.

The current wave of euro-appreciation started back in 2003, if memory serves. The euro bottomed out at something like 80 eurocents to the dollar, compared to its recent 1.43.

Political risk is so hard to quantify, but my general feeling is that markets ignore politicians almost completely. Markets are much bigger than governments, and far more powerful. And governmental idiocy is easy to counteract. All you have to do is move your capital and your activities somewhere else.

The people who really get hurt in this process are the ordinary folks without significant capital mobility, and who vote for the idiot politicians in the first place.

Our policy is succeeding. The figures prove it. Secure in the knowledge that steadily decreasing deficits will turn in time into steadily increasing surpluses, and that it is the deficit of today which is making possible the surplus of tomorrow, let us pursue the course that we have mapped.

Was this Arthur Laffer? Pres. Bush? One would think so. FDR said this in the first week of January, 1936. FDR created massive budget deficits by giving money to Americans through spending projects. Bush created massive budget deficits (national debt now near $10 trillion) through tax cuts and spending increases. Furthermore, I can excuse FDR for his spending because of the dire economic conditions of the time, but Bush has no excuse. What is the difference between borrowing to give money to Americans through government programs and borrowing to give money to Americans through tax cuts? Tax cuts are more efficient, but that's about it. We need to cut taxes, but tax cuts must be tied to spending cuts. Perhaps the market recognized sooner than many conservatives that Bush's economic policy was nothing short of progressive Keynesian policy sold in the guise of conservatism, which became most evident in 2003 via the Bush tax cuts and the Iraq War. I am not supporting McCain, but I am very proud of him for refusing to vote against Bush tax cuts for the only reason one should ever vote against tax cuts: it wasn't tied to spending cuts.

***********************************
And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_

...because it's just a hunch and not a well-developed theory.

But early 1936 was a time of extreme risk-aversion by banks. (It also was the eve of a wicked recession that the Fed engineered in 1937 because they thought the economy was overstimulated.)

My hunch is that Keynesian spending works best as a tool for overcoming risk-aversion by normal lenders (and the consequent capital starvation), only when there is pent-up hunger for business activity.

The policy-risk you face is identical to what the Fed faces if they cut interest rates too much: overinvestment, credit-quality deterioration, and eventually recession as the cycle repeats.

This was one thing in 1936 and 1937, but it just might be very different today, as the US economy makes a secular move to lower growth. If I'm right, there really aren't any good policy tools for managing the economy and the government is best off just sitting on their hands.

Bush's restraint on spending has been atrocious, however, tax cuts can pay for themselves through economic growth. All that's required is that spending stays less than the rate of inflation, and that's been the problem. Ideally, tax cuts and spending cuts would happen at the same time, unfortunately there is about zero chance of politicians doing both.

If spending was held to the 2002 levels at the time of the 2003 tax cuts, the budget would've been balanced in 2004. If it was held at the 2003 levels, it would've been balanced by 2005. See - http://www.whitehouse.gov/omb/budget/fy2008/pdf/hist.pdf - as a result of the 2003 tax cuts, revenues increased from 1.9 trillion in 2004 to 2.4 trillion in 2006(or 26%), spending in 2004 was 2.3 trillion and increased to 2.65 trillion in 2006(or 15%).

Go with Milton Friedman - "That’s why for a long time now I have been in favor of any tax cut, under any circumstances, in any way, in any form whatsoever." - http://corner.nationalreview.com/post/?q=ZmNhOWU4ZWZmY2NiOTUzZjRjZTg3N2M...

True that the monetary contraction started in late 1928, but it's not the whole story, it probably started the economic pullback, but there are more pieces that made it the Great Depression instead of a normal pullback. Hoover signing the Smoot-Hawley tariff on 20,000 different goods or so, did a great deal of damage as well, as did all of the bank failures(resulting in more monetary contraction). My point is all of Hoover's and FDR's missteps and experimentation resulted in more risk aversion, rather than less - as you said, you can lead an investor to risk, but you can't make him drink. While Prohibition hardly made a dent in alcohol consumption, government policy made a bit dent in risk consumption.

I disagree that markets ignore politics. True enough that government idiocy is easy to counteract globally(assuming there is no liquidity discount), but it has a great impact on a local and national level - look at Michigan's policies and the impact on its citizenry.

As far as the euro, my point in picking November 2006 is that that's when it broke out of the 1.18-1.28/$ range that had held it for roughly the past year and a half(or slmost 3 years, if you throw out the brief rally and pullback at the beginning of 2005).

We're on the same page as far as your premise that risk aversion is what matters and central banks have little they can do to change it. My additional point is that other government policies cause the uncertainty and risk aversion to increase, which causes impacts that may start out local(ie Michigan), but will eventually cause national(lower economic output in MI results in less overall sales and fewer sales nationally) or global impacts(same effect).

...the financial world and the real world. You said that many things in addition to a monetary contraction contributed to the economic pullback that became the Great Depression.

Quite absolutely true, although these channels and mechanisms are a matter of debate to this day.

The ill-conceived liquidity contraction (which was intended to cool off the stock market- that worked, at least) created a reasonably predictable rash of financial crises and bank failures. But these were not peculiar to the early Thirties. In fact, the entire decade of the Twenties was characterized by spectacular bank failures and serious financial disorders everywhere in the world. (The gold standard at work.)

The still-unexplained thing is how all this financial disorder got translated into economic distress, with reduced output and high unemployment. And extreme risk-aversion by bankers is a pretty good explanation for this.

All of this is highly relevant to today. Two extreme financial disasters in recent years (the 1987 stock-market crash and the 1998 Long-Term Crisis) had little to no impact on the real economy. But the Subprime Crisis we're in now has at least the potential to massively disrupt the real economy.

As with the '87 crash(portfolio insurance) and LTCM(thinking they were smarter than the markets and that there was no shot of their models breaking down), we clearly have a burgeoning financial disaster looming with the potential to massively disrupt the economy. So what are the differences between '87 and LTCM and now? They were largely seen as anomalies by most people(in '87 the investor class wasn't as large and in '98 not too many were worried about millionaires losing their money) - correct me if I'm wrong on those perceptions. If I am correct and that was largely the mood, wouldn't the current situation hit people closer to home, ie my coworker is losing their house, the house I bought last year is worth $25k less, etc? Thus, it would likely have a bigger affect on the national mood, which in the current environment calls for the govt to do something about it. So, the government kicks around a bunch of ideas like bailouts, rewriting contracts, filing lawsuits, including the mortgage in bankruptcy filings, etc, which scares people further, causing people and businesses to be uncertain and sit on their hands. I also think it's debatable whether the subprime 'crisis' is as big as the media makes it out to be.

Of course, the govt solutions that might actually help peoples' and business' mood and situation, such as cutting property taxes or other taxes aren't even on the table.

...the then-new tools of futures and options played a major role as events unfolded. As ugly as the crash in the cash stock-market was, what nearly happened (and was narrowly averted) in Chicago was far worse.

I was just a puppy in 1987 but I don't remember any kind of widespread distress, fear for jobs, or anything else arising from the crisis.

In late-summer of 1998, which I remember very well, your average person was completely unaware that the financial world had narrowly avoided Armageddon.

The current crisis in credit markets is all too real. I'm not sure how the media could be overselling it. Everyone I know agrees that it's far worse and far more extensive than the Long-Term crisis.

What's the impact on the real world? That's a very uncertain question. Many very intelligent people are looking at the outlook in the credit markets and believe that weaker economic growth is inevitable. That's a reasonably convincing case.

Many other people are looking at the diminished value of people's homes in many parts of the country, and saying that weak consumer spending will inevitably result. But for that, there is basically no evidence at all (yet).

...due to distressed assets (or if, like Citibank and HSBC, you consolidated distressed assets in order to avoid losing your reputation), then you're perfectly happy to just ride the yield curve until you're more liquid. You don't have to take real risk if you can just lend to the government.

That's actually the normal behavior when the Fed cuts rates. (Even Greenspan has admitted that in moments of candor. And plenty of libertarians consider this illegal, but I'll bet they don't own Citigroup shares.) But there's some evidence that it didn't happen this time.

Part of my point here is that short-term liquidity issues (which central banks can do something about) are indicative of more-structural problems. And these, the Fed can't easily fix.

Short-term interbank borrowings are usually done over-the-counter on an overnight basis. The closely-associated "money markets" are wide open, of course.

LOL! Rather than answer your question directly, let me remind you that Acheson appears to have vigorously hated FDR. His first experience in government as a young lawyer was in the State Department in 1933, and he appears not to have impressed the President at all.

When you finish Beisner's book, read Acheson's memoir. I think it's called "Present at the Creation" or something similar. And as with any political memoir, keep in mind that he's settling scores and shamelessly sucking up to his boss, Truman. :-)

Vigorous hatred is a strong characterization, and not one that was described by Beisner. Perhpas the autobiography you recommend will reflect that characterization better.

It seems that you imply a pre-existing hatred for his opinion of FDR's gold revaluation, when in fact it may be just the opposite. The sequence of events as told by Beisner is that FDR's actions (which were considered illegal by a respected attorney with a bright future ahead of him - Acheson) is the cause of his dislike for FDR.

And, he was acting as under secretary of the treasury at the time of the conflict. He resigned his position, and it wasn't long before FDR asked him back to begin service in the state department. He went on to work with FDR until his death (which would be hard to do given a vigorious hatred), and then Truman became president, they aggressively changed the foriegn policy of our country together.

The Republicans of the time (as well as the majority of Americans) were painted as "isolationist" and their policies unsound in a dangerous post WWII world. But, I digress. :)

I think a big part of Acheson's problem with FDR arose because FDR apparently had a problem with Acheson.

I have a great deal of respect for Acheson... as Truman's Secretary of State.

You're asking a question about the legality of FDR's actions with respect to gold. I'll grant that it's a question of historical interest but I'd rather stick to finance and economics, and the implications for today's situation.

The US was the last major economy (except for Italy, if memory serves) to leave the interwar gold standard. Britain left it in 1930, three years before we did, and they rapidly pulled out of the economic problems (chiefly unemployment) that they had been having up to that time.

I acknowledge your reluctance to answer the question (In which I was only asking for your opinion, not a legal tretise).

And, as a gentleman (sometimes), I will not press the issue any further. You certainly are entitled to a right to privacy, and that quesiton did stray away from the subject of your post.

That much is relatively courteous and reasonable.

However, I also choose subjects to get to know well based on their relevance.

You're asking whether I believe FDR and his people acted lawfully in manipulating the price of gold throughout 1933 and finally fixing it 40% higher than its historical price in 1934.

He asked for and received enabling legislation to do this in the first days of his Administration.

Roosevelt lived in an age which had enormous, unshakable faith in the power of learned experts to fix what was wrong with society and with life in general.

He was also astute enough to recognize that the American people were willing for the first time in their history to transfer operational control over the economy to the Federal government. And he had the leadership ability to make that happen.

You ask, was it legal? I answer: yes, because he made it so.

It's not for nothing that the Depression (along with the Civil War) is one of the pivot-points in American history.

Now the relevance for today is that we have at least one politician (Hillary Clinton) who appears sincerely to believe that we are arriving at another such moment, and may harbor dreams of becoming a new FDR.

She's wrong. An historic pivot-point is indeed approaching in regard to our economic life, but she's totally misreading the moment.

I had given up on that line of questioning. Thank you for answering anyway.

I wish I had the strength to resist commenting on your answer, but alas, I don't.

No disrespect intended, but you seems to be saying that FDR was our nation's first monarch, and that Hillary is now running for queen. If the executive branch can exceed the powers granted to it by our consitution at will, then what is the point?

I would like to learn more about the enabling legislation that you speak of (forgive my ignorance), what specifically are you referring to?

"Shrilling for Ron Paul" made me laugh; it perfectly describes the default methodology of the man's supporters. Which is to say, screaming and leaping.

(scribble scribble) Here is your pass permitting you to speak of your man-god freely on this site; show it to anybody who asks it of you.

Moe

PS: :Holding up hand: Please do not tell me that it was inadvertent on your part; I cherish this thought that there may be more wit among your sort than I first guessed, and I would be oddly depressed and saddened to have this revealed to be untrue.

The Fuzzy Puppy of the VRWC. I've been usurped!