Who's Next?

In order to regain a shred of credibility, the Fed has to let someone fail. Even if Ben does not realize it, Hank knows that someone has to take one for the team.

The question is, who?

Not the public. We're on the menu as a slow roast.

WaMu? Spreads say its a good bet. The question we're pondering is cui bono, who benefits. Ben has to be gagging on this one since they are a 'real bank,' but the breakup fees and carcass picking must be tempting indeed to the pigmen. Maybe, but more likely for later. It might be messy. Same goes for Wachovia. Possible, but potentially dangerous.

LEH? It would make a manageable splash and the desperation is apparent. Dick "The Gorilla" Fuld is widely disliked and he's been at Lehman for so long he's probably not very wired into the right places. He's on the Board of the NY Fed, but we'd bet he used his time there to generally piss off the wrong people. An asset sale and then death by boofoo seems like a decent bet. Or just a sudden death and fire sale after the fact. Contrarian-wise too many expect it, but that might just be a way to keep it from shocking the markets, which is a plus.

MER? They are in deep trouble, but John Thain is making the right moves and knows too many gravesites, and is well respected. Maybe, if he gets airlifted out first and taken care of in a big way. He'd make a great chairman of the SEC, Treasury Secretary, or a government Resolution Trust chief.

We'll be looking for the unwinding of obligations by the right crowd. They-who-must-not-be-named very publicly put one behind Bear's ear by pulling their business, but its unlikely to be that publicly obvious next time. That was payback for LTCM.

That's the gameplan unless something unexpected happens. Then its time to grab some gold and head for the nearest door. But for now it looks like the Working Group on Managed Markets has this one by the nose and is just taking care of business.

Not With a Bang But a Whimper

And of course discreetly-placed denials by KDB (and LEH?) in the media were quick to follow this statement...

Korean regulator says KDB talks with Lehman ended
By Steve Goldstein
7:02 a.m. EDT Sept. 9, 2008

LONDON (MarketWatch) -- South Korea's Financial Services Commission Chairman Jun Kwang-woo said Tuesday that talks between state-run Korea Development Bank and Lehman Brothers Holdings Inc. have ended, Dow Jones Newswires reported. He declined to say what conclusions, if any, had been reached, the report said.

Fannie and Freddie Used Accounting Tricks to Create a "House of Cards"

Fannie and Freddie have been the bastions of the housing industry holding trillions of dollars in securitized mortgages.

Housing has been a significant driver of the US economy for the past ten years, and a major source of credit growth and personal wealth in a long period of wage stagnation.

If Fannie and Freddie are a "house of cards' and an accounting fraud, what does that make our economy? Hollow, thin, and unstable?

Fannie, Freddie `House of Cards' Prompts Government Takeover
By Dawn Kopecki
Bloomberg

Sept. 9 -- Fannie Mae and Freddie Mac used accounting rules that created a ``house of cards'' as the housing market descended into its worst slump since the Great Depression.

While the two largest mortgage-finance companies met regulatory requirements for their capital, reviews by the Treasury, the Federal Housing Finance Agency, and the Federal Reserve found they probably wouldn't weather the highest delinquency rates on record, lawmakers and regulators said.

``Once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there,'' U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. ``They found out they had a house of cards.''

Treasury Secretary Henry Paulson and FHFA Director James Lockhart seized control of Fannie and Freddie less than a month after Lockhart, whose job is to oversee the companies, declared them ``adequately capitalized'' under law. The discrepancy highlights the flaws in legislation and in the regulatory oversight of Fannie and Freddie that didn't demand they keep more assets as a cushion against losses, according to Joshua Rosner, an analyst with Graham Fisher & Co. in New York.

``Fannie and Freddie's accounting during the housing crisis appears to have been more fantasy than reality,'' said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.

`Not Adequate'

Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie's capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA's standard, filings show.

``They met the legal definition,'' Lockhart said in an interview with Bloomberg Television yesterday. ``As I have been telling lawmakers for a long time, that legal definition was not adequate.''

As their stock prices declined and yields on their debt rose to the highest in at least 10 years above benchmark rates, the FHFA saw ``big questions out there,'' Lockhart said.

``The issue is that the exposures are continuing and continuing to grow and it looked like in the future there were going to be significant issues and they were going to have capital problems,'' Lockhart said.

Lockhart said he brought in financial examiners for the Federal Reserve and the Office of the Comptroller of the Currency to help with a review of the companies' finances. Treasury also sought help from Morgan Stanley officials, who prepared a report after trawling through the accounts.

`Too Low'

After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed President Richard Fisher said yesterday.

``We concluded that the capital of these institutions was too low relative to their exposure,'' Fisher said in response to an audience question after a speech in Austin, Texas. Further, ``that capital in and of itself was of low quality.''

Fannie counted $20.6 billion in so-called deferred tax credits toward its $47 billion of regulatory capital as of June 30, according to company disclosures. Freddie applied $18.4 billion in deferred-tax assets toward its $37.1 billion in regulatory capital in the second quarter.

Fannie and Freddie have posted four straight quarterly net losses totaling a combined $14.9 billion and have said they anticipate more. The tax credits don't have any value unless the companies are generating profit. (They had to bring in the Fed, Treasury and Morgan Stanley to figure this out? - Jesse)

`Not Even Real'

``That's not even real money,'' Shelby said.

Senator Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee responsible for oversight of the companies, said yesterday he plans to hold hearings on why the Bush administration didn't act sooner.

``Why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?'' Dodd said in a Bloomberg Television interview. ``I have a lot of questions about where was the administration over the last eight years.''

Market Value

After more than eight years of debate, Congress passed a law in July expanding Lockhart's authority to raise capital requirements, curb growth and to take over the companies' operations in a conservatorship or liquidate their assets under receivership. The legislation also gave Paulson temporary power to inject unlimited sums of taxpayer money into the companies.

The companies just four years ago admitted to $11.3 billion in earnings misstatements that led to $525 million in federal fines, tighter regulatory controls and the ouster of the CEOs.

Paulson said he stepped in to prevent a collapse of the companies, protecting investors owning more than $5 trillion of Fannie and Freddie corporate debt and mortgage-backed securities while potentially sacrificing holders of the common and preferred stocks.

The companies yesterday lost the majority of their market value, with Fannie falling 90 percent to 73 cents in New York Stock Exchange composite trading, its lowest level since 1982. Freddie dropped 83 percent to 88 cents, the lowest since the regular common stock began trading 20 years ago.

No Exit

The Fed's policy error begins with the question, "Which institutions can we allow to fail?"

While academics and government bureaucrats believe in market capitalism in theory, they want nothing to do with it in practice. They see risk as an aberration to be harnessed, and failure a fatal error of financial planning, an admission of imperfection.

And what are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest." Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later.

But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.

Ben Bernanke, May 13, 2008

Bernanke seems to imply that the problem we have had in past crises was not in the fallible judgement of men and the invisible hand of the market, but a lack of an indefinitely expansible money supply. To understand this is to understand the Federal Reserve's decisions since Greenspan and their continuing efforts to expand the money supply while masking its deleterious effects.

This is the heart of our difficulty. We have forsaken market principles and embraced neo-liberal statism with an inherent belief in the perfectibility of centralized economic planning, a benevolent monetary dictatorship.

The notion that setting hurdle rates for financial viability is solely a mechanism to protect a scarcity of capital overlooks the simple fact that some projects, some companies, just don't deserve to be funded, because they do not provide a sufficent return with risks compared to others, and the market is the place where these things are most effectively determined. Fair and open competition is the great leveler of privilege and influence, and a mortal enemy to monopoly and subsidy. It is the most genuine stimulus to real growth, profit, and savings.

The Fed seems to think that if they plan more precisely and make their decisions with the best data and equations and brightest minds, and vigorously increase availability of liquidity, they can succeed in producing an optimal economy and permanently subdue the vagaries of risk. A financial utopia. Experience suggests that they will create an imbalanced monster dominated by whatever sectors they choose to support.

The problem is that those who are in charge of safeguarding and regulating and encouraging free markets simply don't believe in them anymore.

Until we embarce market capitalism again there shall be no exit, at least none that we may prefer or intend.

"Through pride we are ever deceiving ourselves. But deep down below the surface of the average conscience a still, small voice says to us, something is out of tune."

Carl Jung

Is there an exit strategy?
Kenneth Rogoff
Guardian UK
September 08 2008 08:00 BST

A year into the global financial crisis, several key central banks remain extraordinarily exposed to their countries' shaky private financial sectors. So far, the strategy of maintaining banking systems on feeding tubes of taxpayer-guaranteed short-term credit has made sense. But eventually central banks must pull the plug. Otherwise they will end up in intensive care themselves as credit losses overwhelm their balance sheets.

The idea that the world's largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour.

If this is the right diagnosis of the "financial crisis", then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.

The United States Federal Reserve, the European Central Bank, and the Bank of England are particularly exposed. Collectively, they have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated "investment banks". Many other central banks are nervously watching the situation, well aware that they may soon find themselves in the same position as the global economy continues to soften and default rates on all manner of debt continue to rise.

If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the financial crises of the 1990s. But history suggests that fixing a central bank's balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalisation by taxpayers. Both solutions are extremely traumatic.

Raging inflation causes all kinds of distortions and inefficiencies. (And don't think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence.

There is also a fairness issue. The financial sector has produced extraordinary profits, particularly in the Anglophone countries. And, while calculating the size of the financial sector is extremely difficult due to its opaqueness and complexity, official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006. Multi-million dollar bonuses on Wall Street and in the City of London have become routine, and financial firms have dominated donor lists for all the major political candidates in the 2008 US presidential election.

Why, then, should ordinary taxpayers foot the bill to bail out the financial industry? Why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years? This argument is all the more forceful if central banks turn to the "inflation tax", which falls disproportionately on the poor, who have less means to protect themselves from price increases that undermine the value of their savings. (And that's why this will be the choice, because the poor also have the least power and influence. - Jesse)

British economist Willem Buiter has bluntly accused central banks and treasury officials of "regulatory capture" by the financial sector, particularly in the US. This is a strong charge, especially given the huge uncertainties that central banks and treasury officials have been facing. But if officials fail to adjust as the crisis unfolds, then Buiter's charge may seem less extreme.

So how do central banks dig their way out of this deep hole? The key is to sharpen the distinction between financial firms whose distress is truly panic driven (and therefore temporary), and problems that are more fundamental.

After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions' key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.

In principle, the financial industry can become smaller by having each institution contract proportionately, say, by 15%. But this is not the typical pattern in any industry. If sovereign wealth funds want to enter and keep capital-starved firms afloat in hopes of a big rebound, they should be allowed to do so. But they should realise that large foreign shareholders in financial firms may be far less effective than locals in coaxing central banks to extend massive, no-strings-attached credit lines. (Not necessarily in the US where power and influence have undermined the Constitution and the political process, at least for now - Jesse)

It is time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future.