John Carney has some interesting commentary on the first day of the Financial Crisis Inquiry Commission hearings.  He writes:

A structured credit product—whether its as simple as a mortgage backed security or a complex CDO—is not necessary flawed if it produces losses. Even enormous losses. Indeed, it might be perfectly well-designed but still deliver the buyers losses.

The point of creating structured financial products is to create exposures to certain risks and opportunities. A mortgage backed security, for instance, might be designed to expose buyers to subprime mortgages. If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it.

Of course, a financial product can be badly designed. It could fail to track the performance of the mortgages it was meant to. This tracking failure is one of the big critiques of many ETFs, some of which are poorly designed. This was not the problem with the credit products sold by Goldman—they went down when the housing market collapsed and the mortgages backing them went sour.

When Goldman was selling the financial products, it wasn’t necessary telling the buyers that these were great investments. It was telling them that they were investments that would give them the exposures they were looking for. If you were bullish on the mortgage market and a skeptic of the Bubble Thesis—a thesis that Goldman had very publicly embraced—then buying mortgage backed securities from Goldman was a way to put that bullishness into action.

Angelides, the former California state treasurer, just has too much of paternalistic world view to understand that it is possible to sell a financial product without believing the buyer’s rationale for buying it.

This really is the heart of the matter. Angelides thinks it is wrong for Goldman to underwrite financial products that create exposures it does not want for itself. As long as Goldman wasn’t lying to clients or over-hyping the financial products—and so far, no one has shown any evidence of this—there’s nothing really wrong with what Goldman was doing. If sophisticated investors want to take on risk, they should be permitted to.

There is nothing wrong with a firm selling exposure to assets that it does not want (the crux of the securitization business) or the idea that good products with good collateral behind them can be money-losing investments.

However, I do not find John’s defense of Goldman or his assault on Philip Angelides’ regulatory acumen convincing, not because of his principles, which, for the most part, I agree with.  Instead, I think that thesubprime mortgage business and the manner in which those loans originated, were acquired, securitized and sold was a significant abandonment of those principles.

If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it

Qualitatively neutral descriptions of what structured products should or should not do, while helpful to those without a financial background, are not helpful in this particular instance.   As housing prices rose and subprime mortgage lending dramatically increased in volume, the business became rotten to the core.  Mortgage fraud rose dramatically.  Lending standards vanished.  Loans were made to just about anyone who had a pulse and could sign their name to a sheet of paper (i.e. the strawberry picker making $14,000 per year getting a $720,000 home).  Home values were rising to unprecedented levels.  Collateral from this storm was piling into these products.  Wall Street firms were buying these loans in massive quantities.

The firms did little due diligence on the quality of these loans.  Furthermore, the firms tasked with evaluating the loan pools were 1) working in an environment where the incentive was to sign off on as many loans as possible (quantity vs. quality) and 2) evaluating a representative sample of the total pool (the sellers were able to impose this condition because of the competitive environment for their product).  This is all detailed in Chain of Blame by Paul Moulo and Matt Padilla.   Investors were clamoring for product and Wall Street simply churned it out from whatever source they could acquire with little to no regard for the underlying quality.

The banks didn’t know (or worse, didn’t care) what they were piling into these securities and then strong-armed the rating agencies into giving these securities the coveted AAA ratings so that the pool of possible investors would be as large as possible.  So no, they did not just create securities to fill a market demand.  They were also working to present the most optimistic risk picture possible.

Given what happened to the mortgage markets, I see nothing paternalistic about grilling the banks about how this business was carried out for mortgage products.  Angelides’ words may have been poorly chosen, but this doesn’t get the banks off the hook for their role in the securitization crisis, even if their actions were technically legal.

After I read Ross Douthat’s column this morning, I tweeted that I was nominally on board with his attempt to massage George W. Bush’s reputation.

Three hours, two cups of coffee, and a nice helping of sense later, I think I can safely say that my original assessment was a little…off.  First, here’s Douthat in his own words:

America has had its share of disastrous chief executives. But few have gone as far as Bush did in trying to repair their worst mistakes. Those mistakes were the Iraq war — both the decision to invade and the conduct of the occupation — and the irrational exuberance that stoked the housing bubble. The repairs were the surge, undertaken at a time when the political class was ready to abandon Iraq to the furies, and last fall’s unprecedented economic bailout.

Both fixes remain controversial. But for the moment, both look like the sort of disaster-averting interventions for which presidents get canonized. It’s just that in Bush’s case, the disasters he averted were created on his watch. [...]

And perhaps his best decisions, on the surge and the bailout, were made from the bunker of a seemingly-ruined presidency — when his approval ratings had bottomed out, his credibility was exhausted and his allies had abandoned him.

This is not a blueprint that future presidents will want to follow. But the next time an Oval Office occupant sees his popularity dissolve and his ambitions turn to dust, he can take comfort from Bush’s example. It suggests that it’s possible to become a good president even — or especially — when you can no longer hope to be a great one.

I’m not sure how much of this is the fault of the medium rather than the messenger, but I don’t think Douthat quite grasps the gravity of President Bush’s mistakes.  The Iraq War wasn’t just a run-of-the-mill piece of unfortunate, but easily corrected, policy.  It was – and is – a strategic and humanitarian disaster of the highest order.  Over the course of six years, the United States has squandered trillions of dollars, destroyed hundreds of thousands of lives and done almost irreparable damage to Iraq’s social fabric.  In retrospect, the surge was a welcome breath of pragmatism from the Bush administration, but even with that (limited) success in mind, it’s incredibly difficult to say that President Bush “fixed” anything.

The same goes for the financial crisis.  While there’s plenty of blame to go around for the collapse of the housing market and subsequent collapse of the financial system, it’s fair to say that the Bush administration deserves a fair amount of blame for stoking the “irrational exuberance” that in turn stoked the housing bubble.  What’s more, the twin collapses have yielded a tremendous amount of suffering, especially among the poor and working-class.  Since the recession officially began in December 2007, the country has had a net loss of about 5 percent of its non-farm payroll, the brunt of that borne by the most economically insecure members of our society.  The bailouts and TARP were certainly good moves by the administration, and should be recognized as such despite their flaws, but again, to say that those make up for the initial failures is a bit of a stretch.

And I guess that’s my main complaint with Douthat’s column.  To borrow a phrase from President Bush, what Douthat has written is a classic example of the “soft bigotry of low expectations.”  Saying that we should applaud President Bush for taking steps to salvage his disastrous presidency is like praising a roommate for cleaning up a bit after trashing the apartment.  Not only should the place never have been trashed to begin with, but cleaning up after oneself is a matter of course and not particularly praiseworthy.

Update: I left out a pretty critical part of the Douthat column.

I’m sure many of you have had your fill of new perspectives on the financial crisis and the conditions that led to it; I thought I had, too. But I find the piece “Infinite Debt” by Thomas Geoghegan to be absolutely essential reading. Harpers gates it’s content for subscribers only, but this video interview with Geoghegan does a great job of explaining his point of view. Go ahead and watch it. Really. Watch it. (I know, I’m demonstrating that I’m an unreconstructed lefty by linking to Democracy Now. Bear with me.)

Geoghegan identifies the beginning of the instability and bubble/bust cycle that has come to dominate American finance as being a product of the United States essentially abandoning usury law in the 1970s. As Geoghegan points out, usury law (laws that regulate the kind of interest rates lenders can charge to their lendees) have been around in almost every civilization that has had a currency, stretching back thousands of years. And he points to this current crisis as a demonstration of the basic wisdom of usury.

Geoghegan points out that, when banks can charge whatever they want for interest– 12%, 15%, 18% on credit cards, 200% on payday loans, etc.– capital will inevitably be invested in financial vehicles rather than in businesses based on manufacturing or providing services. A really fantastically profitable and efficient manufacturing concern might get an investor 5% or 6% return on his investment. But lenders, free from any constraints on the rates of interest they can charge, can claim to double or triple that return to investors. So capital flows away from businesses that actually provide products or services that people want to pay for and towards lending credit. As Geoghegan points out, GM and General Electric, two huge and once hugely profitable manufacturing concerns, both created banks to lend money, because that’s where the greatest profitability came from. And when companies are allowed to represent as assets money they are owed rather than money they have collected, with no reasonable accounting for the odds that the money lent is going to be repaid, the lenders have an enormous advantage in profitability over manufacturing companies– even if profitability is something of an empty term in these conditions.

The problem, though, is that this profit rests on the supposed value of the agreement of the people and companies who have been lent money to pay that money back and then some. And as more and more investor want to be involved in the credit lending business, as it shows the most impressive rates of return, there is more and more pressure on the lenders to lend to those who are unlikely to pay back the principle and interest. The subprime crisis couldn’t have happened if there weren’t so many investors trying to create profit (or the appearance of such) by getting people to agree to pay back more than they borrowed. The lenders went after subprime borrowers because they were looking for borrowers, period, and they had to start looking under rocks previously unturned in order to generate more interest, and more paper profits…. And in the short term, this limitless lending and interest looks like a spectacular deal for the country, as all the financials are reporting record profits. The problem comes when people start to look for, you know, the actual money and not just the promise of being paid back.

Worse still, as more and more capital was invested in credit lending, there was less money going into the real, productive economy of manufacturing and providing valuable services. This is a big problem in an era of hyperactive credit and lending, because the workers actual wage growth has stagnated, meaning they aren’t making the kind of money they would need (as a class) to pay back this enormous credit burden. If the real economy is humming along, and the buying and selling of actual goods and services is generating growth, then the workers (due to higher wages) would have the capacity to pay off higher interest rates, at least within reason. But in our economy, the loss of real wage growth meant that there was no capacity for these workers to pay off what they owed. Unfortunately, there wasn’t the possibility of a groundswell of populist support for changing the system, because the workers and middle class could get what they wanted to buy– because of all the credit out there! Banks and financials lent money, charged absurd interest rates, people borrowed the money and bought things they couldn’t have possibly afforded, the banks represented the money owed as assets, and everyone was happy, except for the people who were financially ruined by the lack of any meaningful limit on the ability to borrow and the crushing interest rates. But once people got a little worried, and wanted to see the actual capital involved– when spooked investors wanted actual liquid capital, rather than representations of capital in stock or the “asset” of being owed money– the system collapsed.

Clearly, this system is deeply flawed. But it’s very easy to see why it’s seductive for everyone involved. The banks show record profits, thanks to the fact that they can represent the value of what they are owed as assets, often regardless of the likelihood that those debts would be repaid. The investors were seeing huge returns on their money. The average consumer, provided he didn’t fall so far behind that he lost access to the great flow of cheap and easy credit, was able to buy and consume at previously unheard of levels. True, he was likely carrying a mountain of debt, but he had stuff, and if a lot of his net worth was tied up in a house that had its value artificially inflated, he didn’t feel particularly insecure. Besides, the stigma of being deeply in debt had almost vanished. Every was getting ahead, as long as we all agreed to believe in the value of agreements to pay back money. The problem is that many of these agreements were actually valueless, because the debtors had no genuine capability to repay the debts.

There’s a lot of consequences to our understanding of this situation. The first is, I think, another nail in the coffin in the notion that you can ever have a truly free market when you have a currency. When you have a currency, you’ll have lending, and when you have lending, you’ll have interest, and human nature being what it is, lenders will wring out as much interest as they can when they can, offsetting the balance of our economy. You’d like borrowers to be rational, and say “I’m not paying 18%, no way;” but people aren’t rational, a lot of the time, and they don’t make good decisions, and when people really need money they will make terribly impractical decisions in order to get it. So we need a strong regulatory apparatus to limit the size of interest rates and the degree to which banks are leveraged, in order to prevent the kind of situation we have now, where there is vastly more money owed than the people of the country have the capacity to repay. Adjustable rate mortgages and CDOs and all the other various shenanigans that helped get us here are symptoms of a larger disease of interest rates run amok and the flight of capital into financial investment and away from the real economy.

Secondly, the pro-globalization furor that has gripped our consciousness in recent decades bears a lot of blame. We have a very diverse set of opinions and ideas here on the Web and in our media, but there are certain ideas that are enforced in an exclusionary way. Being at all skeptical about globalization for too long has meant being excluded from the ranks of the “serious”. The idea that globalization is good for the United States, the world and its people is an attitude that people insist on with incredible zeal, and this insistence comes from conservatives and liberals, Democrats and Republicans. But the consequences of globalization for the United States have meant a hollowed out economy, where we produce very little of actual value, and where a huge amount of our growth comes from the accumulation of imaginary money. Unfortunately, the policies that could spur a return to the ancient and tested method of generating growth– making products people want to buy– have been derided by many of the pro-globo set as mere protectionism, nativism or simple naivete. We have to begin to push back against the rigorously enforced idea that globalization is some wonderful tonic that spreads money and stability around the globe. Some degree of globalization is necessary and welcome, but we cannot allow our dedication to a global economy to leave us with no domestic capacity to generate growth through the buying and selling of internally produce commodities. We’ve got to resist the Tom Friedmans.

Third, I think it’s time for those of us who are sympathetic to unionism to stop our long retreat and start fighting again, armed with the fact that unions increase wages for the middle class, and that what this country needs is a middle class which actually makes more money in real dollars, rather than getting what they want from going deeper and deeper into debt. Whatever else is true, union workers tend to get paid more, and those higher wages represent actual money that can actually be spent to stimulate the economy and spur growth, without the inevitable payback that an economy based on debt requires. It’s true that unions reduce the raw profitability of the factories and businesses that have been unionized; decent wages and benefits cost money that could otherwise be diverted to profit. But perhaps the owners and CEOs and boards could be made to see that they have a financial interest in the country having a middle class that is capable of significant wage growth, and not just the replacement of wage growth through the extension of more and more debt.

This all has the fringe benefit of refocusing our vision of the point of society, so that we look not at the growth of GDP or the total amount of wealth being moved around, but at how the majority of the people have their lives materially improved. I wish that those who cheerlead economic growth as the end-all, be-all of human existence would admit that this financial crisis has proved that paper growth does not in fact ensure the best for our people. It’s time to ask, what is the point of progress if it doesn’t lead to human abundance and happiness, and sustainable human abundance and happiness?

We have to move back to being a society that buys the things it can pay for and lives according to its means. Look, banks and lending are good things when they exist in a context of real growth through production. If a guy has a great idea for a widget, he should be able to borrow money from the bank to start his factory, so that he can hire workers to make a decent wage in sound working conditions, so that they can make the widgets, earn money to spend in the real economy, earn him profit and enable him to pay back the bank. All of that is to the good. But when we incentivize the extension of credit so far beyond the degree to which we invest in the making and marketing of tangible goods and services, we ensure growth without actual value, and it leaves us in the kind of untenable position we are now. If we’re going to rebuild our real economy, we need to firmly regulate the lending of money, we need to restigmatize the accumulation of too much debt, we need to have policies and laws that benefit our manufacturing sectors, and we need to stop apologizing for privileging institutions and movements that put real money into the hands of our workers.

Will Wilkinson reprints the response of John Cochrane to the Brad DeLong-Luigi Zingales debate at the Economist.  [The whole debate is very much worth the read].

Cochrane begins:

Nobody is Keynesian now, really. Keynes distrusted investment and did not think about growth. Now, we all understand that growth, fueled by higher productivity, is the key to prosperity.

This may sound like a dumb question, but do we all understand (i.e. agree with) that growth, fueled by higher productivity is the key to prosperity?  Say when the media income (adjusting for inflation) for the average full-time worker is now lower than it is was in 1973?  Not to sound like a Marxist here, but isn’t Cochrane’s statement only correct depending on where one sits in the economic world?  Growth fueled by higher productivity is the key to prosperity for certain players in the game no doubt, but not everybody.  Whose the royal we here?  If it counts me, I’d like to absent myself from affiliation with this consensus.

A counterexample where growth would not lead to prosperity—say the short/medium-term prosperity is causing serious devastation to the natural wealth of the earth on which we depend and without whom we would be pretty well sunk.  In that scenario, more growth (as we currently practice/understand the term) leads to longer term loss of prosperity.

Some more Cochrane:

We all now understand the inescapable need for markets and price signals, and the sclerosis induced by high marginal tax rates, especially on investment. Keynes recommended that Britain pay for the second world war with taxes. We now understand that it is best to finance wars by borrowing, so as to spread the disincentive effects of taxes more broadly over time.

Again–do we all now understand that it’s best to finance wars by borrowing?  Especially when the borrowing can reach beyond comprehensible levels allowing for continued long past their expiration date wars?  [This seems a relevant question since today is the 6th Anniversary of Iraq War II].

All of which leads to this policy prescription/conclusion:

Neither fiscal stimulus nor conventional monetary policy (exchanging government debt for more cash) diagnoses or addresses the central problem: frozen credit markets. Policy needs first of all to focus on the credit crunch. Rebuilding credit markets does not lend itself to quick fixes that sound sexy in a short op-ed or a speech, but that is the problem, so that is what we should focus on fixing.

I’m basically with him on fiscal stimulus/conventional monetary policy but I don’t get the central problem is frozen credit markets.  [Again unless the "we" here is the world of investors].  Credit is the core problem, I suppose, if you think this debt-burdened economy fueled by growth (aka wage stagnation/increasing debt for many) can just go on forever.  And that said growth will bring prosperity down the line.  I think the current economic events are in many ways a critique of that core assumption.

If you think the primary issue is the debt bubble bursting (what Soros calls the super bubble), deflation in the short term, and then frighteningly given the amount of funny money being created by the Fed, a potential pendulum swing reverse to hyperinflation on the far side of the deflationary spiral, then no I don’t think you would think the credit crunch is the central problem.

Jack Gillis proves that sometimes less is more:

Dear Abby:

I’ve been in a long-term relationship with Benry. Bank cheated on me back in the 1930s but I put my foot down at the time, threatening to kick him out. To my surprise, he’d been faithful ever since and seemed very contented. So I loosened the leash a little in 1999 and everything seemed to be going well. He even bought me chocolates every day!!

But now I found out he got the money for chocolates by mortgaging our house without telling me, and he bought his mistress a BMW for every box of chocolates he gave me!! And he’s says I’m fat, which maybe I am a little, but only because of the chocolates he gave me. And he picked up something toxic from his girlfriend and gave it to me and now my asset is itchy constantly and sometimes it bleeds. The money’s gone and the house is mortgaged to the hilt again, and for more than it’s worth, so we’re stuck together. I’m really, really mad at him. But that’s not why I’m writing.

Here’s my problem. He just asked me for beer money.

Should I give it to him?

I should mention that I still love him.

Sincerely,

Perplexed.

This post grows out of some discussion Freddie and I have participated in over at The Confabulum  re: Conor’s post about potential bank nationalization.

Bank nationalization,were it to occur, would undoubtedly be the result of a failure of all the attempted re-capitalization plans (either from Europe or the TARP in the US,etc.).

I’m convinced that TARPy legislation in whatever guises around the world is bound to fail.

Here is Cassandra on this point (h/t Yves S. of Naked Capitalism):

this is The Big One, we’ve smacked head-first into the boundary of the maximum amount of debt that can be assumed by households, corporates and governments in our economy and be reasonably sustained with the fruits of our labour, and investment. Actually, I would posit that we long-ago pierced any reasonably sustainable threshold, and only through sheer inertia and the fortuitiousness of pulling of rabbits-out-of-hats have we lasted this long. But it is the anchoring of popular belief in faith and absent solvency from days long passed combined with the extrapolation a series of non-extrapolatable macro income streams which could cause any sensible human being believe or have believed that the boundary lay somewhere in front of us and not far behind us.

Cassandra calls this situation “Peak Credit”.  If Cassandra is right–and evidence continues to pile up that she may well be, including China (China!!!) in a recession–then here is her prediction of what transpires:

So IF what we are currently witnessing, commonly termed as The Credit Crunch, is in fact, an expression of what I will term Hubbert’s financial equivalent – “Peak Credit” phenomena , and IF as I posit, we long ago untethered the financial wagon from the real economic train, what does this mean?

Many things, but first and foremost, that we are at a major and painful inflection that will impose a real Kunstleresque austerity upon Americans converging their desires with their means. In a word, this means “revulsion”, a somewhat arcane and long-forgotten term for large-scale write-downs and/or economy-wide elimination of outstanding debt(s).

As further proof, check out this post by Yves from Naked Capitalism [who is indispensable to understanding what is going on] which shows that banks that received TARP money gave out LESS loans.  And this is completely logical once we understand this is not a credit crisis but a solvency one.  (Cassandra’s point as well).

Yves:

But that aside, why should we expect that the TARP would lead to more lending? First, there should be less lending, independent of the economic contraction. We know now that TONS of credit was extended to people who shouldn’t have gotten it at all or should have been granted much less than they got. Those balances NEED to shrink, ideally by paying them down, although a fair bit will be via defaults and writedowns…

Now offsetting that to a fair degree is that a lot of businesses are dragging out payments, which puts financial stress on their vendors. They could really use more financing now, if you assume that the business itself is viable and the customers won’t default on their obligations. But banks aren’t set up to do that level of credit investigation. If you fit in the right box on their grid, great, otherwise, you are toast.

The whole depressionary enchilada in other words is baked in the oven of knowledge about the amount of debt loads institutions hold–who holds the debt, what levels, who is trustworthy, who is not, etc.

Any money a bank gets from the government is going to be hoarded to protect their financial backsides because they don’t know how much debt they are actually holding.  But they can guess that’s a helluva lot more than they think it is and they better hold whatever small change they get from the taxpayer in that likely scenario.  Also, they have to realize at this point that a whole bunch of these debts are just going to be written off, so if there is a mass financial Jubilee, (tip o’ the Bowler hat to John Robb) they have some cash on the far side of the leveling.

Nicholas Nasim Taleb says the banks will become public utility companies (like electric, gas, and water).  Whether those are fully nationalized or rather public-sponsored or publicly sanctioned private monopolies which are massively regulated, seems the inevitable outcome of all this debt unloading. At best it means that the injection of liquidity into the banks has only staunched total arrest and complete hemorrhaging (i.e. mass runs on banks).  It has not in any sense brought recovery.  There is way too much more debt (“bad blood”) to be leeched out of the global finance body.

But perhaps my brothers in the League will have alternative theories as to how this could play out or would indulge in some discussion of how to prepare for and give a better spin to (as human life) an “austere” age.  If that is in fact to be the case.