John Quiggin

We’ve all been strictly enjoined to avoid schadenfreude in the current crisis, and indeed few are likely to escape unscathed. Still I’m struck by a couple of examples of historical irony

• Ten years ago, I was debating representatives of the Dutch bank ABN-AMRO, who were pushing for the privatisation of Australian Capital Territory Electricity and Water (ACTEW). A couple of days ago, the Dutch operations of ABN-AMRO were nationalised

• British Bank Northern Rock was nationalised following a run by customers seeking to withdraw their money. Now, seen as safer than its competitors, it is being forced to limit deposits.

The argument by talking point style that characterizes all sections of the political right in the US has been evident as usual in relation to the financial crisis, so I guess it’s time to play whack-a-mole yet again. The most prominent points I’ve seen are

• It’s all the fault of the Community Reinvestment Act, which forced banks to lend to low-income borrowers. Quite a few people have pointed out that many of the subprime loans weren’t required under CRA. More to the point, given that the market structures in the bubble made mortgages a fungible asset, the CRA was a nonbinding constraint. It’s clear that many more subprime loans were given out in the bubble years than were required under the Act and that the excess was greatest in the areas where the bubble was worst. The CRA had no effect at all under these conditions.

• If regulation were the problem, how come the hedge funds haven’t been affected? In fact, it was the failure of Bear Stearns hedge funds that signalled the spread of the crisis beyond the subprime mortgage market. And the main reason hedge funds haven’t yet been hit by the crisis of the past few weeks is that they don’t allow redemptions except at stated dates (for most of them it will be next Tuesday. Perhaps there won’t be a problem, but that’s not what the markets think. In any case, those making the claim seem to be unaware of the redemption restrictions.

Robert Waldmann of Angry Bear has a fascinating post exploring the possibility that sharp movements in the value of Lehman senior debt could be explained by the possibility that Lehman had sold Credit Default Swaps on itself. Since a CDS is insurance against the possibility of default on debt, this is a no-lose bet for Lehman. If the firm survives, they collect the premiums and pay nothing and, if it doesn’t the losses are borne by the creditors. And, as Waldmann points out, it’s not crazy to buy such a CDS, since it will retain some value in bankruptcy. If you’ve already sold a lot of Lehman CDS yourself, there’s a significant hedging benefit. So both parties benefit, and the losers are the existing bondholders. Waldmann has an interesting optimization exercise to show that optimal (for Lehman) use of the CDS option could explain the collapse in the value of Lehman bonds.

Thinking about this, I’m more and more convinced that Warren Buffett’s description of derivatives as financial weapons of mass destruction applies in spades to CDSs.

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Since the collapse of the US financial system became undeniable, I’ve been struck by the number of people insisting that this has no implications for free-market policies because the US (and particularly its financial sector) is not truly a free-market economy. [1]

In the spirit of market economics, I want to offer a trade to all such people. I will agree that
(a) the US is not a free-market economy, and its failures do not constitute evidence against the claim that a pure free-market economy is the best possible form of social organization
(b) no other actually existing society is, or has ever been, a free-market economy, and no actual or conceivable events anywhere constitute evidence against the claim that a pure free-market economy is the best possible form of social organization
(c) In discussion with parties to the agreement, I will not contest the claim that a pure free-market economy is the best possible form of social organization

All I ask in return is that the counterparties to the deal agree not to advocate, oppose, criticise, or comment on any policy or political position that might actually be implemented, to ensure that the purity of the free-market ideal is not compromised by actual experience.[2]

fn1. Since I haven’t checked, I’ll assume that this set of people has zero overlap with those I once debated who insisted that the supposedly superior performance of the US economy over social-democratic competitors demonstrated the superiority of free market economics.
fn2. I’m willing to make the same offer to Marxist-Leninists and (two for the price of one) to combine both offers for free-market Marxist-Leninists

One thing that really puzzles me about the great bailout plan is the almost universal acceptance that Paulson should be the one to run it, at least until the next Administration. More generally, I’m surprised by the kid-glove treatment he’s been getting in public discussion, even from people highly critical of the plan.

Let’s stipulate that he’s a smart guy. He wouldn’t have risen to the top in Wall Street if he wasn’t. And, of course, if having smart guys running the show was sufficient to ensure good outcomes, Wall Street wouldn’t be in its current mess.

Looking back at the record, plenty of people have observed that, at least in his public statements, Paulson repeatedly underestimated the severity of the crisis. And there’s nothing in the ad hoc shifts between cash infusions, bailouts and bankruptcies to suggest that he has much more of an understanding of what’s going on than anyone else. As Paul Krugman has said, he’s making it up as he goes along, just like the rest of us.

But the bailout plan is something else. The possibility of a meltdown like this has been talked about, increasingly seriously, for the last couple of years. Yet Paulson responds with a three page document saying “I need $700 billion, no questions asked”. Wasn’t there a contingency plan? Or worse still, was this the contingency plan?

Either way, Paulson should be sacked forthwith.

Steven Poole is taking a break from blogging, so we can’t get his thoughts on the “clean bailout” as an example of Unspeak. To me the natural association is something like “clean handover” as in “I want a clean handover. Leave the money in unmarked used bills, no tricks and no police, nobody gets hurt”

At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.

By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

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While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:

“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.[1]

It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.

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Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.

Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.

BTW, if you have cash parked in a money market fund, you might want to read this. (Insert disclaimer about financial advice)

UpdateBrad Setser has the same reaction.

Now that Lehman Bros and Merrill Lynch are gone, attention is turning to insurance company AIG. When the first big failure, that of Bear Stearns was coming up, the initial offer of $2 a share suggested that the company was worth less than the building it operated it (the deal was subsequently sweetened, courtesy of the US taxpayer[1]). Looking at AIG, this WSJ story says that, as of last quarter, assets exceeded liabilities by $78 billion, a number that has almost certainly declined since then, given that the $1 trillion asset book includes lots of toxic sludge. But the story also notes that the company’s aircraft leasing subsidiary (where did they get this?) owns planes worth more than $50 billion. So, it looks clear that, apart from the planes, AIG is worth little, nothing or (most likely) a large negative value.

Update Commenters object, correctly, that it isn’t legit to value the planes without taking account of the associated debt. However, after today’s debacles, it doesn’t matter too much. AIG is toast, the only question being whether the Fed will treat it as another Bear or another Lehman. Next cabs off the rank appear to be Washington Mutual and Wachovia, taking the FDIC with them. I even saw GE mentioned somewhere, but it seems too soon for that.

[1] Despite the tough talk and the refusal to bail out Lehman, the Fed has given yet further ground to the banks this time around, agreeing to lend public money against subprime trash.

In the comments to my last post, reader Peter Schaeffer provides exactly what I asked for: a breakdown of the discrepancy between 30 per cent growth in US household income over the last 40 years and 117 per cent growth in income per person. In addition to the factors I’d mentioned (falling household size and growing inequality) Schaeffer notes two more: the fact that GDP has grown faster than national income and the fact that prices faced by households (the CPI-U-RS) have risen faster than the GDP deflator. He provides the details to show that this fully explains the discrepancy.

What should we make of this. As far as the situation of the average American is concerned, the only correction we need to make to the household income figures is to correct for changes in household size. That makes the increase over the last 40 years about 63 per cent, or an annual growth rate of 1.2 per cent. By contrast, the 117 per cent growth in GDP per person implies a rate of just under 2.0 per cent. So, changes in GDP per person (let alone changes in total GDP) are essentially irrelevant as a guide to how the average household is doing.

And of course, the poor have done much worse. Household incomes for the bottom quintile have barely moved for decades. Growth in consumption has been driven largely by increasing access to debt, a process that now looks to have run out of road. That would seem to indicate a looming social crisis. But the coming election will still turn on whether Obama called Palin a pig.