Spero Consulting

Posts Tagged ‘mortgage crisis’

We tend to be pes­simistic; so, per­haps the news isn’t as bad as it seems, but con­sider these two facts, which were both reported in today’s The Wall Street Jour­nal:

1. A sur­vey by the Mort­gage Bankers Asso­ci­a­tion found that 13.2% of mort­gages on homes with one to four units were at least one-​month over­due or in the fore­clo­sure process in the sec­ond quar­ter. That’s almost 50% higher than at the same time last year, and much of that increase is due to prob­lems with prime loans, not sub­prime loans. (See Sour­ing Prime Loans Com­pound Mort­gage Woes.)
2. A June sur­vey by Inside Mort­gage Finance of real-​estate agents found that 36% of all sales involve “nondis­tressed” prop­er­ties. Of those sales, only 31% were what the sur­vey described as “unforced or optional.” Mul­ti­ply 0.36 by 0.31, and you’ll dis­cover that only 11% of sales – about one-​out-​of-​nine were “unforced or optional.” That means that nearly 90% of sales by home­own­ers involve some­thing unpleas­ant. (Improv­ing Home Sales Belie Mar­ket Real­ity.)

Now, both sur­veys may be ter­ri­bly unrep­re­sen­ta­tive of actual mar­ket con­di­tions and facts, and con­di­tions could actu­ally be much bet­ter (or much worse). How­ever, if both are accu­rate, it seems that we are fac­ing a very slow and grad­ual recov­ery. Of course, that’s IF the econ­omy is, in fact, begin­ning to recover. More­over, this can’t be good news for hold­ers of mortgage-​backed securities.

We rarely try to “time” the mar­ket and rarely make spe­cific invest­ment rec­om­men­da­tions, but we think that today was a fine day to sell a few of our mutual funds, and we did.

If you haven’t read it, For the Vix, 40 Looks Like It’s the New 20 in today’s The Wall Street Jour­nal please know that is a decent column.

We par­tic­u­larly like the paragraph:

“Volatil­ity may not return to its highs, but it isn’t clear when it will get back to nor­mal, either. Volatil­ity breeds fear, which breeds more volatil­ity. There is still too much uncer­tainty about the losses lurk­ing on bank bal­ance sheets and about the depth and breadth of the cur­rent reces­sion to inspire much calm.”

Now, the first sen­tence is true but says absolutely noth­ing. We’re not try­ing to ridicule Mark Gon­gloff the writer of the Ahead of the Tape column; instead, we empathize with the dif­fi­culty he faces writ­ing about mar­kets and uncertainty.

The notion of uncer­tainty about uncer­tainty–and the inabil­ity to mea­sure it in a sim­ple man­ner – tends to make state­ments about the topic either sound overly-​complex and overly-​qualified (by all of the nec­es­sary descrip­tive qual­i­fi­ca­tions to the state­ment) or makes them sound trite. Some­times that’s the writer’s fault, but often it is the reader’s fault, too, espe­cially when the reader incor­rectly pos­sess no uncer­tainty about their own “knowledge.”)

Now, we espe­cially like Mr. Gongloff’s fol­low­ing sen­tences because that’s almost exactly what we’ve writ­ten dur­ing the past sev­eral months – almost three months now.

The mort­gage cri­sis that cre­ated the con­fi­dence and liq­uid­ity cri­sis and the result­ing equity mar­ket volatil­ity all con­tin­ued unabated. Last Wednes­day, in The Mort­gage Cri­sis: Why Not Incen­tivize the Pri­vate Sec­tor? we wrote: “By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.” 

While we try not to make much of one-​day changes, even when they are as large as today’s drop of 680 points in the DJIA and the nearly 9% decreases in the S&P 500 and NASDAQ indices, we do believe both the con­tin­u­ing volatil­ity and losses pro­vide evi­dence that the government’s actions to date have not helped instill con­fi­dence. In all like­li­hood have hin­dered econ­omy and finan­cial activ­i­ties by not allow­ing any res­o­lu­tion of the uncer­tainty of the value and via­bil­ity of large finan­cial intermediaries.

We wrote about that in Could a “Bailout” Pro­long the Finan­cial Cri­sis? and The Uncer­tain Value of Mort­gage Secu­ri­ties (among other posts) in late Sep­tem­ber. How­ever, the government’s exe­cu­tion and lack of plan­ning has been even worse than we could have imag­ined, and we had extremely low expec­ta­tions to begin with. 

As we have been men­tion­ing since that time, we wish fed­eral gov­ern­ment would pro­vide tax incen­tives – say, mort­gage invest­ment tax cred­its – to moti­vate pri­vate pur­chases of trou­bled assets. 

We also wish the gov­ern­ment would expro­pri­ate the worst offend­ers – the most poorly cap­i­tal­ized large banks. We know that the Trea­sury can’t run banks any bet­ter than the exist­ing man­age­ments, but that’s not one of our reasons. A main rea­son is to moti­vate other health­ier insti­tu­tions to act. Hav­ing ready buy­ers – moti­vated by such tax cred­its – would cer­tainly help those banks exchange assets for cash, and that lack of trade keeps the analy­ses of each bank’s finan­cial con­di­tional need­lessly opaque, and that’s (by def­i­n­i­tion) no way to resolve uncertainty.

We’re not sure when dur­ing the day, Mr. Paul­son spoke of new pro­grams (Paul­son Says Trea­sury Actively Mulling New Res­cue Pro­grams), but we doubt if that stemmed the (ebbing) tide of sharply decreas­ing equity val­ues. Unfor­tu­nately, there is no rea­son to expect any pos­i­tive news any time soon.

In today’s (Novem­ber 26) edi­tion of The Wall Street Jour­nal, there is a Deal Jour­nal arti­cle enti­tled, “Paul­son Plan: ‘Truly Idiotic.’”

Although we’ve not gone that far in describ­ing TARP et al, we’ve been harshly crit­i­cal of Mr. Paul­son. In fact, we’ve men­tioned that his series of actions don’t seem to con­sti­tute an actual plan, because the word “plan” implies a cer­tain degree of, well, plan­ning or fore­sight and forethought, and those pre­req­ui­sites seemed absent in his Panic of ’08.

The quoted accuser in the Deal Jour­nal arti­cle is Charles Calomiris, a prof at Colum­bia, and he make sev­eral good points, includ­ing “we’re using half-​measures designed in an inap­pro­pri­ate way,” and “The prob­lem is the com­pletely opaque dis­tri­b­u­tion of losses because no one knows how to value these mort­gage losses.”

We’ve made sim­i­lar remarks any num­ber of times, and it is exactly those opaque joint dis­tri­b­u­tions of cash flows (and there­fore losses) that cause all the trou­ble and makes the pools impos­si­ble to value with any degree of precision.

While we do agree with his crit­i­cism, we don’t agree with his rec­om­men­da­tions. Pri­mar­ily his sug­ges­tion that “the gov­ern­ment offer to buy any mort­gage for 40 cents on the dollar.”

It is unclear how the 40% solu­tion is derived, and think­ing in terms of Akerlof’s Lemons Model, you can be sure that only one type of mort­gage would be offered: one with a value between zero and 40% of face value.¹ Thus, if the gov­ern­ment com­mits to pur­chase any mort­gage, it would cer­tain over-​pay, and thus sub­si­dize the worst cases, and if the gov­ern­ment does not com­mit, then it is likely the mech­a­nism would fail with few or any trans­ac­tions. (The dif­fi­culty of valu­ing the mort­gages does com­pli­cate mat­ters as does their cur­rent book value.)

Why not try a pri­vate solu­tion? Why not offer mort­gage invest­ment tax cred­its or per­mit imme­di­ate and accel­er­ated amor­ti­za­tion (depre­ci­a­tion) of the pur­chase price of those mort­gages and mortgage-​related secu­ri­ties for prospec­tive buy­ers? Then set low tax rates for prospec­tive real­ized cash flows.

We’re sure that many buy­ers have some val­u­a­tion model, but likely (and jus­ti­fi­ably) do not trust it. Giv­ing a 30% — 40% tax break should pro­vide them with an ample cush­ion to take a chance. How could such a plan be any worse than a government-​administered plan, or a government-​regulated, fixed-​price one? (Remem­ber the government’s suc­cess at other attempts at price con­trols: both sup­ports and ceilings.)

By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.

Noth­ing has solved the over­whelm­ing prob­lem that the mar­kets do not trust the large finan­cial inter­me­di­aries, and those banks do not trust each other. The mort­gage cri­sis informed about the banks’ short­com­ings; so, solv­ing that mort­gage cri­sis won’t cause any­one to believe that the bank’s judg­ment has improved – at least for quite some time. In that respect, Mr. Calomiris is quite right. Mr. Paul­son has done noth­ing to help.

Thank god we live in a coun­try that can with­stand such epic mis­man­age­ment. What was the total $7.5 trillion?

(New read­ers can search the archives from the past sev­eral months to find many related articles.)

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

Reg­u­lar read­ers will know that we often crit­i­cize the stu­pid appli­ca­tion of math­e­mat­i­cal mod­els, espe­cially ones related to finance and eco­nom­ics; ergo, our firm’s motto, “Thought Before Calculation.”

In that light, we note that in last Friday’s The Wall Street Jour­nal (Novem­ber 7) the edi­tors excerpted a speech that Michael Crich­ton gave at Cal Tech in 2003, entitled ‘Aliens Cause Global Warm­ing.’ (For those who don’t know, Mr. Crich­ton passed away early last week.)

In the speech, Mr. Crich­ton dis­cussed the Drake equa­tion which attempts to illus­trate the winnowing-​down process of all the plan­ets in the uni­verse to ones that could sup­port life and could send intel­li­gent sig­nals (to us). There are seven vari­ables in the equa­tion, which was the impe­tus of the SETI project and one of the jus­ti­fi­ca­tions for spend­ing funds on it. For SETI, think Jody Fos­ter in the screen ver­sion of the late Carl Sagan’s Con­tact.

Mr. Crich­ton made the excel­lent points that the Drake Equa­tion is a serious-​looking equa­tion and that its seri­ous appear­ance pro­vided poten­tial inves­ti­ga­tors with a veneer of serious, scientific inquiry. This is despite the fact that NONE of the seven vari­ables can ever be known or esti­mated. Thus, the inves­ti­ga­tion was not sci­ence and was/​is not that dif­fer­ent than count­ing the num­ber of angels on the head of a pin. 

Mr. Crich­ton con­cluded that SETI et. al. “is unques­tion­ably a reli­gion.” (Below we argue it is a bad reli­gion – mean­ing a poorly-​considered one.)

More­over, he con­tin­ued his argu­ment by not­ing that with­out legit­i­mate sci­en­tific inquiry and pro­ce­dure, “soon enough garbage began to squeeze through the cracks…” (By this point, the reg­u­lar reader and the astute reader can see where we are headed by this post’s title.)

He went fur­ther to note that the achiev­ing con­sen­sus around a “model” is not sci­ence, and vice versa.

We go fur­ther to argue that such con­sen­sus is not sci­ence, nor even part of science’s broader super-set, reason. 

Yes, we view sci­ence as a sub­set of rea­son – the empir­i­cal part of rea­son. And so, we’d argue that such con­sen­sus is in fact a sub­sti­tute for rea­son. In fact, it fills the entropic chaos of unknow­ing that is the absence of reason. 

Thus, we con­trast such sci­en­tism with more fully-​developed reli­gions like, say, Christianity, which via numer­ous pas­sages, includ­ing the first chap­ter of the Gospel of St. John, defines God as rea­son (logos) and com­mands man to use that same rea­son to be bet­ter than instinc­tual, impul­sive ani­mals amidst the chaos.¹

At first glance, it might seem that the val­u­a­tion (and sub­se­quent real­iza­tion) of mortgage-​backed secu­ri­ties (MBS) and other finan­cial assets has lit­tle in com­mon with the esti­ma­tion of the cur­rent num­ber of intel­li­gi­ble planets.

However, both method­olo­gies require giant leaps of faith when mov­ing from real­ity to a model as both suf­fer from the absence of rel­e­vant data. Other galax­ies and solar sys­tems (and plan­ets) are just too far away to con­sider care­fully, and there are only (rel­a­tively) short his­to­ries of mort­gage prod­ucts and repay­ments avail­able from which one HOPES to extrap­o­late the future, and this is where and why the con­sen­sus arises. 

There are no good mod­els; so, indi­vid­u­als agree to use mod­els already in use (as a val­i­da­tion for their choice). Often, such mod­els first appeared in text­books for entirely dif­fer­ent pur­poses but were used out of convenience.

Mort­gage port­fo­lio, MBS, and CDOs suf­fer a few addi­tional bur­dens not shared by ET’s would-​be friends, including: (1) depen­den­cies and inter­ac­tions between or among bor­row­ers that would seem to be absent with plan­ets; (2) non-stationarities through time with respect to these (and other rel­e­vant) rela­tion­ships; and (3) the inter­ac­tions are endoge­nous as they involve people’s cog­nizant responses through time to eco­nomic con­di­tions and per­sonal cir­cum­stances. (In that sense, it is truly a daunt­ing task.)

Please see our ear­lier post for a descrip­tion of the mort­gage pool or port­fo­lio prob­lem. In it, we illus­trate how recent calls for more trans­parency are non sequiturs and sim­plis­tic, but do show a lack of under­stand­ing about the nature of the problem.

It seems that the soci­olo­gies of both plan­e­tary and mort­gage mod­el­ing envi­ron­ments do seem to place a pre­mium on con­sen­sus. While every indi­vid­ual trader or struc­turer may have their own idio­syn­cratic tweaks, most solve val­u­a­tion prob­lems in sim­i­lar man­ners because there just aren’t that many tractable ways to per­form the cal­cu­la­tions. But, as many for­mer traders and struc­tur­ers have dis­cov­ered, choos­ing a method­ol­ogy for its tractabil­ity is very dif­fer­ent than choos­ing one for its applic­a­bil­ity, par­tic­u­larly when the envi­ron­ment changes rapidly or drastically.

In fact, we’d argue that the recent lack of exchange or illiq­uid­ity in these mar­kets results from the real­iza­tion and inter­nal­iza­tion that these mod­els have failed, and no suit­able replace­ment yet has been found; ergo, the paralysis. 

As fur­ther evi­dence of paralysis, today Mr. Paul­son announced the Trea­sury Depart­ment wouldn’t pur­chase any trou­bled assets as part of their TARP efforts. (Recall that the “TA” in TARP stands for “Trou­bled Asset.”) It seems that the gov­ern­ment doesn’t know how to value them, either. We’d have been sur­prised by the announce­ment had we not pre­dicted it six weeks ago.

As always when we dis­cuss these top­ics, we point read­ers to our essay Uncer­tainty Man­age­ment, which presents a broader view of the nature of unknow­ing – far broader than the nar­row empha­sis on risk or mea­sur­able uncer­tainty one typ­i­cally sees.

Finally, as usual, we also note that we have pro­posed a pri­vate solu­tion to the mort­gage cri­sis that uses tax incen­tives – via the equiv­a­lent of accel­er­ated depre­ci­a­tion or invest­ment tax credit – to induce pri­vate pur­chases of the trou­bled assets. We sug­gest Mr. Paul­son con­sider that alternative.

Exclud­ing fools – which we admit pro­vides a non-​trivial exclu­sion – we doubt that finan­cial mod­el­ers or ana­lysts will regain the (mis­placed) self-​confidence they exhib­ited in the calm-​market era prior to mid-​2007. 

In our view, such well-​earned and well-​deserved humil­ity will be ben­e­fi­cial for soci­ety as a whole. Such feel­ings may spur inno­va­tion and increase the level of thought­ful of analy­ses per­formed (rather than rote, pro­ce­dural tasks). Perhaps it may change the struc­ture of contracts.

Per­haps the recent fail­ures will allow senior man­agers to gain effi­cien­cies through the real­iza­tion that irrel­e­vant details are not infor­ma­tion and so many rou­tine tasks and algo­rithms are indeed worth­less – despite the claims of reg­u­la­tors and audi­tors. (Oh, who are we try­ing to kid. The skep­tic in us sug­gests that we’re show­ing our naiveté.)

Dis­parate issues linked by their over­whelm­ing smallness.

It’s been a few of weeks since our last post, and such a long gap is highly unusual as we’re rarely at a short­age for words. We’ve been busy, but more impor­tantly, we didn’t feel com­pelled to write about our nor­mal top­ics of inter­est; despite the mar­ket volatil­ity, lit­tle has changed in the inter­ven­ing days.

In addi­tion, the accu­mu­lated effect of see­ing so many behave in such small ways over large mat­ters was and is rather sad and depress­ing. No, we’re not talk­ing about the elec­tion cam­paigns, which, by the grace of God do have a def­i­nite end­ings – if only for a year or so until the next ones begins.

The Small­ness of Our Lead­ers: in the finan­cial cri­sis, few indi­vid­u­als took right, rea­soned, and prin­ci­pled courses of action or both­ered to think before they spoke. While we expect such fallen behav­ior on a day-​to-​day basis, we do hope that our elected and appointed offi­cials are able to rise to the occa­sion. Their fail­ures to do so – their panic and expe­di­ency – remain sources of dis­ap­point­ment. Here is a very, very, very small exam­ple that has stuck with us for nearly a month and was likely unno­ticed by most.

In the days between the two Con­gres­sional votes on the bailout, we saw a Con­gress­man from Ten­nessee rant about mark-​to-​market account­ing. He knew no more about account­ing issue than he did about any­thing else, except talk­ing per­haps, but that didn’t stop him.

While we lis­tened to his dia­tribe against it, we thought, hmmm, not a sin­gle spe­cific ref­er­ence to the under­ly­ing issues of rel­e­vancy, reli­a­bil­ity, eco­nomic effi­ciency, etc. Replace “mark-​to-​market account­ing” in his oth­er­wise generic spiel, “we have to some­thing about mark-​to-​market account­ing before it…,” and he had a ready-​made speech for all that is evil du jour: AIDs in Africa, the lack of clean water in vil­lages, ille­gal drugs, legal drugs, drunk dri­ving, inter­na­tional piracy, child labor, greed, for­eign car man­u­fac­tur­ers, can­cer, dia­betes, Wall Street exec­u­tives, oil prices, etc., and no other words would have changed. He had a handy demo­niza­tion tem­plate, and that made actual con­tem­pla­tion super­flu­ous; so, he had changed his mind and would vote for the bailout.

A the time, we thought, unfor­tu­nately, there are no lit­er­acy or poll tests for vot­ing in Con­gress. Or was it another exam­ple of voter fraud.

As we men­tioned, it is a very small exam­ple, but it suf­fices for small men and their lack of depth, and it also relates to the main pur­pose of this post.

A Few Words on Finan­cial Mar­kets: By the way, on those mar­ket and incen­tive top­ics – our nor­mal blog fod­der – we stand by every­thing that we’ve writ­ten and con­tinue to believe the bailout was and is a mis­take. Even if it does mit­i­gate the liq­uid­ity cri­sis – and we’re not sure that it has – we ask, at what cost to our econ­omy and our freedom?

For exam­ple, we’ve been mus­ing that many gov­ern­ment offi­cials have been able to quite inad­ver­tently meet their elec­tion year promise of sub­stan­tially reduc­ing energy costs – even before the elec­tion. But at what cost? They can rightly argue that their actions – whether planned or not – have saved bil­lions for the Amer­i­can peo­ple as oil has moved from its peak of $147 dol­lars per bar­rel to its cur­rent range in the mid-​60s. Unfor­tu­nately, it has been at the cost of tril­lions of dol­lars of wealth.

On that topic, in April, we pre­dicted (wildly guessed) that oil could be at $40 per bar­rel by year end. We could actu­ally see it quite lower – even in the $25 per bar­rel range. Our ratio­nale: the cohe­sion of OPEC and its part­ners, par­tic­u­larly Rus­sia, will likely fail­ure, and we expect large invest­ment funds – like CALPERS – to con­tinue to liq­ui­date their com­mod­ity hold­ings since equity val­ues have plummeted.

We’ll have more to say about eco­nomic issues in the next few days, par­tic­u­larly with respect to the recent change in tax poli­cies that pro­vide a ben­e­fit – the absorp­tion and use of loss car­ry­for­wards – that the IRS is per­mit­ting acquir­ing banks to take in the recent mergers.

That pol­icy change, while far less grace­ful and effi­cient, is not much dif­fer­ent than our idea to solve the mort­gage cri­sis – but not the liq­uid­ity cri­sis; so, pro­vides a small bit of hope. (Search the archives or read just about any­thing we wrote in Sep­tem­ber and early Octo­ber. We’ll still not sure that offi­cials real­ize that these two crises are distinct._ It is not nearly as clean or as pre­cise as our approach, but that’s not why we are writing.

Sarah Palin: as we wrote almost two months ago, we con­tinue to be amazed at the sense­less vit­riol and sheer hatred spewed towards Mrs. Palin, par­tic­u­larly among Hol­ly­wood and New York celebri­ties, who put forth as much thought as the above-​referenced Con­gress­man from Ten­nessee. As we wrote in our ini­tial post, they hated her before they knew her, and they could hate her with such ease because of who she is – some­one very sim­i­lar to many peo­ple we know, like, and love: con­ser­v­a­tive, pro-​family, pro-​life, middle-​aged, reli­gious and gun-​totin’.

But, we must add, we’re not sur­prised that so many thought­less and dull folks dis­miss her small town may­oral expe­ri­ence and her small pop­u­la­tion guber­na­to­r­ial expe­ri­ence. It says more about them and their lack of expe­ri­ence and intel­lec­tual empa­thy than it does about her.

We spent ten years in acad­e­mia, but it didn’t take that nearly long to appre­ci­ate the valid­ity of Henry Kissinger’s quote that – and we para­phrase – the fight­ing in acad­e­mia is so vicious pre­cisely because the stakes are so small.

What’s true in uni­ver­si­ties it is also true in small towns and most other orga­ni­za­tions as well, includ­ing the staff depart­ments of large corporations.

Regard­less of all the many ways that one can describe func­tions of gov­ern­ments, at a min­i­mum it involves resource allo­ca­tion and gath­er­ing (fund­ing). In other words, who gets what the gov­ern­ment has and who has to give for the gov­ern­ment to have.

Does the reader think that resource allo­ca­tion deci­sions are eas­ier in a small town than in the naiton’s cap­i­tal? One’s pur­chase deci­sions in a small town may aid or bank­rupt a neigh­bor, an acquain­tance or a for­mer class­mate who walks or dri­ves by your home every­day or attends the same church or shops at the same stores or eats in the same restau­rants. Con­sider that as opposed to doing this or that to a neb­u­lous and abstract groups like “small busi­ness­men” or “big cor­po­ra­tions?” in a locale where almost every­one – mostly strangers – are rep­re­sent­ing some­thing or some­one else: rather than directly feel­ing the pain of actions and decisions.

Does the reader think that tax­ing deci­sions are eas­ier in small towns than within the fed­eral gov­ern­ment? Raise prop­erty assess­ments and earn the wrath of those same neigh­bors, acquain­tances, and for­mer friends.

[Where is one more likely to receive the imme­di­ate feed­back from uncom­fort­able con­ver­sa­tions and cold stares? In Wash­ing­ton or Wasilla? Where is one more likely to receive neg­a­tive feed­back fil­tered and diluted through a staff of gut­less, careerist syco­phants? Wash­ing­ton or Wasilla? Yeah, the ques­tions really do answer them­selves. (Our hypoth­e­sis: local politi­cians find more dog waste in their front yards than aver­age cit­i­zens do.)

In one of our own vol­un­teer activ­i­ties, we allo­cate a pre­cious, scarce, and first-​class resource among a group of indi­vid­u­als who do not pay for its use. Such a set­ting is, of course, a recipe for exces­sive demand. Based upon that expe­ri­ence we’d cer­tainly argue in Mrs. Palin’s favor over some­one whose main pri­vate sec­tor expe­ri­ence seemed to be orga­niz­ing beg­ging efforts directed towards the fed­eral gov­ern­ment. (In our case, we joke that the best evi­dence of fair treat­ment is when every user is annoyed with us so try to ensure it.)

Of course, the con­tentious reader might always argue that such small towns are so cor­rupt that there is no notion of tak­ing actions that annoy friends and acquain­tances, i.e., the whole objec­tive is to enrich them (and one­self) while in town hall. In that case we’d then argue that it, indeed, pro­vides excel­lent train­ing for work in the nation’s cap­i­tal. But, that’s not really why we’re writ­ing, either.

Our point is much smaller though it is related to Mrs. Palin.

Mr. Letterman’s Per­sis­tent Lack of Humor: we were too involved in our work to change the chan­nel when David Letterman’s show began last night. We don’t recall any of the mono­logue bits, but they were as lame as usual. (No one, in good con­science, could call his lines jokes.)

What we do recall was a skit where one of the child actors wore an over-​sized ver­sion of Sarah Palin’s pass­port as a Hal­loween cos­tume. It was stamped Mex­ico and Canada (and the USA) and nowhere else, and that was it. That was the whole “joke.”

The car­di­nal that flies into and bangs its head on the fam­ily room win­dows hun­dreds of times each morn­ing exhibits about the same level of wit.

I guess the point of the pass­port cos­tume was to show that Mrs. Palin hasn’t trav­eled much out­side of Alaska or the US. Pre­sum­ably, such travel is now a qual­i­fi­ca­tion for Vice Pres­i­dent because…well, who knows why. It must be some­thing that only some­one as sophis­ti­cated and learned and cul­tured as our Ball State grad, Mr. Let­ter­man, could appre­ci­ate. Per­son­ally, we’ll take some­one will­ing to kill a moose. It takes more skill and courage.

Now, maybe we’re slow or just don’t pay enough atten­tion, but that’s when it finally hit us.

Mr. Let­ter­man has been unfunny for years; that’s not news, we and many oth­ers have writ­ten about that, and it seems to be true since at least the Rea­gan administration.

No, what we’ve con­cluded is last night was not only is Mr. Let­ter­man inher­ently unfunny, but to do that night-​after-​night, year-​after-​year, requires a staff. He can’t be doing the very lit­tle that he does alone. It is very likely that he has a very large and equally untal­ented staff of writ­ers excret­ing such mate­r­ial like ele­phants with dysen­tery five nights a week.

As we see it, it would take a sub­stan­tial num­ber of inse­cure and untal­ented indi­vid­u­als to gen­er­ate the group think required to per­mit such crap to air. Why, at its essence, it almost seems like gov­ern­ment work.

If it were only a few writ­ers, it seems that they would be more likely that they would be able (1) to main­tain their self-​respect and dig­nity and judg­ment, which would then per­mit killing such lame ideas when they were ini­tially dis­cussed or (2) to have the dis­cre­tion not to men­tion them to oth­ers in the first place.

Of course, we must con­sider all pos­si­bil­i­ties, and it could be the case that Mr. Let­ter­man only hires degraded indi­vid­u­als will­ing to do any­thing for money or nox­ious house­hold chem­i­cals. (In that case, he might be a bit more effi­cient than we sus­pect and is able to gen­er­ate his (albeit low-​quality) out­put with only a few comrades.)

So, why does he get the big money? Well, this is one time when we must pro­pose a labor the­ory of value as the answer. Per­haps, the per­sonal effort and sac­ri­fice required to asso­ciate with Paul Shaf­fer for an hour a day jus­ti­fies the com­pen­sa­tion. Bet­ter he than we.

Happy Hal­loween, and don’t worry, it gets worse before it gets bet­ter. The elec­tion is next week.

As the IMF, the G7 and the Pres­i­dent “endeavor to per­se­vere,” we have of own rec­om­men­da­tion to end the global finan­cial crisis.

We’re Not Social­ists or Statists:

We very much believe in free­dom and per­sonal responsibility; strongly pre­fer pri­vate enter­prise to gov­ern­ment ser­vices and bureau­cracy; pre­fer democ­racy – well, repub­li­can democ­racy, at least – to cen­tral­iza­tion and author­i­tar­i­an­ism (except in mat­ters of reli­gion); and pre­fer free mar­kets and cap­i­tal­ism to any of their failed alter­na­tives. We’re not lib­er­tar­ian, but on eco­nomic issues, we’re not that far away.

We’re cer­tainly not leftists.

We’ll hold our nose and vote for McCain despite his recent, wrong-​headed plan to buy bad mort­gages at face value; despite McCain-​Feingold, and despite his views on global-​warming. As we wrote in Well, This Is a Fine Mess You’ve Got­ten Us into…. if only Mr. McCain would retain a sem­blance of humil­ity that we have seen in the past. (It must be quite easy to rec­om­mend buy­ing over-​priced crap when it is not your own money, per Mr. McCain, Mr. Hub­bard, et. al.)

Morover, we don’t view the unprece­dented decreases in global equity mar­kets as a mar­ket fail­ure, nor – despite the lack of trad­ing – we do not view the near shut­down of intra-​bank credit mar­kets as a mar­ket fail­ure. We view both as evi­dence that mar­kets work and that in both cases they inform about the true under­ly­ing fail­ure: the weak­ness of our finan­cial intermediaries.

We Face Two Problems:

Nei­ther the cur­rent finan­cial cri­sis nor the mort­gage cri­sis that pre­ceded it was caused by exoge­nous vari­ables or fac­tors. The mort­gage cri­sis did not result from an earth­quake or vol­cano or tsunami or influenza or wild­fire or any other nat­ural cause. It did not result from the destruc­tion of war or any non-​financial, man-​made action. It resulted from the actions of finance indus­try employ­ees, elected rep­re­sen­ta­tives, and gov­ern­ment bureau­crats. In Saturday’s The Wall Street Jour­nal, on page A13, imme­di­ately below Peggy Noonan’s excel­lent scolding, there is a good sum­mary: The Gov­ern­ment is Con­tribut­ing to the Panic.

Before con­tin­u­ing, please notice that we sep­a­rate the mort­gage cri­sis from the cur­rent, global crisis. 

Despite our government’s obtuse­ness, these crises are indeed sep­a­rate issues. By that we mean that if the mort­gage cri­sis were solved, the banks would still face deep, deep sus­pi­cions and face fund­ing prob­lems. We think that lack of con­fi­dence would be suf­fi­cient to sus­tain the global cri­sis, which at its root is a deep dis­trust of major finan­cial inter­me­di­aries. (See Even A Per­fect Bailout Will Fail for exam­ple.) Conversely, if that sus­pi­cion were elim­i­nated, there would still be a need to deal with the epi­demic of bad loans, par­tic­u­larly in the Sun­belt. (See our pro­posal: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

The Global Prob­lem: The mort­gage cri­sis has informed investors, the pop­u­lace, and bank­ing indus­try cohorts – every­one pre­sum­ably except Messrs. Paul­son and Bernanke – that the global cri­sis stems from a lack of con­fi­dence in many of the nation’s largest, most prestigious banks.

It seems that no one has con­fi­dence in the banks’ business judg­ment, finan­cial acumen, viability, or cred­it­wor­thi­ness, includ­ing their abil­ity to repay an overnight loan, espe­cially other banks. (See Finan­cial Pro­jec­tion in a Cri­sis or most of what we’ve writ­ten recently.)

The Mort­gage Prob­lem: We’ve writ­ten exten­sively about the mort­gage cri­sis and pro­duced a sim­ple, imple­mentable, tax-​based, private-​enterprise solu­tion to THAT prob­lem: A Bet­ter Solu­tion (than a gov­ern­ment takeover). That cri­sis was not inevitable, but it was the result of bad luck com­bined with ridicu­lously flawed gov­ern­ment poli­cies and very poor cor­po­rate over­sight that turned bad luck into hor­ri­bly bad luck via incred­i­bly fast feed­back loops – among both bor­row­ers and lenders – in the hous­ing and mort­gage mar­kets. That’s as close as we’ve come to a wild­fire or any other con­ta­gious cat­a­stro­phe. (We wrote about that, too.)

As we have men­tioned fre­quently, the mortgage-​related losses were indeed con­cen­trated in the finan­cial indus­try because of its lax man­age­ment, poorly-​structured incen­tives and the resul­tant exces­sive and con­cen­trated risk-​taking. In our opin­ion, any­one who states oth­er­wise is either a liar or a fool. One can­not see the egre­giously bad mort­gages made to the undoc­u­mented and the uncred­it­wor­thy and based on the hopes of extrap­o­lated past price increases onto future house val­ues and view it as any­thing except wild bets gone bad – bets per­mit­ted by lax man­age­ment and poorly-​designed incen­tives result­ing in exces­sive and con­cen­trated risk-​taking.

So where does that leave us?

The ini­tial gov­ern­ment bailout was never designed to deal with this larger prob­lem of lost con­fi­dence. If it was, then it is a fur­ther indict­ment of the Trea­sury Sec­re­tary and the Fed Chair­man. In fact, per many of our crit­i­cisms and yesterday’s WSJ edi­to­r­ial, Gov­ern­ment Fear Itself, it doesn’t seem to have been designed for any pur­pose at all, which of course should make every­one sus­pi­cious of Mr. Paulson’s abil­i­ties. (We obvi­ously don’t agree with the Journal’s view against nation­al­iza­tion, but we think they’re miss­ing the big­ger point of not decou­pling the problems.)

Guar­an­tee­ing all deposits? How does that help pro­vide overnight fund­ing or mit­i­gate moral haz­ard or instill con­fi­dence in the decision-​making abil­ity of these (not all) bankers? We’d argue that at least a few depos­i­tors would remove their money just for the prin­ci­ple of it. (Yeah, some peo­ple still have those things.) More impor­tantly, it does not seem to solve any of the intra-​bank lend­ing problems.

Guar­an­tee all bank bor­row­ing? How does that per­mit effi­cient asset allo­ca­tion in the economy? Moreover, it also leaves the per­sons who made the prob­lem still in charge and sub­si­dizes those actors and firms at the expense of every­one else. So, it seems nei­ther effi­cient nor just. (It is expe­di­ent, which was prob­a­bly why it was rec­om­mended.) In our view the guar­an­tee would need to be inter­mi­nate, or the prob­lem would reap­pear when the guar­an­tee expired.

We’d imag­ine that based upon the mag­ni­tude of gains on many deriv­a­tive trades, espe­cially for buy­ers of credit deriv­a­tives and other spread and­ba­sis prod­ucts, the gov­ern­ment would face sub­stan­tial calls for cash as those guar­an­tees would likely quickly turn into such calls – not quite the same, but not that dif­fer­ent than AI. – especially as those instru­ments matured and settled.

No, if the gov­ern­ment is respon­si­ble for all claims on those banks, then it (we tax­pay­ers)) should directly con­trol (own) the assets. So, we say:

Fire, Close, Nation­al­ize, Fire, Reor­ga­nize, Sell

It’s not a 12-​step pro­gram, only six, but it does require the Pres­i­dent to accept the nature of the cri­sis like most 12-​step programs: “God grant us the seren­ity to accept the things we can­not change, courage to change the things we can, and wis­dom to know the difference.”

Fire: Mr. Paul­son and Mr. Bernanke were out-​of-​their-​element in the mort­gage cri­sis, let alone in this larger, more seri­ous prob­lem. The Wall Street Jour­nal edi­to­r­ial staff, pro­po­nents of the $700 bil­lion bailout, admit that Mr. Paul­son had no plan once that money was his to control. On Sat­ur­day morn­ing we lamented Where Have All the Grownups Gone? But we’ve com­plained fre­quently about the lack of thought and analy­sis regard­ing the cur­rent prob­lems and pro­posed solu­tions. (See: Prin­ci­ples Lost and More or Friday’s The Unex­am­ined Cri­sis.)

So, Mr. Bush, please stop clue­lessly talk­ing about endeav­or­ing to per­se­vere and please fire Mr. Paul­son and force Mr. Bernanke to resign.* (We don’t recall every­thing from our Money & Bank­ing class, but we believe that you do not have the author­ity to directly fire him.)

Close: Next, shut the equity mar­kets for one week. After 9/​11, the equity mar­kets were closed that Tues­day and the rest of the week, and this cur­rent cri­sis is at least as seri­ous to the nation’s eco­nomic health as ⁹⁄₁₁. (We know there were facil­ity issues, too.) While this may seem extreme, it is nec­es­sary to give investors, cred­i­tors, and bank cus­tomers the time needed under­stand the nature of true prob­lem and to inter­nal­ize our next rec­om­men­da­tion and what it means to them, i.e., renewed sta­bil­ity and restored faith in finan­cial intermediaries.

Nation­al­ize: Mr. Bush and the United States should nation­al­ize the worst banks. By “worst” we mean ones that have, say, the low­est com­bi­na­tion of (1) equity mar­ket value to total assets, (2) esti­mated unre­al­ized losses to reg­u­la­tory cap­i­tal, and (3) the com­ple­ment of Fed bor­row­ing to total assets, but we’re will­ing to take sug­ges­tions from oth­ers on the exact nature of this metric.

As we have men­tioned, we do not view the cur­rent cri­sis as a fail­ure of the mar­kets. We view it as a fail­ure of gov­ern­ment poli­cies and government-​regulated insti­tu­tions, includ­ing the gov­ern­ment spon­sored enti­ties, and heavily-​regulated banks. So our gov­ern­ment solu­tion is not designed to mit­i­gate a mar­ket prob­lem but instead to reverse prob­lems cre­ated by other gov­ern­ment errors or government-​induced errors.

In that regard, we rec­om­mend that the gov­ern­ment take 100% own­er­ship sub­ject to one caveat. Per­mit non-​executive, employee-​owners who pos­sess restricted shares to main­tain their a stake in the entity. (Over­all, it seems unlikely that other small share­hold­ers would suf­fer as much, par­tic­u­larly if the when the equity mar­kets rebound as they regain con­fi­dence in finan­cial intermediaries.)

Also note, we are not rec­om­mend­ing the nation­al­iza­tion of the entire indus­try – only the weak­est, least trusted banks. For exam­ple, at this point, we see no rea­son for the gov­ern­ment to con­sider nation­al­iz­ing firms like Wells Fargo, PNC, or USB among others.

Fire: Dis­man­tle the boards of direc­tors and fire senior man­age­ments. We rec­om­mend this for two reasons. First, it is the just thing to do. We base that state­ment on our inter­pre­ta­tion of the Para­ble of the Faith­ful and Unfaith­ful Ser­vant, which describes moral haz­ard issues. Sec­ond, it pro­vides a severe warn­ing to sur­viv­ing insti­tu­tions to get their firms’ affairs in order and instill more rig­or­ous over­sight of poten­tially risky activ­i­ties. So, we view it as effi­cient, too. One of the best ways to solve moral haz­ard prob­lems is through the imple­men­ta­tion of severe penal­ties for unde­sir­able out­comes. (We know it is an infor­ma­tion argu­ment based upon likelihoods, but we’re being infor­mal here.)

Reor­ga­nize: Imple­ment our market-​based solu­tion to the mort­gage cri­sis. We’ve linked to it twice already in this post; so, won’t do so again, but it is based upon per­mit­ting either invest­ment tax cred­its or cash-​basis account­ing (extreme accel­er­ated depre­ci­a­tion) for prospec­tive pur­chasers of trou­bled mort­gages, MBS, and mortgage-​related CDOs. That reduces the ini­tial cost and pro­vides a cush­ion for mis­pric­ing. We’d also rec­om­mend low tax rates on sub­se­quent resales or cash flow realizations.

It would also seem that a gov­ern­ment takeover of sev­eral of the weak­est banks would make it much eas­ier to sort and can­cel out mar­gin calls and overnight loans, etc., and to offer promis­sory notes rather than asset pledges or cash for deep-​out-​of-​money trades (in-​the-​money for the other party).

Sell: Offer the refor­mu­lated banks as IPOs as soon as pos­si­ble – hope­fully by next sum­mer. We greatly pre­fer IPOs to forc­ing merg­ers and cre­at­ing ever larger banks. We believe that such merg­ers cre­ate over-​concentration of oth­er­wise idio­syn­cratic risk; they made the idio­syn­cratic sys­tem­atic so-​to-​speak. We wrote about that on sev­eral occa­sions, too. (See, for exam­ple, Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter!, Big­ger Is Not Nec­es­sar­ily Bet­ter or Idio­syn­cratic and Con­cen­tra­tion Risk, Again.)

We real­ize that we could offer more details, but we’re a small orga­ni­za­tion with lim­ited time. More­over, there are far more specifics here than in the Treasury’s ini­tial bailout plan, and we’re not ask­ing for $700 billion.

We’d be happy to receive your com­ments and feed­back on our pro­posal. Are we miss­ing some­thing? Have we ignored cru­cial weak­nesses? If so, let us know. If not, we say, “it’s time.”

As always, we’ll update and revise this in the com­ing days as we clar­ify our thoughts and rework our sen­tence struc­tures and elim­i­nate typos.

Copy­right © 2008 Spero Consulting.

*Yeah, that’s our allu­sion to Chief Dan George’s char­ac­ter, Lone Watie, in The Out­law Josey Wales. Get dressed up in civ­i­lized clothes, go to Wash­ing­ton to meet the Pres­i­dent, and pledge to be united. How exactly does that help?