Public Zone 公開區 => Bookwyrm 書蟲天地 => Topic started by: chin on 08 February 2009, 04:19:05

Title: Zeitgeist of the Great Crash of 2008
Post by: chin on 08 February 2009, 04:19:05
I have mergered the collection of topics that run in the same theme - reflections on the Great Crash of 2008 and the outlook of the future. We will see in a few years if people over reacted.

From Foreign Affairs

The Great Crash, 2008 - A Geopolitical Setback for the West
by Roger C. Altman

Summary:  The financial crisis has called into serious question the credibility of western governments and may precipitate an eastward shift of power.

ROGER C. ALTMAN is Chair and CEO of Evercore Partners. He was U.S. Deputy Treasury Secretary in 1993-94.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 04:33:11
Maybe still too early to judge, but...

I have been saying that the US style democracy and capitalism may not be better than the Chinese style authoritative socialism. The two systems are just different, not necessary one better than the other.

BTW the mainland media has been talking about the "new mulipolar world" for years. But it did not came by in the form of raising of other "polars" but in the form of collapsing of the great one. Is it still too early to judge?

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The financial and economic crash of 2008, the worst in over 75 years, is a major geopolitical setback for the United States and Europe. Over the medium term, Washington and European governments will have neither the resources nor the economic credibility to play the role in global affairs that they otherwise would have played. These weaknesses will eventually be repaired, but in the interim, they will accelerate trends that are shifting the world's center of gravity away from the United States.

A brutal recession is unfolding in the United States, Europe, and probably Japan -- a recession likely to be more harmful than the slump of 1981-82. The current financial crisis has deeply frightened consumers and businesses, and in response they have sharply retrenched. In addition, the usual recovery tools used by governments -- monetary and fiscal stimuli -- will be relatively ineffective under the circumstances.

This damage has put the American model of free-market capitalism under a cloud. The financial system is seen as having collapsed; and the regulatory framework, as having spectacularly failed to curb widespread abuses and corruption. Now, searching for stability, the U.S. government and some European governments have nationalized their financial sectors to a degree that contradicts the tenets of modern capitalism. Much of the world is turning a historic corner and heading into a period in which the role of the state will be larger and that of the private sector will be smaller. As it does, the United States' global power, as well as the appeal of U.S.-style democracy, is eroding. Although the United States is fortunate that this crisis coincides with the promise inherent in the election of Barack Obama as president, historical forces -- and the crash of 2008 -- will carry the world away from a unipolar system regardless.

Indeed, rising economic powers are gaining new influence. No country will benefit economically from the financial crisis over the coming year, but a few states -- most notably China -- will achieve a stronger relative global position. China is experiencing its own real estate slowdown, its export markets are weak, and its overall growth rate is set to slow. But the country is still relatively insulated from the global crisis. Its foreign exchange reserves are approaching $2 trillion, making it the world's strongest country in terms of liquidity. China's financial system is not exposed, and the country's growth, which is now driven by domestic activity, will continue at solid, if diminished, rates.

This relatively unscathed position gives China the opportunity to solidify its strategic advantages as the United States and Europe struggle to recover. Beijing will be in a position to assist other nations financially and make key investments in, for example, natural resources at a time when the West cannot. At the same time, this crisis may lead to a closer relationship between the United States and China. Trade-related flashpoints are diminishing, which may soften protectionist stances in the U.S. Congress. And it is likely that, with Washington less distracted by the war in Iraq, the new administration of President Obama will see more clearly than its predecessor that the U.S.-Chinese relationship is becoming the United States' most important bilateral relationship. The Obama administration could lead efforts to bring China into the G-8 (the group of highly industrialized states) and expand China's shareholding position in the International Monetary Fund. China, in turn, could lead an effort to enlarge the capital base of the IMF.


Conventional wisdom attributes the crisis to the collapse of housing prices and the subprime mortgage market in the United States. This is not correct; these were themselves the consequence of another problem. The crisis' underlying cause was the (invariably lethal) combination of very low interest rates and unprecedented levels of liquidity. The low interest rates reflected the U.S. government's overly accommodating monetary policy after 9/11. (The U.S. Federal Reserve lowered the federal funds rate to nearly one percent in late 2001 and maintained it near that very low level for three years.) The liquidity reflected, among other factors, what Federal Reserve Chair Ben Bernanke has called "the global savings glut": the enormous financial surpluses realized by certain countries, particularly China, Singapore, and the oil-producing states of the Persian Gulf. Until the mid-1990s, most emerging economies ran balance-of-payments deficits as they imported capital to finance their growth. But the Asian financial crisis of 1997-98, among other things, changed this in much of Asia. After that, surpluses grew throughout the region and then were consistently recycled back to the West in the form of portfolio investments.

Facing low yields, this mountain of liquidity naturally sought higher ones. One basic law of finance is that yields on loans are inversely proportional to credit quality: the stronger the borrower, the lower the yield, and vice versa. Huge amounts of capital thus flowed into the subprime mortgage sector and toward weak borrowers of all types in the United States, in Europe, and, to a lesser extent, around the world. For example, the annual volume of U.S. subprime and other securitized mortgages rose from a long-term average of approximately $100 billion to over $600 billion in 2005 and 2006. As with all financial bubbles, the lessons of history, including about long-term default rates on such poor credits, were ignored.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 04:49:45
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This flood of mortgage money caused residential and commercial real estate prices to rise at unprecedented rates. Whereas the average U.S. home had appreciated at 1.4 percent annually over the 30 years before 2000, the appreciation rate roared forward at 7.6 percent annually from 2000 through mid-2006. From mid-2005 to mid-2006, amid rampant speculation in the housing market, it was 11 percent.

But like most spikes in commodity prices, this one eventually reversed itself -- and with a vengeance. Housing prices have been falling sharply for over two years, and so far there is no sign that they will bottom out. Futures markets are signaling that, from peak to trough, the drop in the value of the nation's housing stock could reach 30-35 percent. This would be an astonishing fall for a pool of assets once valued at $13 trillion.

This collapse in housing prices undermined the value of the multitrillion-dollar pool of lower-value mortgages that had been created over the 2003-6 period. In addition, countless subprime mortgages that were structured to be artificially cheap at the outset began to convert to more expensive terms. Innumerable borrowers could not afford the adjusted terms, and delinquencies became more frequent. Losses on these loans began to emerge in mid-2007 and quickly grew to staggering levels. And with prices in real estate and other asset values still dropping, the value of these loans is continuing to deteriorate. The larger financial institutions are reporting continuous losses. They mark down the value of a loan or similar asset in one quarter, only to mark it down again in the next. This self-reinforcing downward cycle has caused markets to plunge across the globe.

The damage is most visible at the household level. Americans have lost one-quarter of their net worth in just a year and a half, since June 30, 2007, and the trend continues. Americans' largest single asset is the equity in their homes. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.

Such large and sudden hits have shocked U.S. families. And because these have occurred amid headlines reporting failing financial institutions and huge bailouts, Americans' fears over the safety and accessibility of their deposits are now more pervasive than they have been since 1933. This is why Americans withdrew $150 billion from money-market funds over a two-day period in September (average weekly outflows are just $5 billion). It is also why the Federal Reserve established a special $540 billion facility to help these funds meet continuing redemptions.


It is increasingly evident that the severe recession unfolding in the United States and Europe will be the deepest slump in the world economy since the 1930s. The United States' GDP fell in the third quarter of 2008 and was forecast to drop precipitously, by nearly four percent, in the fourth quarter. Of 52 economists surveyed by The Wall Street Journal throughout last year, a majority expected the U.S. economy to contract for at least three consecutive quarters, which it has not done in 50 years. At least for the medium term, the global roles of the United States and European states will shrink along with those countries' economies.

Stock markets in the United States and globally are signaling a brutal economic period ahead. By early November 2008, the broadest of the U.S. market indices, the S and P 500, was down 45 percent from its 2007 high. That is a considerably steeper fall than occurred in 1981-82, which, until now, was the worst recession period since the 1930s. The only logical explanation for the plunge is that the market is anticipating an even worse drop in corporate profits for 2009 than occurred almost three decades ago.

Such a major drop in corporate profits might occur because U.S. consumers are deeply frightened and have stopped spending on discretionary items. Shocked by the financial crisis, fearful about the security of their bank and money-market deposits, and rocked by the sense of doom pervading Washington and the U.S. media, they have quickly raised their savings by curtailing spending and paying down debt. The result last September was the biggest monthly drop ever recorded in the widely followed Conference Board Consumer Confidence Index. That month also saw the sharpest monthly drop in consumer spending since 1980 -- and the drop in October was even worse. The chief executive officer of Caterpillar and other business leaders have described these conditions as the worst they have ever seen and are cutting back severely on capital spending.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 05:04:16
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As former Treasury Secretary Lawrence Summers has observed, this recession will be prolonged partly because of the unusual nature of this downward financial spiral. As the value of financial assets fall, margin calls are triggered, forcing the sale of those and other assets, which further depresses their value. This means larger losses for households and financial institutions, and these in turn discourage spending and lending. The end result is an even weaker economy, characterized by less spending, lower incomes, and more unemployment.

This recession also will be prolonged because the usual government tools for stimulating recovery are either unavailable or unlikely to work. The most basic way to revitalize an ailing economy is to ease monetary policy, as the U.S. Federal Reserve did in the fall. But interest rates in the United States and Europe are already extremely low, and central banks have already injected unprecedented amounts of liquidity into the credit markets. Thus, the impact of any further easing will probably be small.

Another tool, fiscal stimulus, will also likely be used in the United States, Europe, and Japan -- but to modest effect. Even the $300 billion package of spending increases and tax rebates currently under discussion in the U.S. Congress would be small in relation to the United States' $15 trillion economy. And judging from the past, another round of stimuli will be only partially effective: the $168 billion package enacted last February improved the United States' GDP by only half that amount.

The slowdown in Europe is expected to be every bit as severe. European consumers are spending less for the same reasons American consumers are. The financial sectors of European countries, relative to those countries' GDPs, have suffered even more damage than that of the United States. The British government reported a contraction of its economy last fall, and the eurozone countries are now officially in recession.

The international financial system has also been devastated. The IMF estimates that loan losses for global financial institutions will eventually reach $1.5 trillion. Some $750 billion in such losses had been reported as of last November. These losses have wiped out much of the capital in the banking system and caused flows of credit to shut down. Starting in late 2007, institutions became so concerned about the creditworthiness of borrowers, including one another, that they would no longer lend. This was evidenced by the spread between three-month U.S. Treasury bills and the three-month LIBOR borrowing rate, the benchmark for interbank lending, which quadrupled within a month of the collapse of the investment bank Lehman Brothers in September 2008.

This credit freeze has brought the global financial system to the brink of collapse. The IMF's managing director, Dominique Strauss-Kahn, spoke of an imminent "systemic meltdown" in October. As a result, the U.S. Federal Reserve, the European Central Bank, and other central banks injected a total of $2.5 trillion of liquidity into the credit markets, by far the biggest monetary intervention in world history. And the U.S. government and European governments took the previously unthinkable step of committing another $1.5 trillion to direct equity investments in their local financial institutions.


As of this writing, there has been a modest thaw in credit-market conditions. But a return to normalcy is not even on the distant horizon. The West's financial system is already a shadow of its former self. Given ongoing losses, Western financial institutions must reduce their leverage much more just to keep balance sheets stable. In other words, they will have to withdraw credit from the world for at least three or four years.

In a classic pattern of overshooting, markets are swinging from euphoria to despair. Now, the psychology of financial institutions has swung to a conservative extreme. They are overhauling their credit-approval and risk-management systems, as well as their leverage and liquidity ratios. Stricter lending standards will prevail for the foreseeable future.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 05:08:40
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These new lending patterns will be further constrained by sharply tightened regulation. It is widely acknowledged that this crisis reflects the greatest regulatory failure in modern history -- a failure that extended from bank supervision to U.S. Securities and Exchange Commission disclosures to credit-rating oversight. The recriminations, let alone the criminal prosecutions, are just beginning. There is unanimity that broad regulatory reform is necessary. Obama and the new U.S. Congress will surely pursue legislation to implement reform this year. European authorities will undoubtedly take similar steps. Minimum capital and liquidity standards for regulated institutions will likely be tightened, among other measures.

If history is any guide, however, financial reform will go too far. The Sarbanes-Oxley legislation that followed the collapse of Enron and WorldCom is an example of such an overreaction. Should something like this occur again, tighter restrictions on the U.S. and European banking systems could delay their return to robust financing activity.

The United States will be further constrained by gigantic budget deficits, the product of sudden government spending designed to fight the financial crisis and of the sharp drop in revenues caused by the recession. It now appears that the United States' deficit for the fiscal year that began in October 2008 will approach $1 trillion, more than double the $450 billion for the year before. This would be by far the largest nominal deficit ever incurred by any nation and would represent 7.5 percent of U.S. GDP, a level previously seen only during the world wars.


There could hardly be more constraining conditions for the United States and Europe. First, the severe recession will prompt governments there to focus inward as their citizens demand that national resources be concentrated on domestic recovery. The priorities of Obama, as expressed in his campaign, fit this mold. If the matter has not already been handled in the lame-duck session of Congress in late 2008, Obama's first major act as president will be to introduce economic-stimulus legislation. He is also likely to take steps to further alleviate the financial crisis, address the plight of U.S. automakers, and begin the complex task of reforming health care and energy policy.

European leaders will also be focusing on the home front. They, too, will be implementing stimulus programs and trying to manage the financial damage. This past fall, French President Nicolas Sarkozy and Italian Prime Minister Silvio Berlusconi were already making fiery speeches about protecting their domestic companies from being acquired by foreign interests -- hardly a message consistent with modern economics.

Second, unprecedented fiscal deficits and difficulties in the financial systems will also preclude the West from embarking on major international initiatives. If Obama inherits a $1 trillion deficit, and temporarily enlarges it to $1.3 trillion with a stimulus program, there will not be much of a constituency calling for increased U.S. spending on endeavors abroad. Indeed, the country may be entering a period of forced restraint not seen since the 1930s. Should a crisis like the 1994 collapse of the Mexican economy present itself again, it is doubtful that the United States would intervene. And even in the event of economic crises in strategically important areas, such as Pakistan, major economic assistance from the United States or key European nations is unlikely. Instead, the IMF will have to be the primary intervenor.

On the private side, Western capital markets will not return to full health for years. For the indefinite future, large financial institutions will shrink as losses continue and as they reduce their leverage further. The overshooting pattern that occurs after crises will also make markets averse to risk and leverage for the foreseeable future.

Historically, U.S. capital markets were far deeper and more liquid than any others in the world. They were in a league of their own for decades, until European markets also started developing rapidly over the past 10-15 years. The rest of the world was dependent on them for capital, and this relationship reinforced the United States' global influence. They will now be supplying proportionately far less capital for years to come.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 05:09:49
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Third, the economic credibility of the West has been undermined by the crisis. This is important because for decades much of the United States' influence and soft power reflected the intellectual strength of the Anglo-Saxon brand of market-based capitalism. But now, the model that helped push back socialism and promoted deregulation over regulation -- prompting the remaking of the British Labour Party, economic reforms in eastern Europe, and the opening up of Vietnam in the 1990s -- is under a cloud. The U.S. financial system is seen as having failed.

Furthermore, the United States and countries in the eurozone have resorted to large-scale nationalist economic interventions that undermine free-market doctrines. The U.S. government has taken equity stakes in more than 20 large financial institutions and, according to Treasury Secretary Henry Paulson, may eventually invest in "thousands" of them. In addition, it has temporarily guaranteed the key debt of its entire banking system. France, Germany, and the United Kingdom have intervened even more extensively, each in a slightly different way, with Germany, for example, backing the full amount of all private deposits. The British government's banking interventions, when measured in relation to the country's GDP, are even larger than those of the U.S. government relative to U.S. GDP.

All these interventions will stop the global shift toward economic deregulation. As President Sarkozy put it, "Le laisser-faire, c'est fini." Or, as Chinese Vice Premier Wang Qishan said more diplomatically, "The teachers now have some problems." This coincides with the natural and very long-term movement away from the U.S.-centric world that started after the fall of the Berlin Wall two decades ago.


This movement also reflects the rapid rise of other economies, especially China and India. The U.S. share of world GDP had been declining for seven years before the financial crisis hit. And it looks increasingly likely that China's GDP will surpass the United States' at some point during the next 25-30 years. The rising nations' growing economic strength brings increased global influence and competition with it. The result, in the words of Richard Haass, president of the Council on Foreign Relations, is the emergence of a "nonpolar world."

China, for example, will suffer a lesser blow from the global crisis. It is experiencing some economic pain. Its export markets, led by the United States and Europe, are slowing dramatically. China is also suffering from price declines in certain urban real estate markets. Its growth slowed to nine percent during the third quarter of 2008 -- a rate that other nations would envy but was China's slowest in five years. These factors explain why the Chinese leadership is implementing a multiyear economic stimulus plan worth over $500 billion, or approximately 15 percent of GDP. Still, the IMF is projecting that the country's economy will grow by 8.5 percent in 2009.

In financial terms, China is little affected by the crisis in the West. Its entire financial system plays a relatively small role in its economy, and it apparently has no exposure to the toxic assets that have brought the U.S. and European banking systems to their knees. China also runs a budget surplus and a very large current account surplus, and it carries little government debt. Chinese households save an astonishing 40 percent of their incomes. And China's $2 trillion portfolio of foreign exchange reserves grew by $700 billion last year, thanks to the country's current account surplus and foreign direct investment.

This means that although China, too, has been hurt by the crisis, its economic and financial power have been strengthened relative to those of the West. China's global influence will thus increase, and Beijing will be able to undertake political and economic initiatives to increase it further. China and the Association of Southeast Asian Nations are just concluding an agreement that would create the world's largest free-trade area, and Beijing could take additional steps toward Asian interdependence and play a stronger leadership role within the region.

China could also expand its diplomatic presence in the developing world, in order to further its model of capitalism and, in places such as Angola, Kazakhstan, and Sudan, satisfy its thirst for natural resources. In the midst of this crisis, it might also help finance emergency loans, either directly, through bilateral financing arrangements, or indirectly, by creating an additional facility at the IMF that could expand the organization's available credit beyond what current quotas allow. China should also be expected to make strategic investments through its sovereign wealth funds. Given China's appetite for natural resources, this is one likely area of interest; its relatively underdeveloped financial-services infrastructure is another.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 05:11:43
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India may also survive the crisis relatively unhurt. There, as in China, the financial system plays a small role in the overall economy. India also remains a fairly closed economy in terms of foreign investment, and so it is less dependent on external capital. Close observers expect India's growth to continue, perhaps at an annual rate of 6.5-7 percent. But India does not have nearly the wealth or the internal cohesion of China. This past fall, the government of Prime Minister Manmohan Singh narrowly avoided losing a parliamentary vote of no confidence and having to dissolve itself over opposition to the nuclear agreement it signed with the United States in 2005. The overall result is that India is inwardly focused and not particularly equipped to advance its geopolitical standing.

Much of the rest of the world, however, has been hit hard by the crisis. The damaged Western banks, which had consistently supplied credit to businesses in the developing world, have abruptly stopped providing it. As foreign capital has been withdrawn, currencies, local banking systems, and stock markets in already poor states have weakened sharply. Eastern European countries that had been running exceptionally large current account deficits and had built up substantial foreign debts are particularly hurting. Hungary, Latvia, and Ukraine are prominent examples, and Hungary and Ukraine have already secured emergency loans from the IMF.

In Russia, the plunge in oil and other commodity prices has caused a near collapse of the ruble and of local share prices. The government of President Dmitry Medvedev has been spending huge amounts, perhaps $200 billion so far, to prop up the currency, Russia's financial system, and several highly leveraged state-controlled enterprises. With $500 billion in foreign exchange reserves, Russia remains in a strong financial condition even after these rescue efforts. Yet these sobering events will make some of its renewed geopolitical ambitions harder to achieve. In theory, this could permit a thaw in U.S.-Russian relations if Obama were to make an overture. Before that happens, however, Moscow might try the "get tough" approach that Soviet Premier Nikita Khrushchev used with U.S. President John F. Kennedy in Vienna in 1961.

The outcome of the crisis will be more serious for Iran and Venezuela, which, like Russia, have suffered from the fall in oil prices but, unlike Russia, have limited foreign exchange reserves. Iran's economy was already rickety, and internal pressures are now likely to grow. Venezuela, which has been spending freely to advance President Hugo Chávez's international agenda, is facing an even more severe problem.


This historic crisis raises the question of whether a new global approach to controlling currencies and banking and financial systems is needed. Many economists and leaders are advocating such a reordering and calling for a Bretton Woods II. But creating a wholly new global financial order would be unworkable. Financial and currency markets are too large and too powerful to be contained; the days of managed exchange rates are over. Global financial regulation would probably cause more problems than it would solve, if only because the reforms needed in the West differ too much from those required elsewhere.

A better approach is to focus on a few key measures. First, the crisis is an opportunity to strengthen and reshape the IMF. The organization has $250 billion in unused lending capacity, but this capital base has not been adjusted since 1997 and may not be large enough to help the many developing nations currently suffering balance-of-payments and liquidity crises. (Hungary, Iceland, Pakistan, Ukraine, and six other countries have negotiated or are currently negotiating emergency-financing packages with the IMF.) This should be remedied. The IMF can also be made more flexible. Historically, it has conditioned its assistance to borrowing countries on their tightening their belts, by, for instance, reducing their budget deficits. Conditionality remains necessary over the long term, but with this crisis still unfolding, the IMF is rightly moving toward temporarily suspending it. Furthermore, high-surplus countries, such as China and the oil-producing states in the Persian Gulf, should be made larger shareholders in the IMF. It would be logical, for example, for these nations to lead any new and separate lending facility established by the IMF.

Title: Re: The Great Crash, 2008 - A Geopolitical Setback for the West
Post by: chin on 08 February 2009, 05:12:39
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Second, the G-8 framework is increasingly obsolete. The economic power and wealth of China mandate that it, at a minimum, be included in the group. Because it is more representative, the G-20 framework (19 of the world's largest national economies plus the European Union) should be used more often, and the G-8 less so.

Third, the Basel II guidelines regulating the capitalization of banks should be revised. They proved severely inadequate at protecting banks against the balance-sheet crises that have befallen them. A better approach would be to build capital cushions for banks during prosperous times that could be depleted during crises.

The United States will remain the most powerful nation on earth for a while longer. Its military strength alone ensures this. But the crash of 2008 has inflicted profound damage on its financial system, its economy, and its standing in the world; the crisis is an important geopolitical setback. The international acclaim that greeted Obama's presidential victory may soften its effects, but even this enthusiasm cannot wipe those away. This is partly because the crisis has coincided with historical forces that were already shifting the world's focus away from the United States. Over the medium term, the United States will have to operate from a smaller global platform -- while others, especially China, will have a chance to rise faster.[/
Title: The end of the world as we know it
Post by: chin on 08 February 2009, 05:39:03
The end of the world as we know it
By Michael Lewis and David Einhorn Published: January 4, 2009

Opinion piece from IHT. Michael Lewis is the author of "Liar's Poker" (The book is in the bookshelf in the upstair master bedroom toilet.) David Einhorn is from Greenlight Capital and author of "Fooling some people all the time" (The book is in the bookshelf on top of the TV.)

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:40:43
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Americans enter the New Year in a strange new role: financial lunatics. We've been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics had been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: For a long time now half the planet's college graduates seemed to want nothing more out of life than a job on Wall Street.

This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence.

Good God, the world seems to be saying, if they don't know what they are doing with money, who does?" Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?

To that end consider the strange story of Harry Markopolos.

Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn't be anything other than a fraud. Madoff's investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.

In his devastatingly persuasive 17-page letter to the SEC, Markopolos saw two possible scenarios. In the "Unlikely" scenario: Madoff, who acted as a broker as well as an investor, was "front-running" his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in IBM at a certain price, for example, and Madoff Securities instantly would buy IBM shares for its own portfolio ahead of the customer order. If IBM's shares rose, Madoff kept them; if they fell, he fobbed them off onto the poor customer.

In the "Highly Likely" scenario, wrote Markopolos, "Madoff Securities is the world's largest Ponzi Scheme." Which, as we now know, it was.

Harry Markopolos sent his report to the SEC on Nov. 7, 2005 - more than three years before Madoff was finally exposed - but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Madoff - he wasn't an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, so Markopolos could not have made money directly from Madoff's failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: He declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the SEC's cursory investigation of Madoff pronounced him free of fraud.

What's interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn't just Harry Markopolos who smelled a rat. As Markopolos explained in his letter, Goldman Sachs was refusing to do business with Madoff; many others doubted Madoff's profits or assumed he was front-running his customers and steered clear of him. Between the lines, Markopolos hinted that even some of Madoff's investors may have suspected that they were the beneficiaries of a scam. After all, it wasn't all that hard to see that the profits were too good to be true.

Some of Madoff's investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.

The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. "Greed" doesn't cut it as a satisfying explanation for the current financial crisis.

Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy.

The fixable problem isn't the greed of the few but the misaligned interests of the many.

A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:41:52
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Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O'Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup's chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower - had stood up and said "this business is irresponsible and we are not going to participate in it" - he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he'd be replaced by someone willing to make money from the credit bubble.

Our financial catastrophe, like Bernard Madoff's pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today's financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that's the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The credit-rating agencies, for instance.

Everyone now knows that Moody's and Standard & Poor's botched their analyses of bonds backed by home mortgages. But their most costly mistake - one that deserves a lot more attention than it has received - lies in their area of putative expertise: measuring corporate risk.

Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody's or Standard & Poor's say, "If you put one more risky asset on your balance sheet, you will face a serious downgrade."

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (GE still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It's almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody's and Standard & Poor's.

These oligopolies, which are actually sanctioned by the SEC, didn't merely do their jobs badly. They didn't simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: Rather than expose financial risk they systematically disguised it.

This is a subject that might be profitably explored in Washington.

There are many questions an enterprising U.S. senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt - and a plausible triple-A rating.

By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or CDOs. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.

Yet the rating agencies didn't so much as blink. On Wall Street the problem was hardly a secret: Many people understood that MBIA didn't deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: "Is MBIA Triple A?" (The answer was obviously no.)

At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA's guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA's failure became such an open secret that nobody any longer cared about its formal credit rating.)

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:43:20
Page 3/6

The SEC now promises modest new measures to contain the damage that the rating agencies can do - measures that fail to address the central problem: that the raters are paid by the issuers.

But this should come as no surprise, for the SEC itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the SEC for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers - the only market players who have a financial incentive to expose fraud and abuse.)

The instinct to avoid short-term political heat is part of the problem; anything the SEC does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the SEC. Thus it seldom penalizes serious corporate and management malfeasance - out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the SEC's agenda.

It's not hard to see why the SEC behaves as it does. If you work for the enforcement division of the SEC you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

The commission's most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the SEC's director of enforcement is to position oneself for the better paying one on Wall Street.

At the back of the version of Harry Markopolos' brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Markopolos to Jonathan S. Sokobin. Sokobin was then the new head of the commission's office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to - you guessed it - take a higher-paying job on Wall Street.

At any rate, Markopolos clearly hoped that a new face might mean a new ear - one that might be receptive to the truth. He phoned Sokobin and then sent him his paper. "Attached is a submission I've made to the SEC three times in Boston," he wrote. "Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations."

How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the SEC that inept? Perhaps, but the problem inside the commission is far worse - because inept people can be replaced. The problem is systemic.

The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy's thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.

And here's the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.

Say what you will about our government's approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:44:31
Page 4/6

When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns' shakiest assets. Bear Stearns bondholders were made whole, and its stockholders lost most of their money.

Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.

But then a few days later AIG failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: The first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it - again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.

In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks - telling the senators and representatives that if they didn't give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.

It's hard to know what Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn't give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity - so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won't be able to do until they're confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.

Paulson must have had some reason for doing what he did. No doubt he still believes that without all this frantic activity we'd be far worse off than we are now. All we know for sure, however, is that the Treasury's heroic deal-making has had little effect on what it claims is the problem at hand: the collapse of confidence in the companies atop our financial system.

Weeks after receiving its first $25 billion taxpayer investment, Citigroup returned to the Treasury to confess that - lo! - the markets still didn't trust Citigroup to survive. In response, on Nov. 24, the Treasury handed Citigroup another $20 billion from the Troubled Assets Relief Program, and then simply guaranteed $306 billion of Citigroup's assets. The Treasury didn't ask for its fair share of the action, or management changes, or for that matter anything much at all beyond a teaspoon of warrants and a sliver of preferred stock. The $306 billion guarantee was an undisguised gift. The Treasury didn't even bother to explain what the crisis was, just that the action was taken in response to Citigroup's "declining stock price."

Three hundred billion dollars is still a lot of money. It's almost 2 percent of gross domestic product, and about what we spend annually on the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development and Transportation combined.

Had Paulson executed his initial plan, and bought Citigroup's pile of troubled assets at market prices, there would have been a limit to our exposure, as the money would have counted against the $700 billion Paulson had been given to dispense. Instead, he in effect granted himself the power to dispense unlimited sums of money without congressional oversight. Now we don't even know the nature of the assets that the Treasury is standing behind. Under TARP, these would have been disclosed.

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:45:40
Page 5/6

There are other things the Treasury might do when a major financial firm assumed to be "too big to fail" comes knocking, asking for free money. Here's one: Let it fail.

Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed "too big" for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders - perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.

This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992. And remember, the Federal Reserve and the Treasury have already accepted, on behalf of the taxpayer, just about all of the downside risk of owning the bigger financial firms. The Treasury and the Federal Reserve would both no doubt argue that if you don't prop up these banks you risk an enormous credit contraction - if they aren't in business who will be left to lend money? But something like the reverse seems more true: propping up failed banks and extending them huge amounts of credit has made business more difficult for the people and companies that had nothing to do with creating the mess. Perfectly solvent companies are being squeezed out of business by their creditors precisely because they are not in the Treasury's fold. With so much lending effectively federally guaranteed, lenders are fleeing anything that is not.

Rather than tackle the source of the problem, the people running the bailout desperately want to re-inflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we'll be in recession for some time to come. Our leaders have framed the problem as a "crisis of confidence" but what they actually seem to mean is "please pay no attention to the problems we are failing to address."

In its latest push to compel confidence, for instance, the authorities are placing enormous pressure on the Financial Accounting Standards Board to suspend "mark-to-market" accounting. Basically, this means that the banks will not have to account for the actual value of the assets on their books but can claim instead that they are worth whatever they paid for them.

This will have the double effect of reducing transparency and increasing self-delusion (gorge yourself for months, but refuse to step on a scale, and maybe no one will realize you gained weight). And it will fool no one. When you shout at people "be confident," you shouldn't expect them to be anything but terrified.

If we are going to spend trillions of dollars of taxpayer money, it makes more sense to focus less on the failed institutions at the top of the financial system and more on the individuals at the bottom.

Instead of buying dodgy assets and guaranteeing deals that should never have been made in the first place, we should use our money to a) repair the social safety net, now badly rent in ways that cause perfectly rational people to be terrified; and b) transform the bailout of the banks into a rescue of homeowners.

And we should begin by breaking the cycle of deteriorating housing values and resulting foreclosures. Many homeowners realize that it doesn't make sense to make payments on a mortgage that exceeds the value of their house. As many as 20 million families face the decision of whether to make the payments or turn in the keys. Congress seems to have understood this problem, which is why last year it created a program under the Federal Housing Authority to issue homeowners new government loans based on the current appraised value of their homes.

And yet the program, called Hope Now, seems to have become one more excellent example of the unhappy political influence of Wall Street.

As it now stands, banks must initiate any new loan; and they are loath to do so because it requires them to recognize an immediate loss. They prefer to "work with borrowers" through loan modifications and payment plans that present fewer accounting and earnings problems but fail to resolve and, thereby, prolong the underlying issues. It appears that the banking lobby also somehow inserted into the law the dubious requirement that troubled homeowners repay all home equity loans before qualifying. The result: very few loans will be issued through this program.

Title: Re: The end of the world as we know it
Post by: chin on 08 February 2009, 05:46:44
Page 6/6

This could be fixed. Congress might grant qualifying homeowners the ability to get new government loans based on the current appraised values without requiring their bank's consent. When a corporation gets into trouble, its lenders often accept a partial payment in return for some share in any future recovery. Similarly, homeowners should be permitted to satisfy current first mortgages with a combination of the proceeds of the new government loan and a share in any future recovery from the future sale or refinancing of their homes. Lenders who issued second mortgages should be forced to release their claims on property.

The important point is that homeowners, not lenders, be granted the right to obtain new government loans. To work, the program needs to be universal and should not require homeowners to file for bankruptcy.

There are also a handful of other perfectly obvious changes in the financial system to be made, to prevent some version of what has happened from happening all over again. A short list:

Stop making big regulatory decisions with long-term consequences based on their short-term effect on stock prices. Stock prices go up and down: let them. An absurd number of the official crises have been negotiated and resolved over weekends so that they may be presented as a fait accompli "before the Asian markets open." The hasty crisis-to-crisis policy decision-making lacks coherence for the obvious reason that it is more or less driven by a desire to please the stock market. The Treasury, the Federal Reserve and the SEC all seem to view propping up stock prices as a critical part of their mission - indeed, the Federal Reserve sometimes seems more concerned than the average Wall Street trader with the market's day-to-day movements. If the policies are sound, the stock market will eventually learn to take care of itself.

End the official status of the rating agencies. Given their performance it's hard to believe credit rating agencies are still around. There's no question that the world is worse off for the existence of companies like Moody's and Standard & Poor's. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided.

Regulate credit-default swaps. There are now tens of trillions of dollars in these contracts between big financial firms. An awful lot of the bad stuff that has happened to our financial system has happened because it was never explained in plain, simple language.

Financial innovators were able to create new products and markets without anyone thinking too much about their broader financial consequences - and without regulators knowing very much about them at all. It doesn't matter how transparent financial markets are if no one can understand what's inside them. Until very recently, companies haven't had to provide even cursory disclosure of credit-default swaps in their financial statements.

Credit-default swaps may not be Exhibit No. 1 in the case against financial complexity, but they are useful evidence. Whatever credit defaults are in theory, in practice they have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the U.S. government will go bust. In the extreme case, subprime mortgage bonds were created so that smart investors, using credit-default swaps, could bet against them. Call it insurance if you like, but it's not the insurance most people know. It's more like buying fire insurance on your neighbor's house, possibly for many times the value of that house - from a company that probably doesn't have any real ability to pay you if someone sets fire to the whole neighborhood. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets.

Impose new capital requirements on banks. The new international standard now being adopted by American banks is known in the trade as Basel II. Basel II is premised on the belief that banks do a better job than regulators of measuring their own risks - because the banks have the greater interest in not failing. Back in 2004, the SEC put in place its own version of this standard for investment banks. We know how that turned out. A better idea would be to require banks to hold less capital in bad times and more capital in good times. Now that we have seen how too-big-to-fail financial institutions behave, it is clear that relieving them of stringent requirements is not the way to go.

Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 17 February 2009, 04:12:51
Another opinion piece from IHT. Paul Krugman won the Nobel Prize for Economics in 2008.

The first few paragraphs remainded me of a book I read maybe 6, 7 years ago. It was a Chinese translation of a French book, called something like the Collapsa of the American Empire. The book did not offer much remarkable arguements, but there are an interesting point of the US national debt.

The author argued that a very large portion of the world's resources was consumed by the US, who finance the purchase by issuing debts. Since the debt was never paid but only replaced with new debt, the consumption was never really paid for. Thus the conclusion that the US is sucking the world's resources for free.

The question has been hanging my my mind for a long time: if the borrower is a country, the loan in a currency that it controls, in terms it dictates, is the "loan" still a loan? Or is it a form of equity injection from other countries?

Paul Krugman: Decade at Bernie's
By Paul Krugman Published: February 16, 2009

By now everyone knows the sad tale of Bernard Madoff's duped investors. They looked at their statements and thought they were rich. But then, one day, they discovered to their horror that their supposed wealth was a figment of someone else's imagination.

Unfortunately, that's a pretty good metaphor for what happened to America as a whole in the first decade of the 21st century.

Last week the Federal Reserve released the results of the latest Survey of Consumer Finances, a triennial report on the assets and liabilities of American households. The bottom line is that there has been basically no wealth creation at all since the turn of the millennium: The net worth of the average U.S. household, adjusted for inflation, is lower now than it was in 2001.

At one level this should come as no surprise. For most of the last decade America was a nation of borrowers and spenders, not savers. The personal savings rate dropped from 9 percent in the 1980s to 5 percent in the 1990s, to just 0.6 percent from 2005 to 2007, and household debt grew much faster than personal income. Why should we have expected our net worth to go up?

Yet until very recently Americans believed they were getting richer, because they received statements saying that their houses and stock portfolios were appreciating in value faster than their debts were increasing. And if the belief of many Americans that they could count on capital gains forever sounds naïve, it's worth remembering just how many influential voices - notably in right-leaning publications like The Wall Street Journal, Forbes and National Review - promoted that belief, and ridiculed those who worried about low savings and high levels of debt.

Then reality struck, and it turned out that the worriers had been right all along. The surge in asset values had been an illusion - but the surge in debt had been all too real.

So now we're in trouble - deeper trouble, I think, than most people realize even now. And I'm not just talking about the dwindling band of forecasters who still insist that the economy will snap back any day now.

For this is a broad-based mess. Everyone talks about the problems of the banks, which are indeed in even worse shape than the rest of the system. But the banks aren't the only players with too much debt and too few assets; the same description applies to the private sector.

And as the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self-defeating when everyone tries to do them at the same time. Attempts to sell assets and pay off debt deepen the plunge in asset prices, further reducing net worth. Attempts to save more translate into a collapse of consumer demand, deepening the economic slump.

Are policymakers ready to do what it takes to break this vicious circle? In principle, yes. Government officials understand the issue: We need to "contain what is a very damaging and potentially deflationary spiral," says Lawrence Summers, a top Obama economic adviser.

In practice, however, the policies currently on offer don't look adequate to the challenge. The fiscal stimulus plan, while it will certainly help, probably won't do more than mitigate the economic side effects of debt deflation. And the much-awaited announcement of the bank rescue plan left everyone confused rather than reassured.

There's hope that the bank rescue will eventually turn into something stronger. It has been interesting to watch the idea of temporary bank nationalization move from the fringe to mainstream acceptance. But even if we eventually do what's needed on the bank front, that will solve only part of the problem.

If you want to see what it really takes to boot the economy out of a debt trap, look at the large public works program, otherwise known as World War II, that ended the Great Depression. The war didn't just lead to full employment. It also led to rapidly rising incomes and substantial inflation, all with virtually no borrowing by the private sector. By 1945 the government's debt had soared, but the ratio of private-sector debt to GDP was only half what it had been in 1940. And this low level of private debt helped set the stage for the great postwar boom.

Since nothing like that is on the table, or seems likely to get on the table any time soon, it will take years for families and firms to work off the debt they ran up so blithely. The odds are that the legacy of our time of illusion - our decade at Bernie's - will be a long, painful slump.

Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 02 March 2009, 07:36:08
Warren Buffett's 2008 Letter to Shareholders

What a fascinating read!

I have attached the pdf file, and letters for other years can be found at Some quotes of interest related to the 2008 crash.

First on Clayton Homes' mortgage operation, that

I will write here at some length about the mortgage operation of Clayton Homes and skip any financial commentary, which is summarized in the table at the end of this section. I do this because Clayton’s recent experience may be useful in the public-policy debate about housing and mortgages. But first a little background.

Clayton is the largest company in the manufactured home industry, delivering 27,499 units last year. This came to about 34% of the industry’s 81,889 total. Our share will likely grow in 2009, partly because much of the rest of the industry is in acute distress. Industrywide, units sold have steadily declined since they hit a peak of 372,843 in 1998.

At that time, much of the industry employed sales practices that were atrocious. Writing about the period somewhat later, I described it as involving “borrowers who shouldn’t have borrowed being financed by lenders who shouldn’t have lent.”

To begin with, the need for meaningful down payments was frequently ignored. Sometimes fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did.

This 1997-2000 fiasco should have served as a canary-in-the-coal-mine warning for the far-larger conventional housing market. But investors, government and rating agencies learned exactly nothing from the manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.

Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash, handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by FICO scores.

Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then decided whether they could live with that commitment. Simply put, they took out a mortgage with the intention of paying it off, whatever the course of home prices.

Just as important is what our borrowers did not do. They did not count on making their loan payments by means of refinancing. They did not sign up for “teaser” rates that upon reset were outsized relative to their income. And they did not assume that they could always sell their home at a profit if their mortgage payments became onerous. Jimmy Stewart would have loved these folks.

Of course, a number of our borrowers will run into trouble. They generally have no more than minor savings to tide them over if adversity hits. The major cause of delinquency or foreclosure is the loss of a job, but death, divorce and medical expenses all cause problems. If unemployment rates rise – as they surely will in 2009 – more of Clayton’s borrowers will have troubles, and we will have larger, though still manageable, losses. But our problems will not be driven to any extent by the trend of home prices.

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.

Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.

The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.

Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.

* * * * * * * * * * * *

Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Then touch on the foundamentals of financial modelling - can the future be predicted from historic data?

Nevertheless, we remain very cautious about the business we write and regard it as far from a sure thing that this insurance will ultimately be profitable for us. The reason is simple, though I have never seen even a passing reference to it by any financial analyst, rating agency or monoline CEO.

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a  devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace.

* * * * * * * * * * * *

The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. “Back-tested” models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.

On derivatives.

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).

The Bear Stearns collapse highlights the counterparty problem embedded in derivatives transactions, a time bomb I first discussed in Berkshire’s 2002 report. On April 3, 2008, Tim Geithner, then the able president of the New York Fed, explained the need for a rescue: “The sudden discovery by Bear’s derivative counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets. This would have precipitated a rush by Bear’s counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets.” This is Fedspeak for “We stepped in to avoid a financial chain reaction of unpredictable magnitude.” In my opinion, the Fed was right to do so.

A normal stock or bond trade is completed in a few days with one party getting its cash, the other its securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This rapid settlement process is key to maintaining the integrity of markets. That, in fact, is a reason for NYSE and NASDAQ shortening the settlement period from five days to three days in 1995.

Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.

Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.

Considering the ruin I’ve pictured, you may wonder why Berkshire is a party to 251 derivatives contracts (other than those used for operational purposes at MidAmerican and the few left over at Gen Re). The answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.

Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.

Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year’s fourth quarter, we had to post less than 1% of our securities portfolio. (When we post collateral, we deposit it with third parties, meanwhile retaining the investment earnings on the deposited securities.) In our 2002 annual report, we warned of the lethal threat that posting requirements create, real-life illustrations of which we witnessed last year at a variety of financial institutions (and, for that matter, at Constellation Energy, which was within hours of bankruptcy when MidAmerican arrived to effect a rescue).

The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.

It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.

To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher. Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor.

Considering everything, I believe the probability of a decline in the index over a one-hundred-year period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5 million ($1 billion X 1% X 50%).

But if we had received our theoretical premium of $2.5 million up front, we would have only had to invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have been profit. Would you like to borrow money for 100 years at a 0.7% rate?

Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my assumptions are crazy or the formula is inappropriate.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.

Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club of optimists is one that Charlie and I have no desire to join.
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 06 March 2009, 04:45:11
Two articles on Fannie Mae. And what's the lesson?

The first article, published in early Oct 08, told of how taking on more risky mortgages brough down Fannie Mae. One of the major sources of pressure to take on more risks was the US Congress demanded Fannie Mae to "steer more loans to low-income borrowers."

The second article, published few days ago, told of how, after the US governmetn taking over the company, is steering even more loans to low-income borrowers, "to buy greater numbers of loans, to refinance millions of at-risk homeowners and to loosen internal policies so they can work with more questionable borrowers."

Are we seeing the convergence of -isms? While China is building a "socialism with Chinese characteristics (aka capitalism)", free market capitalism is shaken to its core with the nationalization of financial institutions and the subsequent changes in mandates.

1st Article

Pressured to take on risk, Fannie hit a tipping point
By Charles Duhigg
Published: October 4, 2008

"Almost no one expected what was coming. It's not fair to blame us for not predicting the unthinkable."— Daniel Mudd, former chief executive, Fannie Mae

When the mortgage giant Fannie Mae recruited Daniel Mudd, he told a friend he wanted to work for an altruistic business. Already a decorated marine and a successful executive, he wanted to be a role model to his four children — just as his father, the television journalist Roger Mudd, had been to him.

Fannie, a government-sponsored company, had long helped Americans get cheaper home loans by serving as a powerful middleman, buying mortgages from lenders and banks and then holding or reselling them to Wall Street investors. This allowed banks to make even more loans — expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the way.

But by the time Mudd became Fannie's chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

So Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.

Dozens of interviews, most from people who requested anonymity to avoid legal repercussions, offer an inside account of the critical juncture when Fannie Mae's new chief executive, under pressure from Wall Street firms, Congress and company shareholders, took additional risks that pushed his company, and, in turn, a large part of the nation's financial health, to the brink.

Between 2005 and 2008, Fannie purchased or guaranteed $311 billion in loans to risky borrowers — more than five times as much as in all its earlier years combined, according to company filings and industry data.

"We didn't really know what we were buying," said Marc Gott, a former director in Fannie's loan servicing department. "This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears."

Last month, the White House was forced to orchestrate a $200 billion rescue of Fannie and its corporate cousin, Freddie Mac. On Sept. 26, the companies disclosed that U.S. prosecutors and the Securities and Exchange Commission were investigating potential accounting and governance problems.

Mudd said in an interview that he responded as best he could given the company's challenges, and worked to balance risks prudently.

"Fannie Mae faced the danger that the market would pass us by," he said. "We were afraid that lenders would be selling products we weren't buying and Congress would feel like we weren't fulfilling our mission. The market was changing, and it's our job to buy loans, so we had to change as well."

Dealing With Risk

When Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.

Just two decades earlier, Fannie had been on the brink of bankruptcy. But chief executives like Franklin Raines and the chief financial officer Timothy Howard built it into a financial juggernaut by aiming at new markets.

Fannie never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers walked away from their obligations.

So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie's stock price and rewarded top executives with tens of millions of dollars. Raines received about $90 million between 1998 and 2004, while Howard was paid about $30.8 million. Mudd had already collected more than $10 million during his four years at Fannie, according to regulators.

Whenever competitors asked Congress to rein in the companies, lawmakers were besieged with letters and phone calls from angry constituents, some orchestrated by Fannie itself. One automated phone call warned voters: "Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership."

The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.

Between 2001 and 2004, the overall subprime mortgage market — loans to the riskiest borrowers — grew from $160 billion to $540 billion, according to Inside Mortgage Finance, a trade publication. Communities were inundated with billboards and fliers from subprime companies offering to help almost anyone buy a home.

Within a few years of Mudd's arrival, Fannie was the most powerful mortgage company on earth.

Then it began to crumble.

Regulators, spurred by the revelation of a wide-ranging accounting fraud at Freddie, began scrutinizing Fannie's books. In 2004 they accused Fannie of fraudulently concealing expenses to make its profits look bigger.

Howard and Raines resigned. Mudd was quickly promoted to the top spot.

But the company he inherited was becoming a shadow of its former self.

'You Need Us'

Shortly after he became chief executive, Mudd traveled to the California offices of Angelo Mozilo, the head of Countrywide Financial, then the nation's largest mortgage lender. Fannie had a longstanding and lucrative relationship with Countrywide, which sold more loans to Fannie than anyone else.

But at that meeting, Mozilo, a butcher's son who had almost single-handedly built Countrywide into a financial powerhouse, threatened to upend their partnership unless Fannie started buying Countrywide's riskier loans.

Mozilo, who did not return telephone calls seeking comment, told Mudd that Countrywide had other options. For example, Wall Street had recently jumped into the market for risky mortgages. Firms like Bear Stearns, Lehman Brothers and Goldman Sachs had started bundling home loans and selling them to investors — bypassing Fannie and dealing with Countrywide directly.

"You're becoming irrelevant," Mozilo told Mudd, according to two people with knowledge of the meeting who requested anonymity because the talks were confidential. In the previous year, Fannie had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.

"You need us more than we need you," Mozilo said, "and if you don't take these loans, you'll find you can lose much more."

Then Mozilo offered everyone a breath mint.

Investors were also pressuring Mudd to take greater risks.

On one occasion, a hedge fund manager telephoned a senior Fannie executive to complain that the company was not taking enough gambles in chasing profits.

"Are you stupid or blind?" the investor roared, according to someone who heard the call, but requested anonymity. "Your job is to make me money!"

Capitol Hill bore down on Mudd as well. The same year he took the top position, regulators sharply increased Fannie's affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

"When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie's mission is of paramount importance," Senator Jack Reed, a Rhode Island Democrat, lectured Mudd at a Congressional hearing in 2006. "In fact, Fannie and Freddie can do more, a lot more."

But Fannie's computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mudd told employees to "get aggressive on risk-taking, or get out of the company."

In the interview, Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.

Employees, however, say they got a different message.

"Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little," said a former senior Fannie executive. "But our mandate was to stay relevant and to serve low-income borrowers. So that's what we did."

Between 2005 and 2007, the company's acquisitions of mortgages with down payments of less than 10 percent almost tripled. As the market for risky loans soared to $1 trillion, Fannie expanded in white-hot real estate areas like California and Florida.

For two years, Mudd operated without a permanent chief risk officer to guard against unhealthy hazards. When Enrico Dallavecchia was hired for that position in 2006, he told Mudd that the company should be charging more to handle risky loans.

In the following months to come, Dallavecchia warned that some markets were becoming overheated and argued that a housing bubble had formed, according to a person with knowledge of the conversations. But many of the warnings were rebuffed.

Mudd told Dallavecchia that the market, shareholders and Congress all thought the companies should be taking more risks, not fewer, according to a person who observed the conversation. "Who am I supposed to fight with first?" Mudd asked.

In the interview, Mudd said he never made those comments. Dallavecchia was among those whom Mudd forced out of the company during a reorganization in August.

Mudd added that it was almost impossible during most of his tenure to see trouble on the horizon, because Fannie interacts with lenders rather than borrowers, which creates a delay in recognizing market conditions.

He said Fannie sought to balance market demands prudently against internal standards, that executives always sought to avoid unwise risks, and that Fannie bought far fewer troublesome loans than many other financial institutions. Mudd said he heeded many warnings from his executives and that Fannie refused to buy many risky loans, regardless of outside pressures .

"You're dealing with massive amounts of information that flow in over months," he said. "You almost never have an 'Oh My God' moment. Even now, most of the loans we bought are doing fine."

But, of course, that moment of truth did arrive. In the middle of last year it became clear that millions of borrowers would stop paying their mortgages. For Fannie, this raised the terrifying prospect of paying billions of dollars to honor its guarantees.

Sustained by Government

Had Fannie been a private entity, its comeuppance might have happened a year ago. But the White House, Wall Street and Capitol Hill were more concerned about the trillions of dollars in other loans that were poisoning financial institutions and banks.

Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.

The White House also pitched in. James Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies' lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move.

"I'm not worried about Fannie and Freddie's health, I'm worried that they won't do enough to help out the economy," the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time. "That's why I've supported them all these years — so that they can help at a time like this."

But earlier this year, Treasury Secretary Henry Paulson Jr. grew concerned about Fannie's and Freddie's stability. He sent a deputy, Robert Steel, a former colleague from his time at Goldman Sachs, to speak with Mudd and his counterpart at Freddie.

Steel's orders, according to several people, were to get commitments from the companies to raise more money as a cushion against all the new loans. But when he met with the firms, Steel made few demands and seemed unfamiliar with Fannie's and Freddie's operations, according to someone who attended the discussions.

Rather than getting firm commitments, Steel struck handshake deals without deadlines.

That misstep would become obvious over the coming months. Although Fannie raised $7.4 billion, Freddie never raised any additional money.

Steel, who left the Treasury Department over the summer to head Wachovia bank, disputed that he had failed in his handling of the companies, and said he was proud of his work .

As the housing crisis worsened, Fannie and Freddie announced larger losses, and shares continued falling.

In July, Paulson asked Congress for authority to take over Fannie and Freddie, though he said he hoped never to use it. "If you've got a bazooka and people know you've got it, you may not have to take it out," he told Congress.

Mudd called Treasury weekly. He offered to resign, to replace his board, to sell stock, and to raise debt. "We'll sign in blood anything you want," he told a Treasury official, according to someone with knowledge of the conversations.

But, according to that person, Mudd told Treasury that those options would work only if government officials publicly clarified whether they intended to take over Fannie. Otherwise, potential investors would refuse to buy the stock for fear of being wiped out.

"There were other options on the table short of a takeover," Mudd said. But as long as Treasury refused to disclose its goals, it was impossible for the company to act, according to people close to Fannie.

Then, last month, Mudd was instructed to report to Lockhart's office. Paulson told Mudd that he could either agree to a takeover or have one forced upon him.

"This is the right thing to do for the economy," Paulson said, according to two people with knowledge of the talks. "We can't take any more risks."

Freddie was given the same message. Less than 48 hours later, Lockhart and Paulson ended Fannie and Freddie's independence, with up to $200 billion in taxpayer money to replenish the companies' coffers.

The move failed to stanch a spreading panic in the financial world. In fact, some analysts say, the takeover accelerated the hysteria by signaling that no company, no matter how large, was strong enough to withstand the losses stemming from troubled loans.

Within weeks, Lehman Brothers was forced to declare bankruptcy, Merrill Lynch was pushed into the arms of Bank of America, and the government stepped in to bail out the insurance giant American International Group.

Saturday, Paulson is scrambling to implement a $700 billion plan to bail out the financial sector, while Lockhart effectively runs Fannie and Freddie.

Raines and Howard, who kept most of their millions, are living well. Raines has improved his golf game. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.

But Mudd, who lost millions of dollars as the company's stock declined and had his severance revoked after the company was seized, often travels to New York for job interviews. He recalled that one of his sons recently asked him why he had been fired.

"Sometimes things don't work out, no matter how hard you try," he replied.

2nd Article

Two fallen U.S. mortgage giants are unlikely to be restored
By Charles Duhigg
Published: March 3, 2009

Despite assurances that the takeover of Fannie Mae and Freddie Mac would be temporary, the giant mortgage companies will most likely never fully return to private hands, lawmakers and company executives are beginning to quietly acknowledge.

The possibility that these companies — which together touch over half of all mortgages in the United States — could remain under tight government control is shaping the broader debate over the future of the financial industry. The worry is that if the government cannot or will not extricate itself from Fannie and Freddie, it will face similar problems should it eventually nationalize some large banks.

The lesson, many fear, is that a takeover so hobbles a company's finances and decision making that independence may be nearly impossible.

In the last six weeks alone, the Obama administration has essentially transformed Fannie Mae and Freddie Mac into arms of the U.S. government. Regulators have ordered the companies to oversee a vast new mortgage modification program, to buy greater numbers of loans, to refinance millions of at-risk homeowners and to loosen internal policies so they can work with more questionable borrowers.

Lawmakers have given the companies access to as much as $400 billion in taxpayer dollars, a sum more than twice as large as the pledges to Citigroup, Bank of America, JPMorgan Chase, General Motors, Wells Fargo, Goldman Sachs and Morgan Stanley combined.

Regulators defend those actions as essential to battling the economic crisis. Indeed, Fannie and Freddie are basically the only lubricants in the housing market at this point.

But those actions have caused collateral damage at the companies. On Monday, Freddie Mac's chief executive, David Moffett, unexpectedly resigned less than six months after he was recruited by regulators, having chafed at low pay and the burdens of second-guessing by government officials, according to people with knowledge of the situation.

Fannie Mae has also experienced a wave of defections as people leave for better-paying and less scrutinized jobs.

Last week, Fannie Mae announced that it lost $58.7 billion in 2008, more than all its net profits since 1992. Freddie Mac is also expected to reveal record losses in coming days.

Most important, by taking over the companies, lawmakers have gained a lever over the housing market and national economy that many — particularly Democrats — are loath to discard, legislators say.

"Once government gets a new tool, it's virtually impossible to take it away," said Representative Scott Garrett, a Republican of New Jersey and member of the Financial Services banking subcommittee. "And Fannie and Freddie are now tools of the government."

One reason that Fannie and Freddie will never return to their earlier forms is simple mathematics: to become independent, Fannie Mae and Freddie Mac must repay the taxpayer dollars invested in the companies, plus interest. Even if the firms achieve profitability, it could take them as long as 100 years — or longer — to pay back the government. And almost no one expects the companies to return to profitability anytime soon.

Moreover, the takeover has provided legislators with a long-sought ability to influence the mortgage marketplace directly and pursue social goals like low-income housing.

"There is a commitment to restructure these companies, and we are going to want to retain a hand in the things that matter, like affordable housing and making sure that the housing economy doesn't become a threat to the entire economy again," said Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee. "Some of what these companies did will be returned to the private sector, and some of it is going to remain with a public entity."

Republican lawmakers — many of whom believe the U.S. government should not be involved in the mortgage business at all — have signaled they will try to end the government's involvement with Fannie and Freddie, even as they acknowledge that effort is likely to fail.

And lawmakers of all stripes are quietly voicing worries that government involvement in the mortgage industry could lead to the very problems that caused the current crisis.

"When you use mortgage companies for political purposes, such as helping low-income borrowers or expanding homeownership, you make bad economic decisions," said Garrett, the Republican congressman. "And bad economic decisions are why we're in this trouble right now."

Analysts say that one reason Fannie Mae and Freddie Mac were privatized in the first place was to prevent political whims from dominating the mortgage marketplace. The companies were founded by the government but sold to investors decades ago.

"The theory was that if Fannie and Freddie were private, they would only be interested in profits, and so they wouldn't take too many risks," said Thomas Lawler, an economist who worked at Fannie Mae for more than two decades before leaving in 2006 to become a consultant. "If the government owns Fannie and Freddie, politicians will make choices that make voters happy, but may not be wise from an economic standpoint.

"Of course, the past year has proved that focusing on profits alone doesn't protect you from bad choices, either," Lawler added.

Lawmakers are quietly discussing a handful of possible proposals for Fannie and Freddie. They range from outright nationalization, in which the government would formally absorb the companies and guarantee millions of new home loans, to public-private hybrids, in which lawmakers would explicitly backstop part of the mortgage industry if economic catastrophe strikes, and would dissolve Fannie and Freddie into smaller, private companies that would handle the day-to-day business of mortgage finance, but be heavily regulated.

Lawmakers say they are unlikely to begin serious discussion about the companies' futures until this fall.

Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 09 March 2009, 05:18:16
While reading an FT article, I suddenly remember a news item from about 1 year ago.

It was around the time when the government announced the secondary school allotment result. The media was interviewing parents about their hopes and plannings for their children.

One family interviewed was reportedly spending about HK$40k/month on the only child - on private tutoring, various classes, education fund, etc...

The mother had a very specific plan - she would like her daughter to get into a particular "old name" Catholic girl school, then attend an Ivy League college in the US, then find an investment bank job at the like of Merrill Lynch.

Zeitgeist of an era? When a mother's dream for her child is to be an investment banker?!
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 23 March 2009, 05:24:14
From IHT. My comments follow the quote.

Thomas L. Friedman: Are we home alone?
By Thomas L. Friedman
Published: March 22, 2009

I ran into an Indian businessman friend last week and he said something to me that really struck a chord: "This is the first time I've ever visited the United States when I feel like you're acting like an immature democracy."

You know what he meant: We Americans are in a once-a-century financial crisis, and yet we've actually descended into politics worse than usual. There don't seem to be any adults at the top — nobody acting larger than the moment, nobody being impelled by anything deeper than the last news cycle. Instead, Congress is slapping together punitive tax laws overnight like some Banana Republic, our president is getting in trouble cracking jokes on Jay Leno comparing his bowling skills to a Special Olympian, and the opposition party is behaving as if its only priority is to deflate President Obama's popularity.

I saw Eric Cantor, a Republican House leader, on CNBC the other day, and the entire interview consisted of him trying to exploit the A.I.G. situation for partisan gain without one constructive thought. I just kept staring at him and thinking: "Do you not have kids? Do you not have a pension that you're worried about? Do you live in some gated community where all the banks will be O.K., even if our biggest banks go under? Do you think your party automatically wins if the country loses? What are you thinking?"

If you want to guarantee that America becomes a mediocre nation, then just keep vilifying every public figure struggling to find a way out of this crisis who stumbles once — like Treasury Secretary Timothy Geithner or A.I.G.'s $1-a-year fill-in C.E.O., Ed Liddy — and you'll ensure that no capable person enlists in government. You will ensure that every bank that has taken public money will try to get rid of it as fast it can, so as not to come under scrutiny, even though that would weaken their balance sheets and make them less able to lend money. And you will ensure that we'll never get out of this banking crisis, because the solution depends on getting private money funds to team up with the government to buy up toxic assets — and fund managers are growing terrified of any collaboration with government.

President Obama missed a huge teaching opportunity with A.I.G. Those bonuses were an outrage. The public's anger was justified. But rather than fanning those flames and letting Congress run riot, the president should have said: "I'll handle this."

He should have gone on national TV and had the fireside chat with the country that is long overdue. That's a talk where he lays out exactly how deep the crisis we are in is, exactly how much sacrifice we're all going to have to make to get out of it, and then calls on those A.I.G. brokers — and everyone else who, in our rush to heal our banking system, may have gotten bonuses they did not deserve — and tells them that their president is asking them to return their bonuses "for the sake of the country."

Had Mr. Obama given A.I.G.'s American brokers a reputation to live up to, a great national mission to join, I'd bet anything we'd have gotten most of our money back voluntarily. Inspiring conduct has so much more of an impact than coercing it. And it would have elevated the president to where he belongs — above the angry gaggle in Congress.

"There is nothing more powerful than inspirational leadership that unleashes principled behavior for a great cause," said Dov Seidman, the C.E.O. of LRN, which helps companies build ethical cultures, and the author of the book "How." What makes a company or a government "sustainable," he added, is not when it adds more coercive rules and regulations to control behaviors. "It is when its employees or citizens are propelled by values and principles to do the right things, no matter how difficult the situation," said Seidman. "Laws tell you what you can do. Values inspire in you what you should do. It's a leader's job to inspire in us those values."

Right now we have an absence of inspirational leadership. From business we hear about institutions too big to fail — no matter how reckless. From bankers we hear about contracts too sacred to break — no matter how inappropriate. And from our immature elected officials we hear about how it was all "the other guy's fault." I've never talked to more people in one week who told me, "You know, I listen to the news, and I get really depressed."

Well, help may finally be on the way: One reason we've been sidetracked talking about bonuses is because the big issue — the real issue — the president's comprehensive plan to remove the toxic assets from our ailing banks, which is the key to our economic recovery, has taken a long time to hammer out. So all kinds of lesser issues and clowns have ballooned in importance and only confused people in the vacuum. Hopefully, that plan will be out by Monday, and hopefully the president will pull the country together behind it, and hopefully the lawmakers who have to approve it will remember that this is not a time for politics as usual — and that the United States, alas, is not too big to fail. Hopefully ...

The AIG US$168 million bonus has been the headline news for many days during this past week. The prominence of this news is a bit puzzling.

- In the grand scheme of things, this $168m is a tiny fraction of the trillions that Americans need to rescue the economy and the banking system. Yet the time, energy, media attention and emotional investment spent on this is unproportionally large.

- As underserving as the AIG executives are, if the "bonuses" were agreed on employment contract regardless of actual performance, they should be called "deferred payments." The difference is not just terminology, but a reflection of the society's value - should promises be kept and contracts be honored!?

- Land of the Laws? Land of Lawyers?!
Title: The Greatest Trade Ever
Post by: chin on 23 January 2010, 01:30:48
I just finish reading "The Greatest Trade Ever" last night. This is one of the many books that came out in the last few months about the great crash of 2008. It's about how a few investors, mainly John Paulson, foresaw the coming crisis and make profit from it.

The market always have different views. Otherwise there won't be any market if everyone had the same view. Therefore there always some guys who bet on the right side and make money.

So this was the assumption I had before reading the book. Thinking that it's just stories of the lucky guys who happened to be on the right side of the bet. After reading the book, my impression is that these guys were not just lucky. They were extremely lucky AND put in the hardwork to profit from it.

They were not the only people who saw things were going crazy at the time. In hind sight, even I saw it coming - all the big tycoons were placing shares which is a sure sign that even they thought the shares were over priced, and the many TV ads on Dish Networks telling people that anyone can get a loan or refinance, or my relative who saw her Manhattan apartment doubled in value in 5 or 6 years. However guys like me just sat on the sideline and waiting for the fireworks.

The people in the book, on the other hand, took the time to figure out how to profit from the coming crash. Seeing the big picture is one thing, developing a concrete plan of action is another. They did not get it right at the start. For example, they initially tried to short shares in financial companies or real estate related business. But shorting shares exposing one to unlimited downside. Then they found derivatives. Not simple puts, but CDS that's effectively insurance on the value of a particular securities. Initially their invested in CDS for particular mortgage related bonds, and later on CDS on the mortgage index that had proven to be the holy grail.

If I get the timeline right, this process took some of them 1 year or more to perfect. And then there was the problem of timing. Some of them acted too soon and had to wait two years before the housing price fell enough for the CDS to be worth anything. When the market crashed, many of them also had to resist the temptation from within and pressure from outside to sell too early to lock in profit. (In 1992 I read a book about the house of Nomura. One of the key events in its early history was shorting rice and had to wait two years before profits came in to bail them out and made them super rich. During the two years they had to tighten their belts and being ridicule at.)

So these people are not just lucky. You have to add some foresight, some courage, lots of perseverance & hardwork, plenty of greed & some craziness. At the end of the book, it says John Paulon's next big bet is against the US$ & many currencies except the Chinese Yuan. His instrument this time is gold.

According to the book, John Paulson made US$15 billion out of this mess. Since derivatives like CDS are zero-sum game, the people on the other size of his bets loss at least as much. And the losers were the houses of Bear Sterns, AIG, Citigroup, etc... who held on to the CDS on house accounts instead of selling to clients.

Now the big question - what's my plan to profit from the next big crash? or from the bubble that builds to the next big crash?
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: chin on 16 March 2012, 01:37:34
I found out this article in Rolling Stones after reading about Greg Smith's resignation from Goldman Sachs.


Greg Smith's resignation from Goldman Sachs

After reading the article, all I could say was that I was not surprised.

Banks has been losing credibility, especially now they have to or like to sell many financial products. I have been specially skeptical about Wealth Management products from banks. Few years ago we were offered by HSBC a product that supposedly benefit our children - except that that product matures in 100 years. Not only I will be long dead in 100 years, my children are most likely dead too by then. When pointed out about this non-sense, the banker couldn't help but laughing too.

Goldman is probably just a much larger version of this non-sense - that they sell whatever they can get away with, regardless whether the product make sense or not.
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: hangchoi on 16 March 2012, 08:10:52
Yep. Previously banks' business is to use your deposits to earn money from others. Now they earn your money direct.

Why do we have private banking everywhere now? Why they put private banking clients in such a prestige status? Who pays the cost of serving private banking client at such level? Is the traditional banking business so bad that they cannot profit again ?
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: q on 16 March 2012, 08:41:23
Banks has been losing credibility, especially now they have to or like to sell many financial products. I have been specially skeptical about Wealth Management products from banks. Few years ago we were offered by HSBC a product that supposedly benefit our children - except that that product matures in 100 years. Not only I will be long dead in 100 years, my children are most likely dead too by then. When pointed out about this non-sense, the banker couldn't help but laughing too.

A HSBC person tried to get me to buy into some kind of CDO fund about two months after the financial crisis hit.
Title: Re: Zeitgeist of the Great Crash of 2008
Post by: hangchoi on 07 April 2013, 22:01:07
Just finished reading "The Big Short: Inside the Doomsday Machine" by Michael Lewis. A very interesting read.

I borrowed it from my sister-in-law last night. This one is a black hole to me and I can't stop once start to flip.

The book is written like a story and it talks about sub-prime mortgage and the later CDO stuff. It covers the period well from 2002/3? to the financial crisis of US banks and generally it is quite in line with his articles posted above by Chin.

It explains the whole story of this "scam" and how the hedge fund guys gambled on this, and made big money from those wall-streeters.

Q: it also tells you when they tried to sell you CDO fund 2 months after the crisis.
Title: Re: The Greatest Trade Ever
Post by: hangchoi on 07 April 2013, 22:39:55
I just finish reading "The Greatest Trade Ever" last night. This is one of the many books that came out in the last few months about the great crash of 2008. It's about how a few investors, mainly John Paulson, foresaw the coming crisis and make profit from it.

I got something more from "The Big Short". Paulson actually was not the first one who foresaw this crisis. Somehow he may be told by others. Guys like Steve Eisman was almost the first one to plan how to earn big money from the crisis. He did what you said (shorting the security of related business, etc.) but (according to the book) the most important move was that he tried to use derivatives to short the mortgage loan with banks. He even made the first short-sale contract by himself and used that for negotiation with i-banks. His drafted contract was later used as a framework for future transaction of similar kind. However, things like CDO was later developed by other i-bankers and this messed thing up further. He did that in about 2004, and started to sell short in 2005 as he noted that the prime rate for mortgage will be revised 2 years later, i.e. 2007. So his "investment" period was originally only 2 years to 2007 as he gambled that prime rate in 2007 will have a huge increase after review. He, together with just a few investors, was gambling against the whole market at that time. Paulson joined to short it a year or 2 later on CDO part.

Yes, they have foresight, courage, greed and perseverance to hold his gamble to the end but the risk is horribly huge. At that time, the whole market was so crazy that almost no one in wall streets understood what they were doing and trading. Even after the crisis hit as they rightly foresaw, they may still lose if the government bailed out the defaulters too soon.

Title: Re: Zeitgeist of the Great Crash of 2008
Post by: hangchoi on 07 June 2013, 16:51:43
Off track a bit from the US to Europe....

This video is funny to explain the problems of EU.......