Comments on Obama’s lost opportunity

Hi from Nairobi Kenya

Last week I communicated my disappointment that President Obama had lost the moral high ground by standing by several appointees to his cabinet who have violated tax laws and my relief that he acknowledge that he had goofed. Here are some interesting comments from some of you.


You are giving them too much credit.

RWR (Richard Rahn, Great Falls, VA)


Dear Warren,

He may have confessed to screwing up, but he still didn’t withdraw the nomination of Geitner. 

And now he’s limiting compensation to $500,000 for execs.  This reminds me of the notorious $1 million limit on tax-deductible exec pay in the early 1990s, which caused the crazy stock option boom (unintended consequences). 

There’s no free lunch.

Best wishes, AEIOU,

Mark (Skousen, Freedom Fest, Los Vegas)



I like the idea of the Rangel Rule for other Americans … a loophole for the ordinary.

Bill (Crosbie, Canadian Foreign Ministry, Ottawa)


This was said AFTER the Secreatry of Treasury was confirmed WITH tax issues.

Donna (Wiesner-Keene, Alexandria, VA)


Enjoy the warm breezes.

I agree and share the outrage and dismay at public figures — in the financial world, so they have to know better–assuming they are above the tax laws, while we the sheep dutifully calculate our pittance and pay up.  Obama (and the Pope, in his sphere)  need to listen up.  Regards,

Dorothy (McManus, Alexandria, Va)


I have a bit different take on it.  The indiscretions were minor in my opinion, but Obama made such a thing during the campaign about style and process (change you can count on; doing things differently in DC; no lobbyists in government) he has now been caught on his own campaign rhetoric.  When substance should matter ("Hey! I really need him for the health agenda"), he has no choice but to dump Daschle because he told people to watch the style and process, not the substance, of his administration.  So…we’re watching.
Jim (Kolbe, former U.S. Representative from Arizona)


I am a fan of President Obama but, frankly, it’s a bit creepy to have a Secretary of the Treasury who’s a tax cheat.  TOM (Lauria, Arlington, VA)


Yes, a pity that he had to do that within the first few days of his administration.  After all he has to rely on his advisors to check things out for him who obviously let him down.  Great that he still accepted responsibility instead of passing the buck to his juniors.  I trust the American public will see that.

I see your "retirement" is a busy one….

Cheers, Sam (Alfreds, Victoria, Australia)



Geithner and Daschle were trapped in a sudden tectonic cultural perception shift, Daschle with greater negative impact.  This was accurately and hilariously identified by David Brooks in his excellent op-ed item in the Feb. 3 New York Times.  q.v.:

I was watching Lehrer’s News Hour a week or so ago, and some Wall Street type seemed perplexed about the massive bonuses provided to high level employees of various failing banks and financial houses.  "It’s been done that way for years," he said (or words to that effect), thus revealing the cluelessness of the malefactors of great wealth.  As Talleyrand said of the Bourbons, "They have forgotten nothing and learned nothing."  The same is true, I might add, of the Democrat Caucus in the House.  They are permanently stuck, like a fly in amber, in about 1978.

Enjoy the Caymans — it’s utterly frigid here.  Dinner when you return?

Tom (Neale, Washington, DC)



I too was pleased with Obama’s mea culpa, and the limousine liberal’s withdraw – but wonder why he was first so willing to fall into the typical cover-up and fight mode.

I also think this salary cap is a bunch of smoke and mirrors nonsense.

All in all, the groundwork is being laid for quite the ambitious administration. 

Rob (Teir, Houston, Texas)

"I think that God in creating Man somewhat overestimated his ability."

-Oscar Wilde


Hi Cayman Warren,
you have probably seen the enormous assault on health care "reform" by the Obama administration.
Do something, please …
And hope to see you in DC or Paris before long.
Very best, J. (Jacob Arfwedson, Paris, France)

A lost opportunity

President Obama promised that he wanted to change the way Washington does business. He wants and more open and honest government. By turning a blind eye to the new Treasury Secretary’s failure to pay his social security taxes for 2001 and 2002 (until he was nominated to head the Treasury Department, which included the Internal Revenue Service), the President missed an important opportunity to demonstrate the seriousness of his commitment to the integrity of his administration. Treasury Secretary Timothy Geithner has risen quickly through the ranks to high position, is highly respected, and will most likely make an excellent Treasury Secretary. However, after being audited by the IRS in 2006 and found to have mistakenly failed to pay his social security taxes for 2003 and 2004, any misunderstanding he might have had about his need to pay these taxes were surely removed. Yet he did not pay the unpaid social security taxes for 2001 and 2002 until his nomination by Obama to his current position at which time he paid an additional $25, 970 in back taxes and interest penalties.[1] No person is indispensable and the failure of the President to sacrifice his first choice for the position looks more like business as usual than a new page of integrity.

The slippery slope has been greased and viola, down the slope we go with the revelation that Sen. Tom Daschle (S.D.), President Barack Obama‘s nominee to head the Health and Human Service Department had not paid more than $128,000 in back taxes over several years. Is that over the line, or should we forgive him as well?

In the interest of fairness and to reestablish the principle that the law applies to every one, Congressmen John Carter’s office issued the following press release:

“IRS Penalties and Interest Eliminated for All U.S. Taxpayers under new “Rangel Rule” Legislation

“(WASHINGTON, DC) – All U.S. taxpayers would enjoy the same immunity from IRS penalties and interest as House Ways and Means Chairman Charles Rangel (D-NY) and Obama Administration Treasury Secretary Timothy Geithner, if a bill introduced today by Congressman John Carter (R-TX) becomes law.

“Carter, a former longtime Texas judge, today introduced the Rangel Rule Act of 2009, HR 735, which would prohibit the Internal Revenue Service from charging penalties and interest on back taxes against U.S. citizens. Under the proposed law, any taxpayer who wrote “Rangel Rule” on their return when paying back taxes would be immune from penalties and interest.

“We must show the American people that Congress is following the same law, and the same legal process as we expect them to follow,” says Carter.  “That has not been done in the ongoing case against Chairman Rangel, nor in the instance of our new Treasury Secretary Timothy Geithner. If we don’t hold our highest elected officials to the same standards as regular working folks, we owe it to our constituents to change those standards so everyone is abiding by the same law.  Americans believe in blind justice, which shows no favoritism to the wealthy or powerful.”

“Carter also said the tax law change will provide good economic stimulus benefits, as it would free many taxpayers from massive debts to the IRS, restoring those funds to the free market to help create jobs.”

Alan Reynolds of the Cato Institute promptly noted that: “The bill also needs a Tom Daschle amendment to also provide immunity from criminal prosecution for outright tax evasion, such as not bothering to report $83,000 a year from consulting fees, or pretending that being given the use of a free limo with driver (a payolamobile) is not really income but simply "a generous offer from a friend." 

This all sounds sadly familiar.


President Barack Obama

January 20, 2009

Happy New Year

Today is a proud day for America. Yesterday, Martin Luther King Day, King’s son, Martin Luther King III, wrote in the Washington Post about "The Dream This Jan. 20" saying that “Martin Luther King Jr. would be extraordinarily proud of Mr. Obama for becoming the nation’s first black president. Perhaps more important, he would be proud of the America that elected him.” We can be proud, not because we elected a son of a black Kenyan (in whose country I will spend three weeks next month), but because we elected a very intelligent and thoughtful leader, who happens to be black—despite his being black (to be blunt). In Obama’s own words “It changes how black children look at themselves. It also changes how white children look at black children. And I wouldn’t underestimate the force of that." I am happy to say that when I saw the title of the Post article in which that last quote appeared, "President-Elect Sees His Race as An Opportunity", I actually thought it referred to his campaign for the Presidency.

But Obama’s own thinking is far deeper than that. “Beyond the symbolism of his historic achievement, Obama said, he hopes to use his presidency as an example of how people can bridge differences — racial and otherwise. ‘What I hope to model is a way of interacting with people who aren’t like you and don’t agree with you that changes the temper of our politics,’ he said. ‘And then part of that changes how we think about moving forward on race relations. Race relations becomes a subset of a larger problem in our society, which is we have a diverse, complicated society where people have a lot of different viewpoints.’

Obama embraces the traditional American values of personal responsibility and hard work. At dinner last night long time friend Sergio Pombo suggested that many older black leaders (the we are victims and are entitled to this or that crowd) are bound to be disappointed that Obama doesn’t deliver to them all the favors they hope for. These old attitudes will pass along with the white prejudices that helped give rise to them and Obama will help speed their passage by insisting that position and honor be earned. Washington DC’s black mayor, angered a few of the city’s older black residence (the vast majority of its residences are black) when he replaced the black chief of police with a white woman and the black Superintendent of Schools with a Korean woman because they were the best available. The vast majority of the city is excited by the implications, and prospects for a better city.

I am very impressed with the professional experience and quality of Obama’s cabinet appointments, especially his economic team. I expect many good things from them. I also expect things I probably will not like much because Obama has more faith in the capacity of government to do good than I do. What we desperately need from our national leaders after eight years of “my way or the highway” is serious debate about the important economic, foreign policy, and security issues before us. President Obama, who as President of the United States works for all of us, must build broad understanding of and consensus for new policy initiatives, and he has the skills and intension to do just that. We need to put behind us the view of some low lives that claiming Obama was really a Muslim (as if that automatically disqualified him) constituted an intellectual argument against what ever he might propose. We must return to a civil public discussion of the pros and cons of policy options rather than demonizing those with whom we disagree. I for one will do my best to marshal soundly reasoned and empirically supported arguments for private market solutions and limited but efficient government. I hope that the debate will focus on the most appropriate and beneficial partnership (and boundary) between government and the private sector (us).

Those who accused Bush W of manufacturing evidence of weapons of mass destruction in Iraq are guilty of the same enemy demonization. The fact that our war in Iraq was a tragic mistake does not mean that Bush did not think he was acting in the national interest. As E. J. Dionne Jr. pointed out in the Post in "Why the Uniter Divided Us", “Bush did not respect the obligation of a leader in a free society to forge a durable consensus. He was better at announcing policies than explaining them. He dismissed legitimate opposition and plausible doubts about the courses he wished to pursue. It is partly because of these failures that Americans reacted by selecting a successor with such a profoundly different political personality.” Fortunately, President Obama is a man of a very different temperament and not a minute too soon.

I suppose that it is human nature, one that civilization is dedicated to overcoming, to be less comfortable with or suspicious of people not like ourselves. The demonization of those we political disagree with feeds on itself unnecessarily sharpening political divisions. In another interesting Post article yesterday Shankar Vendantam reported on research on this subject in his article "Why the Ideological Melting Pot Is Getting So Lumpy". It seems that neighborhoods are becoming more homogenous politically (e.g. Greens vs. garden fertilizerers) rather than ethnically or religiously. My Iranian neighbor dropped by for tea the other day and shared an interesting comment about our neighborhood (he lost everything in Iran when the Shah fell and he and his wife moved to the U.S.). He said, you know there is only one other Republican in this neighbor (of 64 houses) besides you and me. He is also excited about Obama’s Presidency though he didn’t vote for him either.

The Richness of America

As I have not traveled outside of the area since the last Cayman Islands Monetary Authority’s board meeting November 5, my usual excuse for these notes, I would like to share with you a recent twenty minute car trip into town.

November 18

The orchestra for this evening’s concert rose as its young director Gustavo Dudamel walked to the podium. Then, still standing, they broke into The Star Spangled Banner. For a moment this cause some confusion among the Kennedy Center audience, as concerts, plays, movies and other public events in our country do not generally begin with the National Anthem as in many other countries. But we quickly rose to our feet and some even sang along with the orchestra. They played our National Anthem more beautifully than I had ever heard it before and tears actually formed in my eyes. As the music played I quietly reviewed some of America’s many strengths and virtues. I was proud of America again. It had been a while.

Before we could take our seats at the end of the Anthem, the orchestra took up the Hatikvah (the Hope). The haunting, melancholy strains of the Israeli National Anthem kept us standing for a few minutes more. We took our seats and the Israel Philharmonic Orchestra began Felix Mendelssonh’s Symphony No. 4, his “Italian” symphony. The young German composer traveled to Italy at the ago of 21 and wrote: “Italy at last. And what I have all my life considered as the greatest possible felicity is now begun, I am basking in it.” He began his Italian symphony during his nine month visit to Italy and premiered it three years later in London at the age of 24. And I was enjoying his symphony and even more Brahm’s (also German) much richer Symphony No 4 that followed it here in Washington DC performed by Israel’s premier orchestra.

The mix of nationalities reminded me of my first full Opera many years ago. Jean and Tom Dusenbery took me to the Berlin Concert Hall to watch Puccini’s Madam Butterfly. These beautify arias about an American in Japan where sung in Italian. I was watching it in West Berlin (my older friends will remember that there was a West Berlin for 28 years as well as a West Germany for about 45 years). For all its problems the world is a better place for most people.

December 24

Last months concert is one of the many experiences of rich cultural diversity that make life here so rich and exciting. It has been a trying and difficult year in many ways, but we do have so much to be thankful for as well and 2009 will be a new and I think exciting year. I wish you the very best for the coming year.

The Financial Crisis: Act II

A combination of factors are producing huge loses to mortgage lenders that threatened the collapse of a large share of the financial sector. The Main Street consequences could have rivaled the Great Depression. Governments around the world intervened dramatically to save their banking systems with deposit and lending guarantees and the injection of tax payer funds to bolster banks’ capital in an effort to prevent the abrupt and damaging curtailment of normal bank lending. While these unusual steps may have been necessary to avoid still more catastrophic losses to Main Street, they carry significant risks of their own if not carefully designed to minimize moral hazard and explicitly limited in duration. While a collapse of the financial sector would dramatically worsen the recession that the U.S. and Europe are now in, the recession itself makes it more difficult to stabilize financial sectors. None the less, monetary and fiscal measures to moderate the severity and duration of the recession should not prevent macroeconomic adjustments and the healthy shakeout of inefficient firms that the economy needs.


Act I – How We Got Here

Scene 1 – The Housing Bubble Inflates, Then Deflates

Government policies to promote home ownership pressured lenders to lower underwriting standards and increase lending to previously unqualified borrowers. An abundance of world saving and easy monetary policy and the mortgage guarantees from Fanny Mae and Freddie Mac (government sponsored enterprises mandated with attracting funds to mortgage lending) channeled large amounts of low cost funds to home buyers. These factors along with poorly designed land use planning restrictions in some areas increased demand for housing more than supply and prices rose rapidly. The securitization and pooling of mortgages into Mortgage Banked Securities (MBSs) lowered the cost and spread the risk of mortgage lending world wide but also weakened the financial incentives of agents to monitor compliance with already low underwriting standards. With the repeal of the Glass Steagall Act in 1999, which separated investment from commercial banking, the short-term “performance” bonus practices and very high leverage (investing borrowed money) of many investment banks began to dominate the more conservative culture of commercial banks further eroding mortgage underwriting standards to levels no one believed could service beyond a few years (before which bonuses would already have been collected).[1] Thus principle/agent weaknesses were greatly exacerbated. Irrational expectations of ever increasing housing prices attracted speculators on the investment side as well. Overly complex mortgage backed securities over relied on credit rating agencies with no experience with such instruments and conflicts of interest. Gaps in supervisory coverage between the Office of the Comptroller of the Currency (OCC), which supervises all National Banks, and the Federal Reserve, which supervises bank holding companies (among other financial entities), left excessive risk taking unsupervised. The widely held assumption that the government would back up the commitments of Fanny and Freddie, meant that private speculators could take their winnings and the tax payers the losses. Players in the mortgage markets may have acted recklessly but generally they were acting rationally within the policy/regulatory framework the government provided. Wide spread fraud (misrepresenting borrower qualifications), encouraged by the short-termism of investment banking also played a role.

Housing prices couldn’t and didn’t go on increasing at such rates. Demand slowed at such prices. Supply caught up and exceeded demand; the stock of unsold houses rose and the bubble burst. Borrower defaults began to rise above usual rates. The market value of MBSs fell and uncertainty over how much defaults would increase made it difficult to trade them even at steep discounts. By 2007 Wall Street began to realize that banks and other investors were going to absorb hug losses but the complexity and opacity of the structured financial instruments by which mortgages had been distributed made it difficult to evaluate who ultimately would pay them. These developments along with tightening monetary policy (rising interest rates) led the entire financial system to demand more liquidity to compensate for the reduced liquidity of MBSs and a loss of confidence in financial market counterparties. In mid 2007 hedge funds and other Wall Street firms began gradually to deleverage (reduce their reliance on borrowed funds to supplement investors’ funds and to fund investment banks, insurance companies and others). The cost of unsecured interbank lending sky rocketed. The TED spread (difference between the three month London Interbank Offer Rate—LIBOR—and the three month U.S. treasury bill rate) jumped from its usual 0.1% or so to over 4%. Hedge funds and others began to reduce their reliance of borrowed funds (deleveraging).[2]

Housing price bubbles and their collapse even larger than in the U.S. are being experienced in many countries. The UK and Spain are particularly hard hit. These also reflect the world wide glut of saving and very low real interest rates over much of the last quarter century and especially 2002-3. Some of America’s mortgage losses are also being absorbed abroad because of foreign investments in U.S. MBSs.


Scene 2 – Federal Reserve Responds to Liquidity Demand

Whether to correct for the overly lax lending standards of previous years or because of the hording of liquidity by banks concerned by the loss of their normal sources of liquidity (or both), lending standards tightened. The Federal Reserve and the central banks of other affected economies responded in traditional fashion to provide the increased liquidity banks demanded in order to keep interest rates from rising and the money supply and credit growth from collapsing. The Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (Federal Reserve Bank loans are collateralized), and broadened the range of institutions that could access these new facilities. Lenders were also encouraged to renegotiate the terms of nonperforming mortgages if foreclosure could be avoided and the lender’s losses reduced.[3]

Central banks traditionally intervene to provide solvent banks with liquidity when depositors suddenly withdraw funds or secondary markets for bank assets become disorderly. Federal Reserve provision of liquidity to the market takes broadly two forms: collateralized lending to banks and purchases of assets from the market. Collateralized lending does not spare banks losses on their loans or the assets they invested in. The Federal Reserve would absorb losses from “toxic” collateral only if the banks it lends to fail. So called “open market operations” in which the Fed buys securities outright are a different matter. Hence such operations are generally limited to the highest quality assets—generally government securities. The Fed now accepts MBS as collateral in some of its lending facilities but does not buy them in open market operations.[4] More recently it has taken the extraordinary step of buying corporate “commercial paper” in the open market because of the sudden difficultly companies have been having financing their operations in this customary way. In part, this reflects the fact that banks are no longer the dominant source of funds to the economy.

At the same time the Federal Reserve is lending huge amounts to banks and others on Wall Street, it has also been selling (previously purchased) government securities from its portfolio and attracting (now) interest baring deposits from banks in order to keep the federal funds rate at or near its policy target rate. At first glance this two way activity seems hard to understand but a closer look at the deleveraging process makes clear that the Federal Reserve is facilitating the markets rapid shift toward safety. If investors in hedge funds or money market funds (already relatively safe) withdraw funds in order to reduce the riskiness of their investments two questions arise: a) where will the funds get the money to pay for these withdrawals and b) where will the investors put the money they have withdrawn.

With regard to the first question, if funds try to borrow the money needed to repay investors, the leverage of the funds would increase. A larger share of the assets in the fund would be financed with borrowed money rather than with the deposits of investors. But leverage is now more expensive and harder to get. Thus funds will be forced to, or will chose to, sell assets in order to raise the money needed for the investor withdrawals. These sales add to downward pressure on the market price for these assets (every thing from GM stock to subprime MBSs) which might add to the demand by investors to withdraw their funds. Some of the stock markets incredible volatility probably comes from such forced sales. Furthermore, the market’s reduced preference for risk implies higher risk premiums for assets with unchanged expected returns. The fall in the market value of MBSs, for example, even without further deteriorations in their expected performance, reduces banks’ capital. Thus increased demand for liquidity (and safety) and bank capital are interrelated. Banks can use these assets as collateral to borrow the funds needed from the Federal Reserve to cover withdrawal, but this slows the pace of deleveraging.

With regard to what investors do with the money they have withdrawn, they will desire to invest it in something safer. The safest investment is in government securities and the yields on these have been driven to very low levels as the market has moved to safety. The Federal Reserve’s sales of government securities to keep their interest rates from falling too low is in effect helping the market shift from riskier investments to safer ones.

Banks, and “Wall Street” more broadly, received such special treatment because of their special character. Wall Street refers to so called “financial intermediaries” (banks, insurance companies, mutual funds, etc.), which facilitate and intermediate the flow of saving from households and firms to Main Street (manufacturing, agro, and service firms and households), which use these funds for investment and to smooth the uncoordinated flow of income and expenditures. Such market allocation of lendable funds has proven dramatically more efficient in directing them to more productive uses than the centrally controlled allocation of “planned” economies. Our higher standard of living reflects our more productive allocation and use of resources (for investment in physical and human capital). Secondary markets in which financial assets (stocks, bonds and now bank loans) can be traded have increased the “liquidity” of these assets and thus lowered the cost of financial intermediation by reducing the amount of cash banks and other Wall Street firms must keep on hand to bridge the mismatch of receipts and payments. Successful market allocation of resources depends critically on the incentives and discipline of profit and loss. Those taking risks in search of profits must act in the knowledge that they will pay the price of mistakes or bad luck. In addition, banks provide the payment services our modern economy critically depends on.

The American banking system is generally strong and sound because the profit and loss discipline of the market eliminates poorly run ones. Banks limit the risks they take with depositor and shareholder money because they do not expect the government to bail them out of their mistakes. This expectation reflects the willingness of banking supervisors to close insolvent banks. Closing a failing bank, rather than bailing it out, can be risky because of its potential spill over to other sound banks and the risk of wide spread deposit withdraws by depositors fearing the loss of their money, so called “bank runs”. But the U.S. has effective bank bankruptcy laws and tools, which largely overcome these risks. Thousands of banks have been taken over by the Federal Deposit Insurance Corporation (FDIC) and resolved (sold in whole or in pieces, or otherwise liquidated) without significant disruptions to the banking system. These laws give regulators powerful tools (basically the power to nationalize undercapitalized banks and to sell them in whole or in part and liquidate whatever is left) but limit their discretion in how these tools are used by the requirement that critically under capitalized banks must be taken away from their owners and resolved with the least cost to the insurance fund (FDIC) and other depositors.

These tools were applied to the growing but modest number of banks that failed over the past year (Countrywide, IndyMac, Washington Mutual, and Wachovia to name the bigger ones). These resolutions were handled smoothly with no disruption to the market. However, mortgage and related losses also fell heavily on investment banks and even insurance companies.[5] When a few of them began to fail, the legal provisions for bank failures were not available. Thus the arranged buyout of Bear Stearns, an investment bank, earlier this year required the approval of its shareholder who demanded a somewhat higher prices than originally offered and the buyer (JPMorgan Chase) demanded and received from the Federal Reserve a guaranteed limit on its potential losses on Bears Stearns mortgage related assets. While the resolution of Bear Stearns was probably the best that could be achieved with the legal tools available and looked much like an FDIC resolution other than the modest price paid to shareholders, it was not guided by explicit legal rules. The later quasi (re)nationalization of Fannie Mae and Freddie Mac moved closer to the approach of an FDIC resolution but again without the same legal tools. These two Government Sponsored Enterprises (GSEs) where put into Chapter 11 bankruptcy, under the supervision of the newly created Federal Housing Finance Agency (FHFA) and with new managements and boards. However, all creditors were reassumed by the Treasury’s commitment of an unlimited line of credit and up to $100 billion capital if and as needed by each of the two. Shareholders on the other hand were deprived of any dividends and the prospect of surrendering their shares if Treasury capital was needed. On November 14 Freddie Mac reported $25 billion in losses for the third quarter, which activated the first of the promised tax payer capital injections of $13.8 billion to avoid insolvency. The future resolution (downsizing and reprivatization or orderly liquidation) of these two GSEs will be decided by the next congress. They should be liquidated.

As estimates of potential mortgage losses continued to rise,[6] the viability of additional banks came into question. Lehman Brothers and Merrill Lynch (both investment banks) entered into discussions with potential buyers. When Dick Fuld, CEO of Lehman Brothers, refused the buyout offer from Barclays, the Federal Reserve refused to sweeten the deal with guarantees and allowed Lehman Brothers to enter Chapter XI bankruptcy, while Merrill Lynch accepted the buy out offer from Bank of America. America’s remaining two large investment banks, Goldman Sachs and Morgan Stanley, promptly requested and were granted permission to convert to commercial banks, thereby gaining access to Federal Reserve credit facilities in exchange for the significantly tighter regulation of commercial banks.


Act II – Financial Panic and Beyond

Scene 1—Addressing the Panic

The September 15th bankruptcy of Lehman Brothers, the sort of market discipline of excessive risk taking and failed gambles that I favor, triggered a genuine financial market panic. The TED spread rocketed from around 1.0% the first half of September to around 4.5% by early October.[7] Treasury Secretary Paulson rushed to Congress with a two page proposal to authorize the Treasury to buy up to $700 billion of MBS “from any financial institution having its headquarters in the United States”[8] under terms and conditions to be determined by the Treasury. Initially his proposal was to buy MBSs from banks under rules to be determined. After a false start in which the House rejected the proposal, the Emergency Economic Stabilization Act of 2008 was passed and signed into law on Oct 3rd, 2008. In what is now a 451 page law, which included a number of other unrelated or tangentially related measures, the Act essentially authorizes the Treasury to borrow up to $700 billion in order to aid the financial sector in almost any way it decided would help restore normal bank lending. As evidence mounted that lack of capital rather than liquidity was the primary cause of the claimed freeze up of bank lending[9] and that it would be almost impossible for the Treasury to determine appropriate prices at which to buy “toxic” MBSs, the Treasury shifted the primary use of this authority to recapitalizing under capitalized but sound banks. The Act also more than doubled to level of deposit insurance coverage from $100,000 to $250,000.

On October 8, UK Prime Minister Gordon Brown announced that the British Treasury would inject capital (buy shares) in eight major British banks and guarantee interbank loans, the Bank of England would double the size of its “special liquidity scheme,” and the government would increase the size of guaranteed deposits.[10] On October 13 most European government promised to follow suit. These measures taken together were meant to stop bank runs, increase bank capital, and remove the counterparty risk of interbank lending in order to restore normal lending and credit flows.

In addition, the Federal Reserve has taken unprecedented measures to unblock normal credit flows to Main Street firms and household outside of the traditional commercial bank channels, which have become less important in recent years. Following panic public withdraws (“runs’) on money market mutual funds, the government guaranteed their principle. Not only did most such funds stop purchasing most commercial paper, a very important source of trade and industry finance, but they were forced to sell some of the paper they already held to finance depositor withdrawals. The Federal Reserve then introduced an off balance sheet facility for buying commercial paper directly.

These were aggressive interventions into financial markets, which were bound to interfere with normal market discipline of the behavior of its participants. Were they justified? Can they be designed to minimize the moral hazard of encouraging risky behavior by bailing out mistakes? And why bail out Wall Street rather than Main Street?

Why Wall Street rather than Main Street is easy. Wall Street is “merely” the intermediary between savers and investors, between household/firm providers of funds and the Main Street users of these funds. The collapse of Wall Street would seriously impair or even bankrupt quite innocent Main Street firms or households by cutting off the credit they depend on for investment and day to day operations through no fault of their own. Saving Wall Street from collapse potentially saves the entire economy from unnecessary collapse. But were such sweeping interventions necessary to prevent the collapse of Wall Street and restore normal bank lending? That is hard to say for sure, but the risk of misjudgment was too great to take. Given the information in hand, governments were probably justified in taking these measures.


Scene 2 – Bailout Risks

Stopping the financial panic required steps to reassure depositors and investors that it was safe to leave or put their funds in banks and to increase bank capital to levels that would allow them to continue lending to credit worthy customers. Uncertainty about the soundness of banks needed to be removed. It was too late for carefully considered and finely tuned measures, thus broad brushed guarantees and capital injections were used. None the less, the cost to tax payers should be considered and damage to market discipline should be minimized where possible. The rules governing which financial institutions get tax payer funds to bolster their capital and the terms and conditions attached to such funds (e.g. matching private sector capital injections, cost to existing shareholders, tax payers’ share in upside profits, and duration of state funding) should be explicit and transparent to minimize market uncertainty and the risk of abuse.[11]

Partial ownership of AIG and major banks and control of Fannie Mae and Freddie Mac are most certainly not a renewed interest in old socialist ideas of the superiority of state run enterprises, actual experience with which has been almost universally bad. None-the-less, government share ownership increases the risks of political interference significantly. The longer it holds these shares the higher the risks will be and examples can be found already. And broad lending guarantees carry considerable risks of reintroducing the excessive risk taking by Wall Street that started this crisis. Emergency financial market stabilization measures should be ended as quickly as possible.

Charles Dallara, Managing Director of the Institute of International Finance, reported that banks receiving government capital injections have been told not to use the funds to satisfy the liquidity needs of their foreign subsidiaries.[12] The severity of the Great Depression is generally attributed to the failure of the Federal Reserve to provide liquidity to banks sufficient to prevent the collapse of the money supply, the ill conceived attempt to save American jobs with high tariffs embodied in the Smoot-Hawley Tariff Act of 1930, and the competitive devaluations around the world in self defeating efforts by each country to boost its exports. Fed Chairman Bernanke, a well versed student of the Great Depression, is determined not to repeat the Fed’s earlier mistake this time around and is thus providing hug amounts of liquidity to the financial system. All participants at the November 15, Washington Group of 20 (G-20) meeting on the financial crisis and international financial architecture have also confirmed the dangers of and their opposition to a new wave of protectionism. However, as Dallara, warns, the Treasury’s pressure on banks not to support their foreign subsidiaries with the Treasury’s capital injections could be the twenty first century’s version of misguided protectionism. It undermines the logic and premise of globalized banking organizations with a counterproductive effort to “keep capital at home.” Given that the U.S. government’s debt is largely financed by foreign capital inflows, this feature of the Treasury capital injection program (Troubled Asset Relief Program—TARP) is nothing short of shocking.

The purpose of the Wall Street “bailout” is to restore normal bank lending. However, too much pressure to lend runs the risk of recreating the conditions that produced the crisis in the first place (subprime loans to inappropriate borrowers). Banks should be left to exercise their best business judgment about how to use the new capital, and to whom to lend. Political interference in bank lending has almost always had a bad end around the world and the temptation and pressures on banks to favor districts or projects favored by their new government owners will increase with time. The positive contribution of recessions to our longer run economic health and productivity rests with the acceleration of sweeping away inefficient enterprises so that their capital and labor resources can be freed up to be used by more efficient firms. Some firms deserve to fail for the good of the rest of us and measures to “stabilize” the financial system should not interfere with that process more than necessary.

In addition to the nine large banks receiving $130 billion in capital under TARP, and additional 110 banks have asked for $170 billion under the governments bail out plan. The Treasury is now expanding the program to insurance companies and other Wall Street firms. But such larges is a slippery slope. Introducing the prospect of obtaining capital at more favorable terms than available in the market has brought a flood of lobbyists to Washington seeking funds for a wide variety of state and local governments and enterprises. The bankruptcy of a Main Street firm is quite different than of a financial intermediary and can be quite beneficial to the industry by reorganizing a firm or reallocating its assets to more productive hands. If the conditions for government money are made stringent enough (see Sweden’s experience with their bank bailouts in the early 1990s) those who can will find private money instead.[13] Thus government bailout money generally goes to the weakest and least deserving firms, though TARP is designed to try to avoid this usual outcome.

The most controversial appeal for government bailout money has come from Main Street firms like General Motors, Chrysler, and Ford. Detroit auto bosses would like to keep their jobs, of course, but the market is registering its displeasure at their inadequate performance. Beyond them and Big Three shareholders, the overpaid United Auto Workers are the main lobbyists for this bailout.[14] As we all know from the bankruptcies of Delta, United and other airlines, Chapter 11 reorganization does not necessarily mean the end of a firm. But it does void existing contracts (including labor contracts) and replace management in order to put together the good parts into a viable operation (if possible). American bankruptcy laws are well designed to guide the restructuring our Detroit auto firms (“old auto” rather than the more efficient and successful “new auto” manufacturing facilities for Toyota, VW and other foreign owned companies producing in the U.S.)[15] Among other things without a renegotiation of their labor contracts to more competitive levels, they are unlikely to survive. America also needs to honor commitments to the WTO regarding state subsidies to companies that sell internationally as part of our general commitment to the benefits of free trade.

The temporary partial nationalization of selected banks runs other political risks as well especially in Europe where the French President continues to talk of state support of “national champions”. Government supports (capital and guarantees), even when explicitly meant to be temporary, can be hard to remove and failing to do so would be very damaging to market discipline of bank risk taking. They have invariably tempted politicians to interfere to favor pet projects, firms, or relatives, the bane of state owned banks wherever they have existed.

Bank failures (as opposed to temporary illiquidity) are different than the failures of Main Street firms and require a special insolvency regime. For two decades the FDIC has effectively used its authority to resolve failing banks efficiently at minimum cost to the insurance fund and to tax payers and with minimal disruption to the market. While many judgments are required in it’s exorcise of this authority, the criteria on which they are based are explicit in the law (minimum cost to the fund) and can be monitored. Secretary Paulson’s Treasury’s interventions have not had that benefit and have increasingly raised questions about the seeming arbitrariness of some decisions. For example, why was Lehman Brothers allowed to fail while Bear Stearns and Merrill Lynch where “saved”?[16]

Many explanations have been offered. Lehman Brothers was smaller than the others and the markets had been given more time to adjust to and prepare for its bankruptcy and thus the market should be able to absorb it without systemic disruption. And it was time to restore market discipline. Another, not inconsistent, view is that Dick Fuld, CEO of Lehman Brothers, was an insider who overvalued his firm and arrogantly rejected the offers made by Barclays to buy it, while Merrill Lynch CEO, John Thain, come from the outside and had a more objective assessment of his firm’s real value and thus accepted the offer negotiated with Bank of America. But it is also impossible to escape the fact that Secretary Paulson was formerly the CEO of Goldman Sachs, a competitor of Bear Stearns, Lehman Brothers, and Merrill Lynch. A number of key Treasury officials also came from Goldman Sachs. His friend Warren Buffet bought $5 billion worth of Goldman’s perpetual preferred shares with a 10% dividend and an option to purchase $5B of common stock at $115 during the next five years. A cheaply priced capital injection by the Treasury should do nice things for Goldman’s share price.[17] Poor Lehman Brothers, on the other hand has large investments from George Soros, not a friend of Mr. Paulson or the Bush administration. The Washington Post claims that Paulson’s deal to sell Lehman to Barclays was actually killed by British regulators.[18][19]

The new program of assistance signed into law on October 3 and now focused on buying bank shares, is meant, in part, to replace this seemingly ad hoc approach to non bank financial institution resolution with a clearer set of rules and criteria. These rules seem still to be evolving. Both the U.S. approach and the UK/EU approaches dramatically reduce bank accountability for mistakes for the duration of partial government ownership. This period needs to be kept temporary. This is particularly important for guarantees of interbank loans. Normal dividend payments to other shareholders are suspended during the period of government share ownership.

The financial panic could have been ended overnight by a blanket government guarantee of all mortgage loans, however, the moral hazard would have been sever and public outrage over the gross unfairness of rewarding reckless speculators with the tax dollars of more prudent borrowers would surely have been pronounced. Bailing out such behavior would almost certainly bring on much more of it in the future. However, more carefully designed and targeted programs to help home owners able to make modestly reduced payments are already helping significant numbers avoid costly foreclosures. Bank of America, for example, reports that it has employed around 7,000 people to work full time on restructuring mortgages to help keep people in their homes (generally by lowering interest rates and thus monthly payments). They are willing to do so as long as the loss to them is less then would result from foreclosure.[20] Lenders are accepting a modest loss in order to avoid still larger losses. More can be done in this area, which would reduce banks’ mortgage related losses and thus improve their capital, but careful consideration must be given to the unfairness of bailing out poor judgments and providing an incentive to default in order to benefit.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [21] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[22] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to $180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

The case by case renegotiations now underway by Bank of America and others are the best targeted to individual situations but very labor and time intensive. Some what cruder standardized models for restructuring mortgages could be implemented much more cheaply and quickly though would probably cost lenders more. On November 13, Fannie Mae and Freddie Mac announced such a model they intend to use. FHFA Chairman James Lockhart expressed the hope that this model would provide a minimum standard for the industry.[23] FDIC Chairman, Sheila Bair would like to go further by sharing half of the losses of lenders from loan restructuring that meet standard criteria with the government. By increasing the interest rate or principle reductions that would still save the lender money compared with foreclosure as a result of sharing the cost with the tax payer, Ms. Bair estimates that around 1.5 million home owners could be helped.[24]

As the panic subsides, the current temporarily high demand for liquidity by banks subsides, and deleveraging in the rest of the financial sector runs its course, the Federal Reserve must be prepared to reabsorb the huge amount of base money it created as rapidly as it extended it. Doing so prematurely would risk deepening the recession much as the Fed did to cause the second wave of the Great Depression in the late 1930s. “Clear exit criteria for extraordinary interventions should be in place to help address moral hazard and limit the degree to which intervention substitutes for regular market functioning in the long term.”[25]


Scene 3 – The Way Forward

On with the recession

With the financial panic now under control and lending and lending rates gradually returning to normal, monetary and fiscal policy must focus on moderating the recession without preventing it from correctly long standing macro imbalances. American consumers have long saved too little (consumed too much) to finance investments in American technology and productive capacity (and the government’s excess spending). Large balance of payments deficits filled the gap but are not sustainable. To sustain or increase investment with higher private sector saving the new macro mix requires lower external deficits (smaller balance of payments deficits) and lower fiscal deficits. The fall in the exchange rate of the dollar for the Euro and most other world currencies to more realistic and sustainable levels has already started the process of adjustment by making American exports more competitive and imports more expensive. This reduced consumer spending (increased household saving) is being offset by increased foreign spending on American goods (increased exports). These are very desirable adjustments.

However, the dramatic and very large fall in household wealth as a result of falling real estate and stock prices is beginning to reduce household consumption more rapidly than it can be replaced by increased net exports (which includes shifting some consumption from foreign to domestically produced goods and services). The spread of America’s financial crisis abroad and the bursting of Europe’s own real estate bubbles is undercutting the recent increases in American exports as is the appreciation of the dollar’s exchange over the last four months.[26] In short, the adjustments needed within the American economy are not occurring as smoothly as they might have. Investment itself is retracting in the face of the credit crunch induced by financial turmoil and by falling demand. With falling consumption AND investment (rather than falling consumption with increased investment) and stalled growth in exports, only increased demand from fiscal policy (tax cuts or spending increases) can prevent a fall in aggregate demand from producing an increase in unemployment. In short, the American economy is in recession.

It is appropriate for monetary (lower interest rates) and fiscal policy (larger fiscal deficits) to attempt to moderate the recession in an effort to prevent overshooting. Automatic stabilizers, such as rising state and federal deficits as expenditures are maintained in the face of falling tax revenue and increased safety net expenditures for increased unemployment compensation, etc., are a first line of defense. But they might be usefully augmented by measures such as extending the period of eligibility for unemployment benefits and accelerating infrastructure expenditures that are needed in any event. Such fiscal measures, however, should not interfere with the broader macro economic adjustments needed (higher domestic saving and lower trade deficit) for long run sustainability. Nor should they thwart the healthy purging of inefficient firms and pruning of fat to keep viable firms efficient. The dynamism of the entry of new firms and the exit of unsuccessful (unprofitable) ones is a critical factor in our high and growing standard of living.

As noted about the Great Depression was caused by the failure of the Federal Reserve to provide sufficient liquidity to a distressed banking system and protectionist measures in the form of high import tariffs and competitive (and self defeating) currency devaluations around the world in what came to be called beggar they neighbor policies. These last elements call for policy coordination on a global basis and are discussed more fully in the next section in the context of future reforms of the system.


Reforming the system

It is still hard to believe that underwriters approved many of the loans now gone and going bad that have sparked the deleveraging frenzy driving the restructuring of the financial system and the current financial crisis. There are lessons to be learned that will surely involve additional or improved regulation. However, it is naive to say the least to think that government bureaucrats are generally better at spotting risks than those whose money is on the line.

Relevant industry groups are frantically at work seeking solutions that will reduce the prospects of such huge losses in the future. Regulatory bodies would do well to work with them, interfering only when industry self interest clearly conflicts with the broader public interest (easier said than done). Above all, adjustments and refinements to financial regulation should wait until we all have a better understanding of the existing weaknesses that can be fixed by regulation. It is too easy for new regulations to do more harm than good. The rush by the Securities and Exchange Commission (SEC) to ban short selling of traded stocks had among its unintended consequences a negative effect on corporate bond prices.[27] This “reform” is widely believed to have been a mistake. Even Mr. Bad Guy Regulator, Eliot Spitzer, former state attorney general (and Governor) of New York, speaks nicely of the importance of short selling for market discipline.[28]

It is a mistake to characterize the choice as between regulation or no regulation. Regulation comes in a wide variety of forms and degrees, some more aligned with requirement for market development and efficiency than others. Consider the exciting new technology and market for mobile phone payments. Using existing mobile phone accounts (unique phone number for each customer and arrangements for billing and paying for service), mobile payments add simple to use software to the instrument to sending payment instructions, a pass code for each number to authorize them, central deposit update and management software and registered points for receiving and paying out cash (in Kenya and Afghanistan the large preexisting network of air time salesmen are used though any merchant with a mobile phone can also be used). The combination of a unique phone number and pass code function in the same way as swiping a debit card and entering a pass code to pay a merchant from a customer’s bank account, but in the case of mobile payments payers and/or receivers do not need to have bank accounts.

The Vodafone system adopted in Kenya and Afghanistan and now being developed for Iraq is regulated, but not much beyond what the private providers of these services would demand of their customers to protect their operation. To satisfy Anti Money Laundering requirements, phone companies offering mobile phone payment services are required to “know their customers” (names and addresses) who are necessarily linked to their assigned phone numbers. This does not expand information requirements beyond what phone companies require to provide the phone service in the first place. The systems also set limits on maximum and minimum transfer amounts (per day, per transaction, per month), which again would surely be set even without regulation. The most intrusive regulation is that funds deposited in the system for transfer via mobile phones must be kept by the phone service operator in a trust account with a licensed bank and invested conservatively by that bank.[29] Modern market friendly approaches to regulation have left entrepreneurs free to develop and implement this service, imposing only enough regulation to protect the safety of the system and prevent its use for money laundering. It reflects the kind of relationship between government and the market that provides a good model for regulation more generally.

Areas where reforms are being discussed range from extending the legal tools found in American bank insolvency laws to a broader range of financial institutions, improving the “pluming” (back office processing and accounting) for Credit Default Swaps—CDSs—and other derivatives); limiting CDSs to those with the actual credit exposure being insured (i.e. banning naked CDSs), strengthening capital charges for CDSs, reducing or eliminating tax incentives for leverage (including the mortgage interest deduction from personal income tax), refining the treatment of on and off balance sheet items for bank capital adequacy, making rating agencies liable for their work to the same standard as auditors, to strengthening rules on broker/dealer/bank use of collateral.[30] More broadly solutions must be found for the break down of lending standards arising because private sector actors (brokers and agents) make decisions for fees with regard to other peoples money (should mortgage originators be required to keep some of the risk—to have some “skin in the game”—and should bonuses have to be structured to avoid rewording undue risk taking?). In addition, in the U.S. existing gaps in and poor coordination of financial sector supervision should be fixed by the reorganization of supervisory agencies and responsibilities.[31] Morris Goldstein of the Peterson Institute of International Economics has outlined 10 points for reform "Making the G-20 Summit Work: The ‘Ten-Plus-Ten’ Plan" that provide a good basis for discussion of what might be needed.

The focus of the Washington Summit of the G-20 heads of state November 15 on broad principles rather than specific “fixes” is in this spirit and is to be welcomed.[32]

“The Summit achieved five key objectives. The leaders:

  • Reached a common understanding of the root causes of the global crisis;
  • Reviewed actions countries have taken and will take to address the immediate crisis and strengthen growth;
  • Agreed on common principles for reforming our financial markets;
  • Launched an action plan to implement those principles and asked ministers to develop further specific recommendations that will be reviewed by leaders at a subsequent summit; and
  • Reaffirmed their commitment to free market principles.”

They fulfilled Fred Bergsten’s advice to first “do no harm.”[33] We can give a sigh of relief.

The G-20 Communiqué set out a work plan for reform that emphasized the importance of the coordination of monetary, fiscal and supervisory policies internationally and of the importance of the International Monetary Fund’s surveillance and financing roles and the need to ensure that it has sufficient resources. The Communiqué also stressed the need to better balance the voting strengths of member countries in the IMF and World Bank with their current economic importance in the world. This implies a reduction in European country quotas and increases in China, India, and Brazil among other emerging countries. The United States long ago gave up some of the quota it would be entitled to on the basis of its economic size.

The coordination of policies is important to avoid the competitive devaluations of the 1930s that were one of the contributing factors to the severity and duration of the Great Depression. It was precisely for such purpose that the IMF was created at Bretton Woods following World War II. Similarly its recent loans to Iceland, Ukraine and Hungary are classic uses of the IMF’s resources to supplement for the sudden drop in international capital flows that are part of the current crisis.

The G-20 has set out a sensible work plan for reviewing the lessons of the subprime crisis and developing reforms needed to strengthen the global trading system. It is hard to find fault with Communiqués statement that:

“12. We recognize that these reforms will only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively regulated financial systems.  These principles are essential to economic growth and prosperity and have lifted millions out of poverty, and have significantly raised the global standard of living.  Recognizing the necessity to improve financial sector regulation, we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows, including to developing countries.”


“13.  We underscore the critical importance of rejecting protectionism and not turning inward in times of financial uncertainty.  In this regard, within the next 12 months, we will refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports.”

As always, the out come of these efforts will depend on the details developed over the coming months.

[1] Wall Street insiders I have discussed this with speak of a dramatic sea change in attitudes toward risk taking following adoption of the Gramm-Leach-Bliley Act in 1999, which repealed the Glass Steagall Act. The immediate performance bonus system found in investment banks and totally alien to commercial banks encouraged a hit and run attitude toward taking commissions and annual bonuses with little regard for the longer term viability of the exotic instruments being created.

[2] See Coats. “The U.S. Mortgage Market: the Good, the Bad and the Ugly,” Association of Banks in Jordan, June 22, 2008; “Fannie and Freddie: More Good, Bad and Ugly.” July 31, 2008.

[3] Any cost to the lender from reducing the interest rate or other terms of a mortgage to avoid foreclosure that was less than its loss from foreclosure (estimated currently at between 25 to 40% of the mortgage) potentially “saved” it money.

[4] On November 25, 2008 the Federal Reserve added a “Term Asset-Backed Securities Loan Facility” (TALF). The facility will lend to any U.S. person for one year against the collateral of Asset Backed Securities (ABS) that consist of “auto loans, student loans, credit card loans, or small business loans guaranteed by the U.S. Small Business Administration.”

[5] American International Group (AIG), for example, sustained large losses on Credit Default Swaps it had issued (insurance on the default of MBSs). It was taken over by the government to avoid bankruptcy.

[6] In early October the IMF estimated world wide losses from American mortgages and mortgage related securities would reach $1.4 billion of which about half have already been written off. Reported in The Economist, October 11, 2008 “A Special Report on the World Economy” p 4.

[7] See Coats, “The D E Fs of the Financial Markets Crisis,” CATO Institute, September 26, 2008.

[8] Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets, Sec. 2.

[9] Virtually every category of American bank lending, including interbank loans, have increased over the past year through Oct 22 with a small decline in most categories on Oct 29, 2008 (See FRB H-8). Lending declined modestly and temporarily for several months last Spring. However, the composition of such lending changed away traditional business customers and the much larger and more important non bank credit market for corporate credit (e.g. commercial paper market) fell into great difficulty. Huge withdrawals from Money Market funds, a major buyer of commercial paper, were only slowed by a quick government guarantee of the principle deposited in such funds. The market dramatically accelerated the rearranging of the complex linkages through which regular credit flowed. While borrowers and lenders can ultimately adjust to new channels and linkages, the pace with which the (deleveraging) changes were happening could not be easily accommodated without serious disruptions to Main Street enterprises suddenly cut off from normal credit. A very useful discussion is presented in the IMF’s Global Financial Stability Report of October 2008 "Financial Stress and Deleveraging, Macrofinancial Implications and Policy"

[10] "Rescuing the Banks: We have a plan" The Economist, October 11, 2008, p 75.

[11] The ill conceived initial plan to buy toxic MBSs from certain banks has now given way to the use of Treasury’s new authority to inject capital into certain American banks. Peter Whoriskey, David Cho and Binyamin Appelbaum, "Treasury Redefiness Its Rescue Program" The Washington Post, Nov 13, 2008 P A01

[12] The Bretton Woods Committee meeting on the “New Global Financial Architecture”, November 12, 2008, Washington DC.

[13] Warren Coats, "The Big Bailout – What Next?" Cato Institute, October 3, 2008

[14] Jeffrey Mccracken and John D. Stoll, "GM Blitzes Washington in Attempt to Win Aid", Wall Street Journal, November 15, 2008.

[15] The Washington Post Editorial, "No Free Lunch" November 14, 2008, P A14; Daniel J. Mitchell, "Say No to the Auto Bailout" November 13, 2008; Thomas L. Friedman, "How to Fix a Flat", The New York Times, November 11, 2008; Martin Feldstein, "A Chapter for Detroit to Open", The Washington Post, November 18, 2008, Page A27; Kevin A. Hassett, "Recession will be less Damaging without Bailouts", AEI, November 17, 2008.

[16] As noted earlier this characterizations of what happened is an over simplification.

[17] U.S. Treasury, TARP Capital Purchase Program, Senior Preferred Stock and Warrants “The Senior Preferred will pay cumulative dividends at a rate of 5% per annum until the fifth anniversary of the date of this investment and thereafter at a rate of 9% per annum.”

[18] David Cho, "A Conversion in ‘This Storm’" (the Evolution of Hank Paulson), The Washington Post, November 18, 2008. Page A01.

[19] Similar questions have been raised about the role played by Robert Rubin in supporting the repeal of the Glass Steagall Act that made possible the merger of Citibank, Travelers Insurance and Salomon Smith Barney (a bank, an insurance company and an investment bank) to form Citigroup. When he left the Clinton administration Rubin accepted a highly paid position as a Director and Senior Counselor of Citigroup. Steven Pearlstein, "A Bailout Steeped in Irony", The Washington Post, November 25, 2008, Page D01.

[20] Gregory Baer, Deputy General Counsel at Bank of America, in a presentation at the New America Foundation November 13, 2008.

[21] Jonathan G.S. Koppell and William N. Goetzmann, "The Trickle-Up Bailout", The Washington Post, October 1, 2008; Page A17

[22] Henry N. Sanborn, “A Different Solution to the Financial Mess” unpublished

[23] Patrick Rucker, "GSE Chief says Mortgage Aid Plan Should be Model" Reuters, November 13, 2008.

[24] FDIC, "FDIC Loss Sharing Proposal to Promote Affordable Loan Modifications"; Alan Zibel, "FDIC says plan could help 1.5 million keep homes", Associated Press November 14, 2008.

[25] IMF, “Global Financial Stability Report: Financial Stress and Deleveraging Macrofinancial Implications and Policy”, International Monetary Fund, October 2008

[26] The dollar peaked on July 6, 2001 when it exchanged for 1.19 Euros. Seven years later on July 16, 2008 it had fallen 47.5% to 0.63 Euros. Since then it as appreciated 22% (to 0.08 on October 29) but was still 33% below its 2001 peak.

[27] The Economist, "Hedge funds: Collateral Damage", October 9, 2008.

[28] Eliot L. Spitzer, "How to Ground the Street" The Washington Post, November 16, 2008 Page B01.

[29] Aleeda Fazal, Task Force to Improve Business & Stability Operations in Iraq

[30] The Economist, "Prime Brokers: Do the brokey-cokey" Oct 23, 2008

[31] American organization of its supervision clearly needs to be restructured along the lines proposed by Secretary Paulson in March of this year.

[32] White House: "Fact Sheet: Summit on Financial Markets and the World Economy" November 15, 2008.

[33] C. Fred Bergsten, "Stopping the Global Meltdown", The Washington Post, November 12, 2008, Page A19

Church and State in America

Is the United States a Christian nation or a nation of religious freedom and tolerance? Are we implicitly the United Christian States of America in the same way as the Islamic Republic of Iran? Some Christians seem to think so and have been conducting an unrelenting campaign to make it so.

Consider the not so very subtle comments by the not so subtle Paul Harvey: “Life, liberty or your pursuit of happiness will not be endangered because someone says a 30-second prayer before a football game…. But it’s a Christian prayer, some will argue…. If I went to a football game in Jerusalem, I would expect to hear a Jewish prayer. If I went to a soccer game in Baghdad, I would expect to hear a Muslim prayer…. And I wouldn’t be offended.  It wouldn’t bother me one bit.
When in Rome…..” In short, Mr. Harvey wants us to believe that we are a Christian nation rather than a nation with a majority of Christians and are thus justified in incorporating Christianity into our official public acts. But Israel was explicitly established as a religious state and look at the trouble that has caused them and the rest of the world. And though I have not attended a soccer game in Baghdad, I doubt that I would hear a Muslim prayer at one, though prayer rooms are set aside in most buildings for those who wish to pray when called. America has made a different choice. Our constitution tries to protect us from our government and from each other by limiting what our government can do and what a majority of citizens may decide. The separation of church and state is an instrument of that protection.

The prohibition against discrimination in law and public matters on the basis of sex and race is another such protection (after the 14th amendment). Discriminating on the basis of sexual orientation has not explicitly achieved that status but social attitudes have moved a long way in that direction. I found it interesting that in the Vice Presidential debate, where both candidates expressed the same views against “gay marriage”, Sarah Palin stated that she accepted the right of people to choose their sexual orientation. This is a significant advance over anti gay views widely held a generation or two ago but unfortunately still reflects the mistaken view that we can chose to be gay or straight. According to the Anchorage Daily News of Aug 6, 2006, “Palin… said she doesn’t know if people choose to be gay.” Too bad, she should know better.

The narrow adoption of Proposition 8 in California to eliminate the right of same–sex couples to marry provides an example of the mixing of church and state that might not have occurred to you. The problem arises (aside from ignorance and bigotry) because the set of legal rights and obligations bestowed by the state in “civil unions” goes by the same name, “marriage,” as the status bestowed by religious groups. The Catholic, Baptist, Episcopal, Sunni, Buddhist, etc. churches (even the Mormon Church) should be free to define marriage, and who they wish to marry, in whatever manner they think appropriate. At least that is the American perspective. But the state must abide by the words and spirit of its constitution. It may not (or at least should not) discriminate against gay and lesbian couples in granting the marriage contract. And we seem on our way to getting there. What stands in the way is mixing the roles of church and state. Let’s keep them separate as provided in our constitution, not withstanding that the majority of our citizens are Christians of one sort or another.

Hi from Sofia,

In the late 1980s my friend Tom Palmer, now Vice President for International Programs and Director of the Center for the Promotion of Human Rights at the Cato Institute, crisscrossed the captive nations of Central and Eastern Europe cultivating contacts sympathetic to free market capitalism. When I first went to newly “liberated” Bulgaria in February 1992, leading an IMF technical assistant team to the Bulgarian National Bank, Bulgaria’s central bank, Tom gave me the names of his two contacts in Sofia, Bulgaria’s capital. Philip Harmanjiev and Ivo Prokopiev were young reporters for 24 Hours one of Bulgaria’s many newspapers and one of several English language business newspapers. I met with them and have met with them on every subsequent trip to Sofia. They were bright, ambitious, and eager to learn about the West. They were shining examples of the great good to the world resulting from the lifting of the shackles of Soviet repression from a new generation of men and women eager to make their mark on the world.

Today, still in their 30s, they created and own respected business and other publications in Bulgaria. Philip bought a small winery in southern Bulgaria as part of the country’s privatization program and is now a wine producer, wine importer and creator, owner, publisher of Bacchus, Bulgaria’s wine magazine. With Ivo he founded Capital Weekly, a respected political and business paper, then Dnevnik, the leading business daily. These are now among the many publications of Economedia, the leading Bulgarian provider for business media owned by Ivo and Philip. Ivo’s wife Galya is Editor-in Chief of Capital Weekly. Ivo is Chairman of the Board and CEO of Economedia, and of Alfa Finance (which includes among its holdings Capital Bank in Macedonia), and is Chairman of the Association of Employers and Industrialists of Bulgaria (AEIB). For three years now AEIB and Capital Weekly have put on a conference on business and government issues to which Galya invited me as one of this years speakers: "The Financial Crisis: Bulgaria in the Global Economy". This is my second trip abroad to address bankers and the business community on America’s subprime mortgage and related financial crisis that has resulted from friends reading my occasional travel and economic notes. The first was earlier this year to Amman, Jordan.

Yesterday was my 15 minutes of fame in Bulgaria, which lasted most of the day. I was up at 4:00 am (because I couldn’t sleep) and picked up at 6:55 am and driven to the studio of the Bulgarian National Television station. At 7:15 my face was powered to prevent it from shinning under the TV lights and from 7:30 to 7:45 am I was interviewed on the probable impact on Bulgaria of the global financial panic. The conference for which I had been brought to Bulgaria started at 10:00. Following the address of Ivaylo Kalfin, Minister of Foreign Affairs and Deputy Prime Minister of Bulgaria, Kristalina Georgieva, a VP at the World Bank, Fabio Ganzer, Head of the International Department, Shell International, and I spoke. Other speakers included, Ivan Iskrov, Governor of the Bulgarian National Bank and Plamen Oresharsky, Minister of Finance.

At the end of the conference in the late afternoon, two young Capital Weekly reporters interviewed me about the same topics. I could not help but marvel that this story had come full circle. The two young reporters worked for the newspaper established and owned by the two young reporters for 24 Hours I had met just sixteen years earlier. They were about the same ages as Ivo and Philip had been back then. In between Bulgaria experienced a banking crisis and hyperinflation in 1996 and adopted a currency board in 1997 since which it has become one of the most rapidly growing economies in Central and Eastern Europe (currently around 7% per annum). Capitalism, with its freedom for individuals to express themselves and develop their talents, has opened up the human potential and brought the world a very long way. It has always been an irregular path and I am here in Bulgaria to discuss one of its bigger bumps in the road, but I have no doubt that it will continue to open the way for man kind to reach ever greater and greater heights.

Mark to Market Accounting – What are the Issues?

            A number of
respected people have blamed accounting rules for much of the current financial
crisis. “Fair value” or “mark to market” accounting aims to present a more
accurate picture of a bank’s condition and should not be abandoned. The
application of fair value accounting, however, especial to assets like Mortgage
Backed Securities (MBSs) that do not trade or trade in thin, distressed
markets, is flowed and should be improved. The SEC’s recently revised guidance
on valuing such assets is a very positive step in this direction. Accounting
rules should not be perverted to achieve other laudable objectives, such as
moderating the pro-cyclical increases and decreases in bank capital that result
from the pro-cyclical variations in the value of bank assets.


Accounting rules can be complicated
but their purpose is simple, which is to provide as accurate a picture as
possible of the financial performance and condition of an enterprise. Business
and other decisions depend on such information. In the case of banks, an
assessment of its soundness is critical to uninsured depositors and investors
before intrusting their funds to the bank. A bank is insolvent if it does not
have positive net worth or capital, the difference between the value of its
assets and its deposit and other liabilities. One of the most important lessons
of banking supervision of the last half century is that it is very unwise to
allow an insolvent (but liquid) bank, i.e. a bank with negative capital, to
continue to operate. Its losses almost always grow larger until it is finally


participants will do their best to evaluate the soundness of banks before
buying their debt or placing large (i.e. uninsured) deposits there. If they can
rely on accounting statements to reflect soundness to the extent that it is
possible to do so, they will do so. If accounting statements cannot be trusted
or disguise the truth investors will not rely on them, estimating the bank’s
condition as best they can. But not having the best possible statement of
condition increases market uncertainty and the associated risk premiums about
what the true condition really is.


            It has long
been recognized that book values of loans or other assets do not generally
reflect the actual market value of such assets. If a borrower is not making its
payments on a loan (mortgage or otherwise) it is obvious that its book value
(the contractual principle and interest payments first entered into the banks
books) to the bank overstates and potentially greatly overstates its actual
realizable value. It over states the resources the bank has with which to honor
its deposit and other liabilities. The best possible statement of its value
would be to record the present value of the expected income to be received from
such loans (discounting the expected income with the prevailing market interest
rate). This requires judgment and can’t be know perfectly, but it is not too
difficult to arrive at a far more likely value than from using its original
book value.


            This is
quite obvious and uncontroversial for non performing loans but for some reason
the same truth is not so easily recognize for assets that will be fully repaid
but with interest rates that are no longer attractive. If a bank buys a
treasury bond for $1000 with a 6% dividend per year for thirty years and market
interest rates go up to 12%, its real (market) value is reduced significantly
even though its interest and principal will all be paid on time and in full. If
the bank needed to liquidate the bond now it could only sell it for a bit more
than $500. Holding it to maturity just doesn’t change the fact that it has lost
value. Reporting it at face value (its purchase price) would be a fraud, a
deliberate misstatement of the facts. The S&L crisis of the 1980s reflected
exactly such a phenomenon. Savings and Loan banks lost money and became
insolvent not because borrowers were defaulting on their mortgages more than
usual (as now) but because market interest rates increased dramatically and
these banks were stuck with otherwise good long term mortgages that yielded
much less than they now had to pay to their depositors to keep their money
there—the money that financed these mortgages. These good mortgages were producing
huge loses that bankrupted almost 2,000 banks.


Rules for classifying and
provisioning against loans kept on a bank’s books are reasonably well defined.
However, when loans are securitized and resold in the market, different rules
apply. Basically, the prices received or prevailing in the market for similar
loans or pools of loans provide the market’s assessment of current value and
are generally expected to be used to value similar, potentially marketable
loans still held by the bank.


movement to mark to market accounting is an attempt to more correctly account
for a bank’s performance and condition (net worth) by valuing its assets at
their current market price. As such it is an important improvement over earlier
book value accounting. Its implementation, however, is not without problems.
Take mortgages and Mortgage Backed Securities (MBSs), for example. Mortgage
defaults this year and last were much higher than had been expected, especially
for Adjustable Rate Mortgages (ARMs) to Subprime and Alt-A borrowers. Banks and
other owners of these MBSs have experienced unexpected losses and this should
be reflected in lower valuations for these assets in their books. Existing loan
classification rules for non traded loans (including mortgages) would require
provisioning against expected losses on these loans (writing down the expected
value) in light of recent experience even if they are not traded. Banks need to
have the best estimate of the likely value of their loans (even if they are
fully performing up till now). But for traded mortgages the secondary markets
in which these assets trade are very thin and currently non existent (frozen)
and thus market prices in this case might not be a fair measure of the expected
return from holding them. Furthermore, unlike trading government securities or
corporate bonds, which are homogeneous within their class so that the market
price of a 10 year treasury bond clearly should apply to an identical bond held
by the bank, MBSs are heterogeneously and not fully comparable.


of fair value or mark to market accounting fall into two main classes. The
first is that the actual application of fair value accounting in some cases
does not actually result in the best valuation of the asset. The second, which
is misguided, is that even if it results in the best measure of actual value it
should not be used because it contributes to undesirable pro-cyclical swings in
bank capital. These are examined in turn.


Accounting rules formally define
“fair value” as “the price that would be received to sell an asset… in an
orderly transaction between market participants at the measurement date.”[1]  Peter J. Wallison, Chief Legal Council of the
U.S. Treasury during the Reagan administration, criticized the rules for
applying mark to market requirements to MBSs in a study for the American
Enterprise Institute. “It seems an unavoidable conclusion, however, that the
doubts about the financial stability of these institutions were sown by the
drastic cuts in asset prices required by the mark-to-market valuations of fair
value accounting, instead of a fair appraisal of the value of the cash flows their
assets were producing,” he wrote.[2]  Wallison pointed to many legitimate problems
with valuing MBSs when distressed sales and a lack of market liquidity are
believed by many, including the U.S. Treasury, to have resulted in the
undervaluation of these assets in the market. However, he persistently refers
to the present value of “cash flow” as a preferred basis, when it is the
“expected cash flow” that is relevant. On September 30 when the Securities and
Exchange Commission, in junction with the Financial Accounting Standards Board,
issued guidelines under "fair value" accounting rules for financial
firms trying to value of hard-to-trade assets on their balance sheets, they
correctly referred to “expected cash flow” as a proper bases for valuing assets
that are not trading or are trading in disorderly markets.[3]
The fact that the current (historical) cash flow from a mortgage pool is what it
is does not change the fact that it is now generally expected to be lower in
the future and thus the best estimate of the true value of the pool will be
lower because of that.


Earlier SEC FASB interpretations of
the rules for valuing MBSs leaned much more heavily toward current market
prices as long as there were any at all, while the new clarification admits
that current market conditions are not orderly and thus internal expected cash
flow estimates may be appropriate. “Fannie has an underwriting and valuation
shop with models for valuing mortgages that are up and running.”[4] They
forecast default rates for different assumptions about price declines and have
a good track record. They might be deployed to establish valuations in lieu of
reliable market prices until markets return to normal. This new SEC clarification
is welcomed and should increase bank capital in much the way the Treasury’s new
$700 billion TARP program was expected to.[5]  It should also do much to diminish the call
to abandon mark to market accounting.


The other criticism, also made by
Wallison, is that “Procyclicality is obviously an unintended consequence of
fair value accounting, but nonetheless an issue for policymakers…. The central
purposes of fair value accounting were good—to make financial statements easier
to compare and to bring asset values more in line with reality—but these goals,
even if they had been achieved, are not as important as avoiding or reducing
asset bubbles, producing steady growth in the economy, and encouraging stability
in our financial institutions.”[6]


pro-cyclical behavior of asset values is an economic reality. No good policy
purpose would be served by attempting to hide the fact by corrupting accounting
standards. Full transparency is desirable. However, an honest accounting of the
pro-cyclical behavior of asset values does not prevent taking policy measures
designed to moderate the effect of asset value swings on bank lending or other
behavior. A far better approach to the tendency for raising asset values to
encourage banks to expand lending or risk taking pro-cyclically would be to
vary capital requirements over the business cycle such that banks are required
to hold more capital relative to their liabilities during the up side and less
during the down side of business cycles.


            This issue
is reminiscent of the slow evolution of central banks toward acceptance of
International Accounting Standards (IAS) for themselves. Traditionally central
banks rejected the use of IAS they required commercial banks to follow in order
to hid their unrealized foreign exchange valuation gains and losses (“paper”
gains and losses), which can be considerable for a typical central bank. The
banks’ accounts are in their local currency and they necessarily have an
exposure (open position) to foreign currency values through their reserves of
foreign currencies. European central banks resisted the adoption of IAS with
regard to the reporting of these gains and losses because their laws required
them to surrender profits above some minimum to their Finance Ministries and
during the first two or three decades after World War II they generally enjoyed
valuation gains from their foreign exchange reserves because of the tendency
for European currencies to depreciate against the U.S. dollar in which most of
their reserves were held. They did not wish to report these unrealized gains
because they did not wish to pay them to their Finance Ministries. Thus they
hid them by not including them in income. However, in the 1980s the German mark
and some other European currencies appreciated against the dollar for a number
of years causing the famous Bundesbank to become insolvent. The Bundesbank was
recapitalized by the German Government and there after led the field by
amending its accounting standards to reflect unrealized as well as realized
valuation gains and losses.


Drawing on the precedent set by the
Bundesbank, I convinced the Bosnian authorities in 1997 (and the IMF’s legal
advisor) to adopted IAS standards for reporting the Central Bank of Bosnia and Herzegovina’s
income. As we all agreed that it would not be desirable as a matter of policy
to remit to the government unrealized valuation gains (what some might call
purely paper profits from changes in exchange rates when no transactions
occurred), the rules for determining income subject to remittance were adjusted
to exclude unrealized gains. This is far more transparent than the traditional
central bank practice of hiding them from income in their financial statements.


While efforts to improve the
implementation of fair market accounting are welcomed and should continue, the
gains made in making financial statements a more accurate reflection of
outcomes and conditions are helpful and important to the efficient functioning
of markets.

[1] Financial
Accounting Standards Board, Statement of Financial Accounting Standards No.
157, Fair Value Measurements
, September 2006.

Peter J. Wallison, "Fair
Value Accounting: A Critique"
July 2008.

[3] SEC Office of the Chief Accountant and FASB
 "Clarifications on
Fair Value Accounting"
September 30, 2008.

[4] Susan E.
Woodward, "Rescued
by Fannie Mae"
The Washington Post, October
14, 2008 Page A17

[5] See
Coats, "The Big
Bailout–What Next?"
, CATO Institute, October 3, 2008

Wallison, op cit.