Notes on a Bubble

My reaction to the practice of judging market fluctuations as a byproduct of Obama policies and Cheney's assertion that this is a global crisis, therefore prior administration should not be blamed, was to consult my notes from a lecture posted on Academic Earth.

The Ten 'Culprits' of the Financial Mess A Lecture by Alan Blinder

1) The Bond Market: low interest rates set by Fed 2003-04--reach for yield/returns
Not many defaults, during this period, thus lending risks thought to be minimal.
Used short time horizon for mathematical models.
Leverage magnified returns (then losses).
Created a "fixed income bubble" but nobody knew where or when. turns out Aug 2007 subprime market.

2) Ordinary Americans/Ordinary Europeans (AIG had 141 billion worth of European residential mortgages on their books compared to 78 billion in C.D.O's some subprime): believed housing prices would rise faster than everything else, forever.
Took on irresponsible mortgages that could only be paid if housing prices continued to rise.

3) Mortgage Lenders: Subprime Market share ~50% Banks, ~50% non-banks,
Ninja loans (no income, no jobs or assets) liar loans, no document loans, made possible because these loans were written to be passed on in ~four days.
No federal authority over all mortgage lenders.
No 'suitability standards' for mortgages, such as the one applied to stock brokers.
Mode for percentage of loans held to maturity was 0%.

4) Bank Regulators: Failed in both their safety and soundness (test of financial institutions) and consumer protection roles.
Horrible subprime lending practices were visible years before the bust. Worst loans occurred late in the bubble. Subprime market represented 25% of mortgages by 2007.

5) "Private label" securitizers (the non-government or quasi-government entities): Packaged mortgages into Mortgage Backed Securities(MBS) and then into complex derivatives and CDO squared and sold them (to suckers? looks like "curn 'em and burn 'em"?) But stars of wall street held them in portfolios, Goldman Sachs got out. Risk management embarrassing. Large amounts of junk held in terms of capital, large percentages of capital tied up in this one asset class. Chuck Prince "While the music plays you have to dance." former pres of Citibank.

6) Rating Agencies: Investors rely on rating agencies to assess risk, failed miserably. Private label securitizers negotiated ratings with rating agencies to achieve triple AAA ratings.

7) Securities firms and some banks: mountain of complex derivatives built on top of mortgages. Derivatives were unregulated. OTC source of large fees. Operated with 30 to 1 leverage if there is a decline of 3.1% you have negative net worth. Funded by short term loans, allows for possibility of liquidity crunch. None of the big 5 financial firms exist completly in their prior form.

8) SEC: Why allow extreme leverage and tenuous liquidity? Mistake made in 2000 regarding regulating derivatives, request to regulate by lesser regulating agency shot down by SEC, Federal Reserve and Treasury Dept.

9) Disengaged President: Starting in August 2007 coupled with initially passive Treasury that transitioned into a incredibly proactive policy. Never articulated plan (TARP) to public, thus raises the question was there ever a plan.

10) Whoever decided to let Lehman Brothers fail: U.S. had policy of 'too big to fail' for decades. Bailout of Bear Stearns would indicate that Lehman Bros passed that test. Sept. 15th failure of Lehman Brothers destroyed the faith that there were entities that were 'too big to fail'. Less than 24 hours after Lehman Brothers failed, money market mutual funds 'broke the buck'. Since Lehman Brothers met 'too big to fail' or 'too entangled to fail,' was the policy shift ideologically based with no forewarning i.e. inconsistent with decision to bailout Bear.



Here is the question that hasn't been answered by either administration: "Was/Is this a solvency issue or was/is this a liquidity issue?"

If the crisis for the financial institutions is the toxic assets then the solution is to buy them, thereby removing them from companies' balance sheets. This has been done by the Federal Reserve, and is listed on the Fed's balance sheet as Maiden Lane I (condition for JP Morgan's absorption of Bear Stearns), Maiden Lane II (AIG bailout, for residential mortgage backed securities) and Maiden Lane III (AIG's multi-sector collateralized debt obligations CDOs). As of Jan '09 the Fed had 74 billion dollars worth of 'toxic assets' on its books.

Or is the present situation best addressed as a liquidity problem, in which case the injection of capital into troubled firms would avoid the negative implications of mark-to-market accounting in terms of day-to-day business operations. Why should losses on an asset that a company is not going to sell anytime soon impact daily operations? What happens when defaults slow and mortgages are re-worked, then mark-to-market created operating problems that otherwise wouldn't occur. This line of thinking is the impetus for TARP and other Fed (not Maiden Lane) and Treasury bailouts that have been implemented.

In my humble opinion, it seems that at NO TIME has there been a consensus as to which is the greater problem and therefore which solution is/was the better course of action. Economists are still left guessing at Timothy Geithner interviews, reading between the lines and mostly agreeing that the current administration views the problem as primary one to be treated as a liquidity crisis. However, everyone would be better served if the Treasury's view was clearly articulated, unless the goal is to simply buy time. This goal seems to be the only one that makes sense of actions by BOTH administrations.