SECRETARIA DE ESTADO DE ECONOMÍA,

MINISTERIO SECRETARÍA GENERAL DE POLÍTICA ECONÓMICA DE ECONOMÍA Y ECONOMÍA INTERNACIONAL Y HACIENDA SUBDIRECCIÓN GENERAL DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 86-3º (alcance)

Alvaro Espina Vocal Asesor 17 Septiembre de 2008

CD 86-3º de alcance

“En este punto, debería haber quedado claro que estamos al final del juego, que consiste en el rescate de la industria financiera a cargo de los contribuyentes”, afirma Tim Duy. Eso quiere decir que hay que regular, separando a las aseguradoras de los bancos de negocios, entre otras cosas. Y si la “banca en la sombra” quiere ir a establecerse fuera de EEUU, ¡que se vaya! La hora de la competencia financiera tramposa debe terminar. Siguiendo la recomendación de Tim Duy, Nicholas F. Brady, Eugene, A. Ludwig y Paul A. Volcker (nombres bastante respetables para el establishment) proponen lisa y llanamente resucitar la Resolution Trust Corporation. “La era de las finanzas desreguladas está a llegando a su fin”, titula en FT. “Wall Street as we know it is kaput”, afirma Robert Samuelson” en WP, “porque lo que está sucediendo en realidad es el colapso del modelo de negocio de Wall Street”. El problema es que el rescate resultará muy costoso (Pearlstein). Setser observa que hasta los fondos soberanos más interesados en la estabilidad del dólar abandonan EEUU. ¿Quien financiará ahora los déficit gemelos? Una economía dispendiosamente desahorradora ¿se va a someter a la mayor cura de austeridad (de ahorro privado y ortodoxia fiscal) conocida en la economía moderna? ¿O pasará la factura al resto del mundo? Los materiales recogidos en este CD son la mejor ilustración de que nos movemos por aguas no cartografiadas hasta ahora. Y, como no lo conocemos, negamos que esté ocurriendo (mundo hipócrita, dice Stiglitz ...., de la denegación, dice Nocera). Hasta que ocurre lo inevitable. ¿Y si se hunde Lehman (que es como lo de Argentina, según Setser) y no pasa nada catastrófico, como dice Buiters? Pero entonces estamos en la ruleta rusa financiera, de Krugman. Así que Paulson se pone a jugar al póker, pero va de farol (ántes, Bernanke ya había apostado su banca), porque enseguida le da vértigo y nacionaliza a la madre de todas las aseguradoras (y es que, en los tiempos que corren, en EEUU no hay rescate que dure ni dos días, como dice Setser). Y ya tenemos como asegurador al Tio Sam ¿Será suficiente, o se verá que el rey está desnudo? Véase la taxonomía de los pánicos, rememorada por M. Thoma. Hay quien dice que esto no era previsible: ahí están los CD de los últimos cinco años, al menos.

1 BACKGROUND PAPERS:

1. Board of governors of the System, Press releases 3 2. Fed Watch: Quite a Day, by Tim Duy...... 5 3. "Resurrect the Resolution Trust Corporation", by Nicholas F. Brady, Eugene, A. Ludwig and Paul A. Volcker...... 7 4. The end of lightly regulated finance has come far closer, by Martin Wolf...... 8 5. Wall Street's Unraveling, by Robert Samuelson...... 11 6. It looks like the ’ no bailout policy lasted all of two days, by Brad Setser...... 13 7. U.S. to Take Over AIG in $85 Billion Bailout, TWSJ...... 17 8. ."!*#\”£$%&?!!!" Should the government help AIG?, by Mark Thoma ...... 22 9. The flight from risky US assets, by Brad Setser...... 25 10. Orchestrating a Process Neither Neat Nor Fair, by ...... 28 11. A Race for Cash at A.I.G. as Ratings Are Downgraded...... 30 12. Wall Street Posts Worst Loss Since 2001...... 34 13. On Wall Street as on Main Street, a Problem of Denial, by Joe Nocera ...... 37 14. Endgame?, by Tim Duy...... 41 15. What if Lehman files for bankruptcy and nothing much happens?, by Willem F. Buiters...... 43 16. Why Wall Street is Melting Down, and What to Do About It, by Robert Reich...... 45 17. The fruit of hypocrisy, by ...... 47 18. Lehman v Argentina, by Brad Setser...... 49 19. First Men, Then New Rules Can Rescue Wall Street, by Amity Shlaes...... 52 20. Bailouts Revisited, by Lee Hudson Teslik...... 54 21. No alternative to nationalisation, By Martin Wolf...... 56 22. "Paradigms of Panic", by Mark Thoma (& )...... 58

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Release Date: September 16, 2008 For release at 9:00 p.m. EDT The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act.1 The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers. The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance. The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of to common and preferred shareholders.

1 Section 13. Powers of Federal Reserve Banks.- 3. Discounts for Individuals, Partnerships, and Corporations In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe. Section 14. Open Market Operations Rates of Discount (d) To establish from time to time, subject to review and determination of the Board of Governors of the Federal Reserve System, rates of discount to be charged by the Federal reserve bank for each class of paper, which shall be fixed with a view of accommodating commerce and business; but each such bank shall establish such rates every fourteen days, or oftener if deemed necessary by the Board;

3 Release Date: September 16, 2008 For immediate release The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent. Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of , combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth. Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain. The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner Release Date: September 7, 2008 For immediate release Statement by Federal Reserve Board Chairman Ben S. Bernanke: "I strongly endorse both the decision by FHFA Director Lockhart to place and into conservatorship and the actions taken by Treasury Secretary Paulson to ensure the financial soundness of those two companies. These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets. I also welcome the introduction of the Treasury's new purchase facility for mortgage-backed securities, which will provide critical support for mortgage markets in this period of unusual credit-market uncertainty." Release Date: July 13, 2008 For immediate release The Board of Governors of the Federal Reserve System announced Sunday that it has granted the Federal Reserve Bank of New York the authority to lend to Fannie Mae and Freddie Mac should such lending prove necessary. Any lending would be at the primary credit rate and collateralized by U.S. government and federal agency securities. This authorization is intended to supplement the Treasury's existing lending authority and to help ensure the ability of Fannie Mae and Freddie Mac to promote the availability of home mortgage credit during a period of stress in financial markets. Ec

4 Economist's View onomist's View Fed Watch: Quite a Day Tim Duy assesses the day's events: Quite a Day, by Tim Duy: I am in Portland tonight, taking a breath to assess the day’s events as I mentally prepared for a three hour presentation on the economy for a friend’s business group. A spectacular harvest moon was hanging over the Cascades as I approved the city; the deepest orange moon I have ever seen. That can’t be a good omen. To say the least, this was an interesting 24 hours. My son took his first swimming lessons. A forest fire is raging within spitting distance of the family cabin. I understand the local bar has burned to the ground; I can’t see how that is going to be good for property values. And the Fed bought an insurance company. I seem to remember that the US owned at least one “gentlemen’s club” in the wake of the S&L crisis, so what’s the big deal with an insurance company? But I get ahead of myself – consider first the Fed’s interest rate decision. It was the logical choice one would have expected at the end of last week. The Fed Funds rate was held steady at 2%, risks are equally balanced between inflation and growth, and it was acknowledged that commodity prices have moved significantly lower. That the Fed did not cut interest rates in the face of arguably the most treacherous period of the financial crisis says little about concerns, in my opinion. Instead, it indicates the Fed sees little that lower interest rates can do to alleviate the crisis. Policy is directed to the real economy, and by virtually every measure, rates are already lower than one would expect given the flow of data. That is not to say that the state of the real economy is healthy. Anything but, to be sure. But, while one can say that the Fed has been behind the curve with respect to the financial market turmoil, we have seen in the past a considerably slower reaction to real economic data. More interesting is the AIG loan/purchase/bailout. I have to imagine the employees of Bear Sterns and are currently thinking that they clearly did not take on enough risk over the past several years. Lehman employees, in particular, were fed into the moral hazard grinder that was operational for a scant two days. How unfortunate. Which leads me to my most significant concern about Fed policy over the past year – the inconsistency. Facilitate the liquidation of Bear Sterns by backstopping $29 billion of questionable assets. Then, recognizing the moral hazard created by that move, let Lehman collapse. Then, recognizing the consequences of vanquishing moral hazard, effectively purchasing AIG. At this point, the endgame should be clear to policymakers – a taxpayer bailout. The bad assets need to be consolidated and eliminated. Congress needs to be working on a mechanism to make this happen, a new RTC. Any Congressional action needs to include a reevaluation of the state of financial regulation. Perhaps, just a thought here, insurance agencies need to be separate from investment banks. And if, as is often threatened, the shadow banking industry just moves offshore, maybe we should just let it do so. Yet, in all fairness, Bernanke & Co. are faced with a historic crisis that moves as fast as a trader can initiate a sell order (I feel somewhat charitable tonight, as the hotel lounge remains

5 open another hour and I am confident Willem Butier will have something to say that is less than charitable[update]). They often lack the time to consider the consequences of their actions. For example, John Jansen asks: Preferred shareholders? If the deal calls for making them whole, I ask why. There does not seem to be any reason to bail them out. The answer can be found via Yves Smith: Fannie and Freddie preferred were held by banks, so any losses on the preferred would reduce already stressed bank capital. But far worse, preferred stock was the best hope for financial firms to raise new equity. Trashing the Fannie/Freddie preferreds meant that any sane investor would worry that future bank rescues could similarly damage preferred shareholders, and they'd avoid financial firm preferred stocks, including new issues. And indeed, financial preferreds got whacked in the wake of the GSE bailout. Uncharted waters, to be sure. What I think we do know can be summarized as: 1. The Fed is pushing the bounds of its legal limits with the AIG deal. 2. The taxpayer will bear a portion, perhaps a significant portion, of the financial crisis, whether or not the Fed is involved. Arguably the cost will be less if the Fed acts now than if the Fed drags its heels. Again, moral hazard is interesting topic on the way to Starbucks, but is not feasible public policy, especially when policy is behind the curve. 3. We should all be very concerned that the Fed is pursuing a Jack Bauer policy approach, as much as we should be concerned about illegal wiretapping. We should not view this as an acceptable approach to policy. To do so leads to very unhappy places. 4. We should all be very concerned that Congress appears simply unable to understand the financial crisis, especially now that they likely understand they are far behind the curve and are having policy dictated to them by the Fed. Perhaps Congress will now view a bit more suspiciously the claims of Wall Street lobbyists that “everything is under control; we have dispersed the risk.” Bottom Line: It is easy to take potshots at the Fed; I have taken my share over the past year. I think, as an institution, they abdicated their regulatory responsibilities, and we are all now paying the price. I think their communication strategy, and their lack of policy consistency, is maddening. But I think we are now all realizing where we are headed. We are moving into the endgame, when Congress socializes the losses after privatizing the gains.

6 Economist's View

September 17, 2008 "Resurrect the Resolution Trust Corporation" by Nicholas F. Brady, Eugene, A, Ludwig, and Paul A. Volcker Following up on Tim Duy's statement that "bad assets need to be consolidated and eliminated," and that "Congress needs to be working on ... a new RTC," a group of former financial officials has the same recommendation. They want Congress to create something similar to the Resolution Trust Corporation or the Home Owners Loan Corporation, and use these institutions to remove "toxic paper" from financial markets: Resurrect the Resolution Trust Corp., by Nicholas F. Brady, Eugene, A, Ludwig, and Paul A. Volcker: We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse. Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis. ... The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments... Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy... There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management. ... It is certainly the case that the new institution we are proposing will in the short run require serious money. That will involve a risk to the taxpayer; but the institution, administered by professionals, means that ultimate gains to the taxpayer are also possible. Moreover, a failure to act boldly in the fashion we are suggesting would cost the taxpayer and the country far more. The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link. A deteriorating financial system, diminished economic activity, loss of jobs and loss of revenues to the government is enormously costly. And the cost to our citizens' well-being is incalculable. ... What we need, and in part are proposing, is a road map to financial stability.

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The end of lightly regulated finance has come far closer By Martin Wolf Published: September 16 2008 18:47 | Last updated: September 16 2008 20:28

These are dramatic times. By Monday of this week, three of Wall Street’s top five investment banks – , Lehman and Lynch – had disappeared as independent entities. The insurance group AIG is in serious trouble. What was, until recently, the brave new US financial system is melting away before our eyes. Economists’ forum - Nov-16

Over the past few weeks three experiences have helped clear my mind on this crisis. First, I reread Hyman Minsky’s masterpiece, Stabilizing an Unstable Economy. Second, I engaged in a debate on the future of regulation with my admired colleague and friend, John Kay. Finally, on Monday, I moderated a session on this crisis at the Swift International Banking Operations Seminar in Vienna. I structured this latter discussion around four questions. What went wrong? Is the worst over? What are the lessons for financial institutions? What are the lessons for governments? Here then are my current answers to these questions. What went wrong? The short answer: Minsky was right. A long period of rapid growth, low inflation, low interest rates and macroeconomic stability bred complacency and increased willingness to take risk. Stability led to instability. Innovation – securitisation, off-balance- sheet financing and the rest – has, as always, proved a big part of the story. As Minsky warned, undue faith in unregulated markets proved a snare. This is the rake’s progress enjoyed by the US over the past decade. But it has not been alone. Both equity and house-price bubbles affected parts of Europe, as well. But they were particularly important for the UK.

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Is the worst now over? Certainly not. Unwinding of excesses on such a scale involves four giant processes: the fall of inflated asset prices to a sustainable level; de-leveraging of the private sector; recognition of resulting financial sector losses; and recapitalisation of the financial system. Making all this worse will be the collapse in private sector demand, as credit shrinks and wealth falls. None of these processes is even close to completion. Some have barely begun. In particular, property prices are still falling, even in the US. Similarly, the adjustment in the real economy, particularly the inevitable rises in household savings rates in the US and UK are at an early stage. Because even uninformed people understand how uncertain the outcomes are, fear is pervasive. This is demonstrated by, among other things, the high spreads on interbank loans over expected official rates. The biggest outstanding question is whether government-led rescues of undercapitalised financial systems will be needed. This is now looking increasingly likely. In today’s world, governments rescue such crisis-hit economies in four ways: they offer generous lender-of- last-resort liquidity, via central banks; they run huge fiscal deficits, to offset the shift of the private sector into financial surplus; they substitute public debt for private debt, in order to recapitalise undercapitalised financial systems (often after outright nationalisation); and they may adopt inflationary erosion of the value of private (and public) debt. All of this is now likely, including, alas, even the last. What then are the lessons for financial institutions? Stable doors are being shut after herds of horses have bolted. The Institute for International Finance has, for example, produced an excellent report on the things the financial industry ought to do (or, better still, ought to have done).

9 This report focuses, properly, on risk-management (which was a disaster), compensation (which was grotesquely irresponsible), the originate-and-distribute model (which was rife with irresponsibility and fraud) and so on and so forth. No doubt people scarred by this crisis will take such advice seriously, for a while. But some years from now – 20, if we are lucky, less than 10 if the fallout is contained by the authorities – it will be ancient history. In deregulated financial systems crises are inevitable, like earthquakes on a fault zone. Only timing is uncertain. What, finally, are the implications for governments now? The questions are two: how to restructure regulation for the long haul; and how much of their crisis tool box to use now. John Kay argues that regulation must be restricted. His argument is based on two propositions: first, the payment system is the core financial utility; and, second, regulators cannot successfully second-guess the decisions of huge institutions staffed by better-paid and more highly motivated people than themselves. Governments should, he argues, not even pretend they can make the financial system stable. They must, instead, try to “insulate the real economy from consequences of financial instability”. The latter, he suggests, can be achieved by insuring small deposits, creating a special resolutions regime for banks and making the deposit insurance scheme a preferred creditor. I find John’s position both attractive and unrealistic. A compelling reason for the latter view is that governments rightly define provision of financial intermediation and insurance as essential utilities in the modern economy. Another is that it is impossible to protect the real economy from a breakdown of the credit system. For this reason, governments cannot credibly promise to wash their hands of a financial breakdown. This is the lesson of at least a century of financial history. Greater regulation is, alas, inescapable, even if doomed to be imperfect. Two steps must be taken. One is to look for simple rules to improve the operation of the system as a whole, the obvious one being counter-cyclical capital requirements. The other and far more controversial step is a shift in the psychology of supervision away from the presumption that institutions know what they are doing. In particular, far more attention must be paid to behaviour that may appear rational for each institution, but cannot be rational if all institutions are engaged in it at the same time. Financing house-price bubbles with loans equal to 100 per cent of the barely appraised value, because prices only go up, comes to mind. Today, however, the authorities must also ask themselves whether what they are doing will make the system safer after the crisis is over. By these standards, the decision not to bail out Lehman looked right. But it was also risky, because we have to get through the crisis. Let us hope the decision proves to be part of the solution, not an aggravation of the challenges we face. I would now take no bets on this benign outcome. [email protected]

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Wednesday, September 17, 2008; Page A19 Wall Street's Unraveling By Robert Samuelson WASHINGTON -- Wall Street as we know it is kaput. It is not just that Merrill Lynch agreed to be purchased by or that the legendary investment bank Lehman Brothers filed for bankruptcy or that the insurance giant AIG is floundering. It is not even that these events followed the failure of the investment bank Bear Stearns or the government's takeover of Fannie Mae and Freddie Mac, the largest mortgage lenders. What's really happened is that Wall Street's business model has collapsed. Greed and fear, which routinely govern financial markets, have seeded this global crisis. Just when it will end isn't clear. What is clear is that its origins lie in the ways that Wall Street -- the giant investment houses, brokerage firms, hedge funds and "" firms -- has changed since 1980. Its present business model has three basic components. First, financial firms have moved beyond their traditional roles as advisers and intermediaries. Once, major investment banks such as and Lehman worked mainly for their clients. They traded stocks and bonds for major institutional investors (insurance companies, pension funds, mutual funds). They raised capital for companies by underwriting -- selling -- new stocks and bonds for the firms. They provided advice to corporate clients on mergers, acquisitions and spinoffs. All these services earned fees. Now, most financial firms also invest for themselves. They use partners' or shareholders' money to place bets on stocks, bonds and other securities -- so-called "principal transactions." Merrill and other retail brokers, which once served individual clients, have ventured into . So have some commercial banks that were barred from doing so until the repeal in 1999 of the Glass-Steagall Act of 1933. Second, Wall Street's compensation is heavily skewed toward annual bonuses, reflecting the profits traders and managers earned in the year. Despite lavish base salaries, bonuses dominate. Managing directors with 15 years' experience can receive bonuses five to 10 times their base salaries of $200,000 to $300,000. Finally, investment banks rely heavily on borrowed money, called "leverage" in financial lingo. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders' investment (equity) was about $23 billion. All the rest was supported by borrowings. The "leverage ratio" was 30 to 1. Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price

11 rises to $101, you've made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you've doubled your money. Wow. Once assembled, these components created a manic machine for gambling. Traders and money managers had huge incentives to do whatever would increase short-term profits. Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1. It wasn't that Wall Street's leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced. Mortgages went bad. The powerful logic of high leverage went into reverse. Losses eroded firms' tiny capital bases, raising doubts about their survival. This year, Lehman lost nearly $8 billion in "principal transactions." Otherwise, it was profitable. How Wall Street restructures itself is as yet unclear. Companies need more capital. Merrill went to Bank of America because commercial banks have lower leverage (about 10 to 1). It seems likely that many thinly capitalized hedge funds will be forced to reduce leverage. Ditto for "private equity" firms. In time, all this may prove beneficial. Financial firms may take fewer stupid and wasteful risks -- at least for a while. Talented and ambitious people may move from finance, where they were attracted by exorbitant pay, into more productive industries. But the immediate effect may be to damage the rest of the economy. People have already lost their jobs. States and localities, particularly and New Jersey, that depend on Wall Street's profits and payrolls will face further spending cuts. Banks and investment banks may tighten lending standards again and impede any economic recovery. The stock market's swoon may deepen consumers' pessimism, fear and reluctance to spend. There may be more failures of financial firms. It's hard to know, because financial crises resemble wars in one crucial respect: They result from miscalculation.

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It looks like the United States’ no bailout policy lasted all of two days by bsetser Posted on Tuesday, September 16th, 2008 AIG’s bondholders got a huge break. That is an observation, not a criticism. The credit markets were not reacting well to Lehman’s bankruptcy filing. $85 billion is a lot of money. The terms of the loan are onerous. 850 bp over LIBOR (a penalty rate) plus equity warrants. The US government now effectively owns a significant chunk of the US financial system, and provides liquidity to an even bigger chunk of it. To state the obvious, the crisis has entered a new phase. Rogoff and Reinhart’s paper on the cost of systemic banking crisis looked good when it first came out. It looks even better now. An anonymous Federal reserve official was quoted recently in saying: “We’ve re-established ‘moral hazard,’” said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they’re insulated from the consequences. “Is that a good thing or a bad thing? We’re about to find out.” Felix is right; the person involved in the talks didn’t quite get the concept of moral hazard. The US government removed ‘moral hazard” — the availability of insurance that protects investors from losses on risky assets — from a portion of the credit market. I am still not sure if it was a good or a bad thing. But it sure seems to have revealed that a significant portion of the US financial system wasn’t strong enough to stand on its own, without a government backstop. This entry was posted on Tuesday, September 16th, 2008 at 9:21 pm and is filed under Systemic Risk. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

13 11 Responses to “It looks like the United States’ no bailout policy lasted all of two days” 1. September 16th, 2008 at 10:46 pm SS Says: There’s a long list of banks waiting for the same treatment — onerous or not. I don’t think anyone really knows if the Fed will make a full recovery on this one or just took a multi-billion dollar bullet for “the global financial system.” Simplistically speaking, how much would the dollar depreciate if the US had to absorb $1T in losses when all was said and done?

2. September 16th, 2008 at 10:46 pm manch Says: Brad, will you be doing a tally of Fed’s balance sheet any time soon? The Fed is looking more and more like a hedge fund now. Wonder when it will reach for the printing press…. 3. September 16th, 2008 at 11:01 pm Twofish Says: It’s not so much AIG bondholders that got the benefit but rather the bondholders of Lehman and other banks that will close. What got AIG in trouble was taht it was in the credit insurance business, so when Lehmann fails, AIG had to pay up. The I think really worried people was if AIG fails, then who is the next domino? 4. September 16th, 2008 at 11:21 pm bsetser Says: manch — i’ll be most interested in the fed balance sheet data released on thursday, and the data released next thursday. if only other central banks were as transparent 5. September 16th, 2008 at 11:36 pm moldbug Says: Note that this is exactly Bagehot’s cure: lend freely at very high rates. Well, lend freely to solvent institutions at very high rates. But… (I suspect a lot of people tonight could derive real comfort, and possibly even a bit of inspiration, from resting their heads on a copy of good old Lombard Street.) 6. September 16th, 2008 at 11:41 pm Cedric Regula Says: Mama Mia, I go play tennis for a couple hours and the feds spend another $85 billion? Now I a scared to play golf tomorrow. The goons is gonna add this to my insurance policy when I hava to buy protection. What gives goombas???? 7. September 17th, 2008 at 12:31 am Andrew Says: I dunno. Could we possibly have some kind of a cheat sheet? The Sheep, over here, are .

14 Bear Stearns, Countrywide, Fannie/Freddie, Merrill Lynch, AIG, , Bank of America, JP Morgan, Goldman Sachs… The Goats, on my right, can be Thrown To The Wolves, with a bit of creative financing to assure that they have an orderly demise off camera: Lehman Brothers, Washington Mutual, Bank, … Is there rhyme or reason to who gets to be a Sheep and who gets to be a Goat? 8. September 17th, 2008 at 12:50 am Cedric Regula Says: I call my uncle eddie, he just burn a these houses down then a we not have this problem anymore. Capice?? 9. September 17th, 2008 at 1:12 am Rosenberger Says: Andrew’s right, the selectivity of the bailout/no-bailout decisions is worthy of nothing less than ridicule. It’s also the very worst kind of corruption, and encourages the kind of incestuous cronyism that we most identify with banana republics. Whatever the blunders of Richard Fuld at Lehman, I see absolutely nothing that makes Lehman worse off (or more deserving of bankruptcy) than JPMorganChase, Morgan Stanley, BoA, Wells Fargo, Citi and Goldman-Sachs. If Lehman goes, so should they. In fact, if anything JPMorganChase, GS, Morgan Stanley and the others are even more beset with toxic junk than Lehman is. They’re just a little better at the Enron cooking-the- books practices than LEH was. If anything, Fuld will likely make sure that all the ugliness about not only Lehman, but the entire industry comes out now in full detail, to bring down the other banks with his own. That’s probably his only protection from becoming the scapegoat– if his rivals are taken down as well, then everybody’s swimming around for the life rafts. In fact if anything, I’d 10. September 17th, 2008 at 1:55 am Cedric Regula Says: This is so hilarious I had to post it, tho who knows what it has to do with anything. I went to my usual Forex website and looked at the home page and each of the paragraphs listed below is a headline for a research note from one of the analysts. These people all work at the same place. Note the confusion. Wonder when Soros, Rogers and whoever else will try a speculative currency attack on the Fed? That would clarify things. ======US Dollar Could Falter As Federal Reserve Leaves Rates at 2.00%, Signals Neutral Stance Tuesday, 16 September 2008 23:16:43 GMT

15 US Dollar Forecast: Fed Rate Expectations Bolster Dollar vs. Euro, British Pound, Australian Dollar Tuesday, 16 September 2008 20:12:55 GMT Senior Currency Strategist Jamie Saettele Forex Technicals: The Day Ahead, September 17 The technical evidence suggests that the US dollar will retrace a portion of its gains since July. The biggest winner may be the British Pound. Technical Analysis Euro Could Fall Against Commodity Currencies Tuesday, 16 September 2008 23:23:17 GMT Buy Pound, Kiwi Financed by Yen, Dollar, Says Automated Signals Wednesday, 17 September 2008 00:50:08 GMT Analyst Picks Short Euros And Long Pounds A Consistency Across DailyFX Analyst Picks 11. September 17th, 2008 at 3:47 am Rahul Deodhar Says: I was pained that Lehman went bankrupt - it was as good a company, a little better on the insides perhaps, than any other. But I was even more pained at bailout of AIG. I believe a more regulatory approach may have had better effect. In crazy times it is better to slow down and get bearings right. FED should have peeked under the hood of all banks and FIs in US and then used some regulatory enforced structured unwinding over set time-table. That might have been a better bailout without tax-payer money than otherwise. By doing selective bailouts - FED is inviting more trouble. And I think now someone will need to bailout the FED. I think current crises needs global regulatory response and coordination. I hope the politicos hurry up and get their acts together. Else contagion will be erratic - widespread and like self- sustaining wave. Rahul

16

SEPTEMBER 16, 2008 U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up Emergency Loan Effectively Gives Government Control of Insurer; Historic Move Would Cap 10 Days That Reshaped U.S. Finance By MATTHEW KARNITSCHNIG, DEBORAH SOLOMON, LIAM PLEVEN and JON E. HILSENRATH MORE IN DEALS » The U.S. government seized control of American International Group Inc. -- one of the world's biggest insurers -- in an $85 billion deal that signaled the intensity of its concerns about the danger a collapse could pose to the financial system. The step marks a dramatic turnabout for the federal government, which had been strongly resisting overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy. Just last weekend, the government essentially pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to go under instead of giving it financial support. This time, the government decided AIG truly was too big to fail.

Associated Press Businessmen leave an American International Group office building Tuesday in New York. The U.S. negotiators drove a hard bargain. Under terms hammered out Tuesday night, the Fed will lend up to $85 billion to AIG, and the U.S. government will effectively get a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. The two- year loan will carry an interest rate of Libor plus 8.5 percentage points. (Libor, the London interbank offered rate, is a common short-term lending benchmark.) The loan is secured by AIG's assets, including its profitable insurance businesses, giving the Fed some protection even if markets continue to sink. And if AIG rebounds, taxpayers could reap a big profit through the government's equity stake. "This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy," the Fed said in a statement.

17 It puts the government in control of a private insurer -- a historic development, particularly considering that AIG isn't directly regulated by the federal government. The Fed took the highly unusual step using legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under "unusual and exigent" circumstances, something it invoked when Bear Stearns Cos. was rescued in March. As part of the deal, Treasury Secretary insisted that AIG's chief executive, Robert Willumstad, step aside. Mr. Paulson personally told Mr. Willumstad the news in a phone call on Tuesday, according to a person familiar with the call. Mr. Willumstad will be succeeded by Edward Liddy, the former head of insurer Allstate Corp. AIG's bailout caps a tumultuous 10 days that have remade the American financial system. In that time, the government has engineered rescues that insert it deep into the housing and insurance industries, while Wall Street has watched two of its last four big independent brokerage firms exit the scene. The U.S. on Sept. 6 took over mortgage-lending giants Fannie Mae and Freddie Mac as they teetered near collapse. This Sunday, the U.S. refused to bail out Wall Street pillar Lehman Brothers, which filed for bankruptcy-court protection and is now being sold off in pieces. That same day, another struggling Wall Street titan, Merrill Lynch & Co., agreed to sell itself to Bank of America Corp.

The AIG deal followed a day of high drama in Washington. The Treasury's Mr. Paulson and Federal Reserve Chairman convened in the early evening an unexpected meeting of top congressional leaders. Late in the trading day Tuesday, anticipation that the government might assist the insurer helped propel the Dow Jones Industrial Average to a 1.3% gain. In bailing out AIG, the Federal Reserve appeared to be motivated in part by worries that Wall Street's financial crisis could begin to spill over into seemingly safe investments held by small investors, such as money-market funds that invest in AIG debt. Indeed, on Tuesday the $62 billion Primary Fund from the Reserve, a New York money- market firm, said it "broke the buck" -- that is, its fell below the $1-a-share level that funds like this must maintain. Breaking the buck is an extremely rare occurrence. The fund was pinched by investments in bonds issued by now collapsing Lehman Brothers. Money-market funds are supposed to be among the safest investments available. No fund in the $3.6 trillion money-market industry has lost money since 1994, when Orange County, Calif., went bankrupt. A number of money-market funds own securities issued by AIG. The firm is also a big insurer of some money-market instruments. Credit Downgrade

18 AIG's financial crisis intensified Monday night when its credit rating was downgraded, forcing it to post $14.5 billion in collateral. The insurer has far more than that in assets that it could sell, but it could not get the cash quickly enough to satisfy the collateral demands. That explains the interest in obtaining a bridge loan to carry it through. AIG's board approved the rescue Tuesday night. AIG's board said in a statement that the deal would "protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis." The final decision to help AIG came Tuesday as the federal government concluded it would be "catastrophic" to allow the insurer to fail, according to a person familiar with the matter. Over the weekend, federal officials had tried to get the private sector to pony up some funds. But when that effort failed, Fed Chairman Bernanke, New York Fed President Timothy Geithner and Treasury Secretary Paulson concluded that federal assistance was needed to avert an AIG bankruptcy, which they feared could have disastrous repercussions. Staff from the Federal Reserve and Treasury worked on the plan through Monday night. President George W. Bush was briefed on the rescue Tuesday afternoon during a meeting of the President's Working Group on Financial Markets. That the government would prop up AIG financially offers a stark indication of the breadth of the insurer's role in the global economy. If it were to have trouble meeting its obligations, the potential domino effect could reach around the world. For one thing, banks and mutual funds are major holders of AIG's debt and could take a hit if the insurer were to default. In addition, AIG was a major seller of "credit-default swaps," essentially insurance against default on assets tied to corporate debt and mortgage securities. Weakness at AIG could force financial institutions in the U.S., Europe and Asia that bought these swaps to take write-downs or losses. Crisis on Wall Street Real Time Econ: Here Be Dragons | Fed's 'Unusual and Exigent' Clause Greenberg's Letter to AIG CEO Willumstad Wash Wire: Bush Not to Comment on Paulson Meeting Crisis Blog: Questions and Answers on AIG AIG, Lehman Shock Hits World Markets Old-School Banks Emerge on Top Complete Coverage: Wall Street in Crisis AIG's millions of insurance policyholders appear to be considerably less at risk. That's because of how the company is structured and regulated. Its insurance policies are issued by separate subsidiaries of AIG, highly regulated units that have assets available to pay claims. In the U.S., those assets can't be shifted out of the subsidiaries without regulatory approval, and insurance is also regulated strictly abroad. Tuesday afternoon, after the market closed, AIG put out a statement saying its basic insurance and retirement services businesses are "fully capable of meeting their obligations to policyholders." AIG said it was trying to "increase short-term liquidity in the parent company," but said that didn't "include any effort to reduce the capital of any of its subsidiaries or to tap into Asian operations for liquidity." Asia is one of AIG's largest markets.

19 Financial Pain Where the company is feeling financial pain is at the corporate level, even while its insurance operations are healthy. The urgency of federal aid came into stark relief Tuesday as other options fell off the table and pressures continued to build. On Tuesday, AIG's attempt to raise as much as $75 billion from private-sector banks failed. The banks advising the firm concluded it would be all but impossible to organize a loan of that size, making the government AIG's chief hope. As a result of its credit downgrades, the insurer has to post $14.5 billion in collateral to bolster its credit rating. In the debt markets, AIG also has to post additional collateral to investment banks and others it trades with. Adding to AIG's woes, investors continued to pummel the company's stock on Tuesday, pushing the share price down 21%, to $3.75. It was the third double-digit percentage decline in the past three trading days. AIG's shares are now down 94% for the year. AIG's cash squeeze is driven in large part by losses in a unit separate from its traditional insurance businesses. That financial-products unit, which has been a part of AIG for years, sold the credit-default swap contracts designed to protect investors against default in an array of assets, including subprime mortgages. But as the housing market has crumbled, the value of those contracts has dropped sharply, driving $18 billion in losses over the past three quarters and forcing AIG to put up billions of dollars in collateral. AIG raised $20 billion earlier this year. But the ongoing demands are straining the holding company's resources. That strain contributed to the ratings downgrades on Monday. Those downgrades, in turn, ratcheted up the pressure on the company to come up with more cash, quickly. Most insurance companies don't have financial-products units like these. But over nearly four decades, former CEO, Maurice R. "Hank" Greenberg built AIG into a firm that resembled no other. He transformed its insurance business, both by expanding abroad -- notably in , where AIG has its roots -- and by buying up other firms.

20 Mr. Greenberg pushed into areas that have little to do with bread-and-butter businesses like selling life insurance or protecting companies against property losses. In 1990, for instance, he bought International Lease Finance Corp., which leases planes to airlines. In 2005, Mr. Greenberg stepped down amid an accounting scandal. But Mr. Greenberg, who is fighting civil charges related to the scandal and has denied wrongdoing, didn't fade from the scene. He still heads a firm that is AIG's largest shareholder, and on Tuesday, he sent a letter to current CEO, Mr. Willumstad, saying he was "ready to offer any assistance that I can." 'I'll Do It' Now, however, Mr. Willumstad himself will be leaving, after having been asked to step aside by the Treasury's Mr. Paulson. Mr. Willumstad, who recently took over as AIG's chief executive to try to turn around the firm, was surprised by the request. "If that's what you want, I'll do it," he said to Mr. Paulson, according to a person familiar with the call. AIG's board was unhappy with the decision but felt it had no choice but to go along, as the only other option was bankruptcy. The fate of a corporate chief executive is normally the province of a board of directors. The decision by the Treasure Secretary to essentially oust Mr. Willumstad underscores further the magnitude of the government's intervention. Mr. Willumstad's departure marks the end of a brief, tumultuous run. He joined AIG as a director in early 2006, after leaving the No. 2 post at Citigroup Inc., and became AIG's chairman later that year. In June, as AIG was reeling from record losses, the board forced out Mr. Willumstad's predecessor and gave him the top job. He had planned to unveil his own strategy for AIG on Sept. 25. By tapping Mr. Liddy as AIG's next CEO, the government is turning to someone with deep experience in the insurance industry, having served as chief executive of Allstate from 1999 to 2006. He stepped down as chairman earlier this year. Allstate is a different type of insurer than AIG, focusing on selling car and home insurance to Americans, whereas AIG sells an array of insurance policies to individuals and businesses world- wide. Mr. Liddy also has experience pulling apart empires, having helped dismantle Sears, Roebuck & Co. (from which Allstate was spun off) in the 1990s. Before joining Sears, Mr. Liddy worked under Donald Rumsfeld at drug maker G.D. Searle & Co. Mr. Liddy is on the board at Goldman Sachs Group, the investment bank that Mr. Paulson led before becoming Treasury Secretary. As confidence in AIG declined recently, the amount of money it felt compelled to raise to calm its constituents continued to rise. Over the weekend, the figure was $40 billion. That climbed to $75 billion on Monday and, according to a person close to the company, rose further on Tuesday. —Diya Gullapalli, Serena Ng, Damian Paletta and Ashby Jones contributed to this article.

21 Economist's View

September 16, 2008 "!*#\”£$%&?!!!" Should the government help AIG?: Should AIG be funded by the Fed?, by Willem Buiter:2 AIG, the largest US insurance company by assets, is reported to have asked the Fed for a $40bn ‘bridge loan’ to tide it over while it sells assets and attracts new equity. Unless such support is forthcoming, the company fears a downgrade by the rating agencies before it can shore up its capital base. Such a downgrade could further weaken its balance sheet, leading to a downward spiral and possible bankruptcy. While waiting for a Fed decision, AIG’s regulator, NY State Insurance Superintendent Eric Dinallo gave it special permission to access (i.e. to raid) $20 billion of capital in its subsidiaries to free up liquidity. My first reaction to these stories was !*#\”£$%&?!!! The activities of AIG that have got it into trouble are the provision of default insurance on mortgage-backed securities through a range of contracts... If an insurance company like AIG has become a highly leveraged financial institution deemed by the Fed to be too large, too interconnected or too politically connected to fail, and if it is as a result granted access to Federal Reserve resources..., then there has to be a regulatory quid-pro-quo. AIG is not a bank. It is not ... regulated at the Federal level at all. Insurance ... is regulated at the state level. So a financial institution that is large enough to cast a significant global shadow is regulated by some provincial official in New York State. ... I hope the Fed will tell AIG to go away... But should the Fed decide that it is now responsible for all highly leveraged institutions it deems systemically important, then significant regulatory authority and oversight of the Fed over AIG should be (part of) the price. The bridging loan should also be priced punitively and be secured against the best assets in the AIG group. The regulatory regime should involve serious capital requirements, liquidity requirements, reporting and governance requirements as well as the creation of a special resolution regime for AIG should it, in the view of the regulator (the Fed), be at risk of failing. ... But before any money is lent by the Fed to AIG, even on the conditions outlined above, I would like to have the social cost-benefit analysis of this proposed transaction explained to me. Where is the market failure? Where are the systemic externalities associated with requiring AIG to sink or swim on its own? If the Fed were to provide funding to AIG, then, unless a convincing public interest/social welfare case is made (and I have not seen a single sensible argument in support of such an act), I would have to conclude that the

2 Hhttp://blogs.ft.com/maverecon/2008/09/should-aig-be-funded-by-the-fed/H

22 political economy of the US had become one of crony capitalism and socialism for the rich and the well-connected. Another view: Wall Street’s Next Big Problem, by Michael Lewitt, Commentary, NY Times (15-Sept.): ...When Lehman Brothers filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. ... But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds. Late Monday, A.I.G. was downgraded by the major credit rating agencies (which inexplicably still retain an enormous amount of power ... despite having gutted their credibility with unreliable ratings for mortgage-backed securities during the housing boom). This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts. Fat chance. That’s collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. ... Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression. A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian market that is reported to be at least $60 trillion in size. ... If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. ... More failures, particularly of hedge funds, could follow. Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed. While Gov. David A. Paterson of New York ... allowed A.I.G. to borrow $20 billion from its subsidiaries, that move will only postpone the day of reckoning. The Federal Reserve was also trying to arrange at least $70 billion in loans from investment banks, but it’s hard to see how Wall Street could come up with that much money. More promisingly, A.I.G. asked the Federal Reserve for a bridge loan. True, there is no precedent for the to extend assistance to an insurance company. But these are unprecedented times, and the Federal Reserve should provide A.I.G. with some form of financial support while the company liquidates its mortgage-related assets in an orderly manner. The Fed cannot afford to stand on principle. The myth of free markets ended with the takeover of Fannie Mae and Freddie Mac. Actually, it ended with their creation.

23 I agree with Willem Buiter that it would be best if we understood the market failures or the systemic externalities associated with the failure of AIG, that would allow us to better determine the appropriate course of action. But one thing to learn from this crisis is that financial markets are sufficiently interconnected and sufficiently complex so as to make it difficult to fully understand the risk we face with any action (or inaction). It's like trying to evaluate one of those opaque, sliced and diced, repackaged derivative securities we've heard so much about, nobody knows for sure how much risk is associated with the failure of AIG. In that environment, and realizing that all past calls that the unfolding crisis would be contained -- that the crisis would not spread and endanger the broader economy -- have been wrong even with spreading walls of containment, my inclination is to play it safe. Unless we are very certain that telling AIG to "go away" will not endanger the overall economy, then protect jobs and the economy first and foremost by ensuring, minimally, that an orderly liquidation occurs. But Willem Buiter's right about the follow-up to any action, any help needs to be followed by "a regulatory quid-pro-quo." Economist's View

24

The flight from risky US assets Posted on Tuesday, September 16th, 2008 by bsetser It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right. It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August. Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior. The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.* That would normally make it hard to sustain a large current account deficit. The US still needs roughly $60b a month in net inflows to cover its external deficit. Net sales of foreign assets of $32b provided some financing — but not nearly enough to cover the outflow of short-term funds. $75b in net outflows isn’t exactly a good sign, even if the dollar’s rebound suggest more flows (perhaps from large US sales of foreign assets) in August. The same basic trend is apparent in the data for the 12ms through July 2008, which can easily be compared to the 12ms through July 2007 — think pre-crisis and post-crisis. After the crisis, foreigners have bought roughly: $350b of long-term US treasury bonds, and another $125b of short-term bills — for a total of $475b of US Treasuries. That explains how the US has financed its fiscal growing deficit. Foreigners also bought around $150b in Agency bonds, $210b of corporate bonds and $55b of US equity ($20b excluding the SWF capital injections into the banks and broker dealers). Before the crisis, foreigners bought roughly: $205b of long-term Treasury bonds (and reduced their holdings of bills by $10b), $285b of long-term Agencies, $540b of long-term corporate bonds and $210b of US equity. Notice a trend? Sovereign wealth fund flows into equities clearly have been trumped by a broader retreat from risk, including a retreat by sovereign investors.

25 There are a couple of other important swings in the data. US investors dramatically reduced their net purchases of foreign assets. US net purchases fell from $280b to $95b. That helped. US capital outflows have to be financed by capital inflows. And US banks dollar liabilities fell by $400b — producing a huge net outflow that offset much of the inflow. As a result, net “TIC” flows for the last twelve months are only $210b — well below the current account deficit. Some of that gap could be covered by net FDI inflows, but in general FDI inflows and outflows match up pretty well, so it is hard to see that large an inflow from FDI. The remaining gap is an error term — we simply don’t know what all is going on. That net flow can be broken into a $67.7b net private outflow (counting short-term flows) and a $277.8b net official inflow. Two points here: The US data consistently understates official inflows. We know $280b is too low for a host of reasons — not the least the fact that the Fed’s custodial holdings increased by more. The past “survey” revisions have consistently revised official flows up and private flows down. There is no reason to think that this has changed. Indeed, the past revisions would suggest the entire $260b in “private” purchases of Treasuries over the past 12ms in the TIC data are likely official inflows, and that the $90-95b in private purchases of Agencies are too. If those flows are allocated, the net official inflow is over $600b — and the net private outflow is correspondingly larger. The US data doesn’t seem to be capturing all the flows associated with the unwinding of the . That at least is my perception. I don’t have any other good explanation for the gap between identified flows and the US deficit. Now to the country data. I found one country with large reserves that added to its long-term Agency holdings in July: Hong Kong. Everyone else was a net seller. China, Russia, the Gulf (”the Asian oil exporters”), , Korea, Singapore, and Japan. So was the UK — which likely indicates a further fall in official demand. The TIC data indicates a huge reallocation by official investors from Agencies to Treasuries — and a far larger reallocation than showed up in the FRBNY accounts. Let’s look at five specific countries where central banks and sovereign funds typically generate a sizable share of the flow. China added $20.4b to its short-term holdings and Treasury portfolio, while cutting its holdings of long-term agencies by $3.4b. That strikes me as a flight from risk. China was still buying US corporate debt in July, but in smaller amounts than in previous months. This isn’t a flow I understand well. Chinese purchases of corporate debt have increased recently — and that presumably has driven the rise in overall “official” purchases of corporate debt. But there were also substantial Chinese purchases from mid-2006 to mid- 2007. The mystery: these flows weren’t match by a rise in stocks in the survey data. Count me confused. The Asian oil exporters (i.e. the Gulf) added $7.5b to its short-term holdings, and another $0.8b to its long-term Treasuries — for a “flight to safety” flow of $8.3b.

26 China and the Gulf account for a large share of the global surplus, so their flows matter. Russia cut its long-term agency holdings by $0.4b while adding $3.1b to its long-term Treasury portfolio. It also added $5.7b to its short-term Treasury holdings while cutting its holdings of other short-term securities (think Agencies) by $4.4b. One great irony in the data is that in the month before the conflict with Georgia broke out, Russia provided $8.8b in net financing to the US Treasury. Recent pressure on Russia’s reserves at least has eliminated that bizarre flow. Korea — which many claimed might be running out of liquid assets — seems to have reduced its Agency holdings far more rapidly than its Treasury holdings: its long-term Treasury portfolio fell by $1.1b, its long-term Agency portfolio fell by $3.6b and its holdings of corporate debt fell by $1.4b. That strikes me as sound liquidity management; it didn’t sell off its most liquid asset first. Finally Singapore. Singapore cut its long-term Agency holdings by a modest $0.2b while adding $1.1b to its long-term Treasury holdings. But the big story in the data is that it sold $5.2b of US equity. There is no way to know for sure that these sales came from the GIC or Temasek, but it is certainly possible that they did. All in all, I saw a lot of evidence of a sovereign flight from risk at a time when the market for risk assets was under stress. At the global level. And at the national level. I’ll try to flesh this out with a few charts later. * One data point. The detailed data for Agency purchases here doesn’t seem to match the summary data. I used the detailed data. Agency data should be adjusted for ABS repayment, but that adjustment is complex and it doesn’t affect the basic trend, so I reported the unadjusted number.

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Orchestrating a Process Neither Neat Nor Fair By Steven Pearlstein Tuesday, September 16, 2008; D01 When it comes to playing high stakes poker, Hank Paulson knows when to hold 'em and when to fold 'em. Ever since last week, when it became apparent that Lehman Brothers had lost the confidence of investors, the Treasury secretary was ready to gamble that financial markets could withstand the collapse of one of its most venerable investment banks. By that time, regulators had had enough time to comb through Lehman's books and determine that its assets were likely to cover most of its liabilities at the end of an orderly liquidation. And having spent the previous weekend engineering a takeover of Fannie Mae and Freddie Mac, Paulson was desperate to demonstrate that the government was not going to be drawn into bailing out every financial institution that had gotten itself in trouble. So when the masters of the financial universe gathered at the Federal Reserve Bank of New York over the weekend and told him they wouldn't participate in a Lehman rescue without some sort of government guarantee limiting their losses, Paulson was ready to call their bluff. In the end, it was the financiers who blinked. Although they weren't worried enough to underwrite a Lehman rescue, they were worried enough to commit resources to restoring stability to the markets and complete the restructuring and recapitalization of the industry. Bank of America, spotting what looked like a bargain, ponied up $50 billion in stock for Merrill Lynch, the next likely Wall Street domino to fall. And a group of the biggest banks agreed to make $70 billion available to any financial firm in need of short-term cash. Normally, a 504-point drop in the Dow Jones industrial average would not be considered a cause for celebration. And if it is followed by another and another, then it will turn out that Paulson's gamble was a foolish one and that putting a bit more of taxpayer funds at risk would have been the better strategy. But given the extraordinary circumstances, in which giant institutions were literally disappearing before our eyes, trading was remarkably orderly yesterday. If the 504-point drop turns out to be a one-day event, then Paulson

28 will have succeeded in forestalling a market meltdown without having to resort to another government bailout. While taxpayer money was not directly implicated, however, the government was deeply involved in yesterday's effort to erect financial firewalls around Lehman Brothers. The Federal Reserve and other central banks spent the day frantically pumping cash into the banking system -- more than $100 billion in all. The Fed also agreed to loosen the requirement on two new lending facilities that will allow banks and investment houses to use much riskier securities as collateral for those loans. At the same time, state and federal regulators were scrambling to help insurance giant AIG raise capital and avoid a dangerous downgrade of its credit ratings. As private equity firms considered making an equity investment, New York's state insurance commissioner gave the green light for AIG's parent company to invest $20 billion in its regulated insurer. And by day's end, Goldman Sachs and J.P. Morgan Chase were being urged by government officials to extend AIG a $70 billion bridge loan, according to several sources. Meanwhile, the Securities and Exchange Commission hinted that it was prepared to move quickly to permanently ban hedge funds and other investors from selling short the stocks of major financial institutions without first arranging to borrow the shares from someone who actually owns them. Many investors also are expecting the Fed to lower the federal funds rate today at the regularly-scheduled meeting of its monetary policy committee here in Washington. At 2 percent, the short-term rate is already below the rate of inflation and delivering plenty of economic stimulus. And with the Fed always reluctant to appear that it is manipulating markets, it is more likely that it will merely deliver a promise to cut if economic conditions deteriorate further. And make no mistake, they will deteriorate. The developments of the last two weeks, while dramatic, are simply part of the process by which the markets and the economy are adjusting to the bursting of a massive credit bubble. That bubble, which artificially inflated the value of stocks, bonds, real estate and commodities, diverted too much talent and resources to the financial sector and encouraged households and governments to live beyond their means. The process for correcting these excesses is never neat or even fair. The challenge for policymakers is to keep that process as orderly as possible without trying to protect failing companies or prevent the inevitable decline in incomes and asset prices.

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September 16, 2008 A Race for Cash at A.I.G. as Ratings Are Downgraded By MARY WILLIAMS WALSH and MICHAEL J. de la MERCED Major credit ratings agencies downgraded the American International Group late Monday, worsening its financial health, as Federal Reserve officials and two leading investment banks were in urgent talks to put together a $75 billion line of credit to stave off a crisis at the company. The credit downgrades are likely to force the company to turn over billions of dollars in collateral to its derivatives trading partners. Without the financing, which was being arranged by Goldman Sachs and JPMorgan Chase in talks with the Federal Reserve officials, A.I.G. might be forced to declare bankruptcy, according to two people briefed on the situation. The talks, which began last week and continued through the weekend, added to the sense of agitation in the stock market on Monday, as investors grappled with the implications of the bankruptcy of Lehman Brothers, which, like A.I.G., was a large counterparty to derivatives contracts held by countless financial institutions. Shares in A.I.G. tumbled more than 60 percent on Monday morning as concerns grew that the firm lacked capital to withstand cuts to its debt rating, which were borne out later in the day. The company’s potential write-offs are mounting and may reach $60 billion to $70 billion, according to two people briefed on the situation. Most of A.I.G.’s businesses are healthy, but its troubles grew from one unit that dealt in complex debt securities and derivatives and now threatens to drain cash more quickly than the financing package can be assembled. The day started off with news that A.I.G. had requested a $40 billion bridge loan from the Fed, a request that was rebuffed, and ended with the word that its need had soared to $75 billion. The firm suffered several credit-rating downgrades Monday evening, including cuts by Standard & Poor’s and Moody’s. The complex discussions, continuing into the night as a deal was sought before United States markets open on Tuesday, involved New York state regulators, federal regulators, private equity firms and Wall Street banks that rely on A.I.G.’s ability to honor its derivatives contracts, as they do with Lehman Brothers. “It’s not just the failure of one company,” said Julie A. Grandstaff, vice president and managing director of StanCorp Investment Advisers. “It’s the ripple effect of

30 the disappearance of counterparties” that was spurring urgent efforts to bolster A.I.G. A large counterparty to derivatives contracts has not declared bankruptcy since the market grew to such enormous size, so Lehman will be a test. Financial officials fear another failure of a big counterparty could start a chain reaction. The need to find fresh money for A.I.G. is bringing new layers of complexity to the credit crisis. As an insurance concern, A.I.G. has wholly different regulators and capital requirements than the banks and Wall Street firms that have suffered most of the huge losses so far. One person briefed on the matter said that potential lenders doubted that the facility could come together without the Fed’s backing. A.I.G. itself has had three chief executives in the last three and a half years, and one person briefed on Monday’s discussions said its officials seemed uncertain about how to proceed. The Fed was not able to provide the $40 billion bridge loan because it oversees banks, not insurers. The talks about backing up A.I.G. began last week, when the company approached regulators, saying it was concerned that if a deal could not be put together to save Lehman, A.I.G.’s own future would be in doubt. A.I.G., through its financial products unit in London, has exposure to the same mortgage-linked debt securities that brought about the downfall of Lehman. The talks between A.I.G. and its regulators led to the announcement at midday by Gov. David A. Paterson of New York that the state would allow A.I.G. to borrow $20 billion from its own subsidiaries, to help bolster its capital in the face of potentially disastrous credit downgrades. Mr. Paterson said he had authorized the state insurance superintendent, Eric R. Dinallo, to include the $20 billion asset transfer in the broader plan being worked out at the New York Fed. Normally state insurance regulations would prevent a holding company like A.I.G. from pulling assets out of its subsidiaries, which are insurance companies that need sufficient liquid resources to pay their claims. But Mr. Paterson said the situation was dire. “I hope you’re aware of the risks if we don’t act,” he told journalists at a midday news conference. “It is a systemic problem.” Mr. Paterson said A.I.G. was “financially sound,” but was unable to tap the liquid assets in its subsidiaries because of regulatory constraints. He stressed that New York taxpayers were not on the hook for the $20 billion. “No taxpayer dollars are involved,” he said. A.I.G. is the parent of dozens of major insurance companies, and Mr. Paterson said it was possible for them to lend money to their corporate parent without putting their policyholders at risk, because the subsidiaries would receive some form of

31 collateral. He said the collateral would consist of “illiquid assets,” but did not describe them. Insurance sources said some of the money could be produced by exchanging assets between the holdings of A.I.G.’s life insurance subsidiaries and its property and casualty subsidiaries, which have different capital requirements. For instance, an A.I.G. property insurer might buy stock from an A.I.G. life insurer’s portfolio, paying for them with high-quality bonds from its own portfolio. Life insurers have tighter capital requirements than property insurers, so replacing stock with bonds would strengthen the life insurer’s capital structure, allowing it to send the surplus to the holding company. Such a transfer would leave the life insurance company with investment assets that would produce less income, so the insurer would probably have to make up the difference by charging more for its life insurance policies, annuities and other products. Spokesmen for A.I.G. and the New York State Insurance Department said they could not provide any details on which of A.I.G.’s insurance companies would be involved in the asset transfers, because the plan was not yet final. The governor’s announcement appeared to help arrest the decline in A.I.G.’s stock. Trading below $4 shortly before noon, the shares briefly recovered to about $6, but ended down almost 61 percent at $4.76 from their Friday close. Ratings agencies had threatened to downgrade the insurance giant’s credit rating by Monday morning, a step that could allow counterparties to A.I.G.’s swap contracts to require A.I.G. to post collateral of up to $13.3 billion. The urgency of the talks grew by late Monday as A.M. Best Company, a credit rating organization specialized in insurance and health care companies, downgraded the credit of A.I.G. and several of its major subsidiaries. Fitch Ratings also downgraded A.I.G.’s credit Monday evening. Standard & Poor’s downgraded its long-term and short-term counterparty ratings of A.I.G.. and Moody’s cut its rating of A.I.G.’s senior debt, to levels requiring A.I.G. to post collateral of up to $10.5 billion. People briefed on the matter said that if JPMorgan and Goldman Sachs were able to raise a $75 billion credit line by Tuesday, it could avert an escalating series of collateral calls. But it was unclear whether they could put together such a complicated package in time. A.I.G. has also considered sales of virtually all of its business assets, but conducting such sales quickly would be hard. During the weekend, A.I.G. had been negotiating for a capital infusion from three private equity firms, people briefed on the matter said. But A.I.G. rejected an offer from J. C. Flowers & Company to buy $8 billion in preferred shares, because the bid included an option to buy the rest of the company at a steep discount.

32 Two other buyout firms, Kohlberg Kravis Roberts and the Texas Pacific Group, withdrew their offers to buy preferred shares as the Fed made clear that it would not provide any sort of backstop. But Maurice R. Greenberg, the visionary leader who built A.I.G. but was removed during an accounting scandal in 2005, has offered to help with any restructuring. Mr. Greenberg and his lawyers asked on Saturday if he could play a role in overhauling A.I.G. The deadpan response, according to a person close to the company, was: If you are willing to make a multimillion-dollar equity investment, we are happy to talk. Mr. Greenberg has seen the value of his holdings plummet as A.I.G. shares have sunk. He holds about 39 million A.I.G. shares directly and an additional 243 million through his private equity firm, Starr International. The shares were worth about $15.8 billion at the beginning of this year, but just $1.3 billion as of Monday. Jenny Anderson and Eric Dash contributed reporting.

33 Business September 16, 2008 Wall Street Posts Worst Loss Since 2001 By STEPHEN LABATON WASHINGTON — In another unnerving day for Wall Street, investors suffered their worst losses since the terrorist attacks of 2001, and government officials raced to prevent the financial crisis from spreading. Trading opened sharply down Monday morning, and the mood later turned even gloomier, despite efforts by President Bush and Treasury Secretary Henry M. Paulson Jr., in separate appearances at the White House, to reassure markets that Wall Street’s deepening problems would not weaken an already anemic economy. Amid worries that the bankruptcy of Lehman Brothers and the sale of Merrill Lynch over the weekend might not be enough to stop the downward spiral, stocks fell sharply in the last half hour of trading. By the end of the day, the Dow Jones industrial average had dropped 504.48 points, or 4.4 percent, as a record volume of more than 8 billion shares traded hands on the New York Stock Exchange. It was the biggest decline since Sept. 17, 2001 — the day the index reopened after the 9/11 terrorist attacks — when it fell 7 percent, or 684.81 points. A concern hanging over the market is the fate of other financial companies, most notably the American International Group, one of the world’s largest insurers. After the Fed rebuffed a request by the company for a $40 billion temporary loan, federal and state officials worked on Monday to stabilize A.I.G., with the State of New York relaxing rules to allow the company to borrow as much as $20 billion in much-needed cash, while the New York Federal Reserve Bank was engaged in talks with JPMorgan Chase and Goldman Sachs on a $75 billion loan for the insurer. Market participants fear that without a cash infusion for A.I.G., losses on its financial insurance contracts could cause a ripple effect that would damage other companies. Shares of A.I.G., already battered in recent weeks, plunged another 60 percent on Monday, closing at $4.76. Last year, the company had traded as high as $72. The stock market’s descent in the closing minutes Monday could set the stage for more fallout on Tuesday, when Asian markets that were closed for a holiday the day before will reopen. In response to the market turmoil, officials at the Federal Reserve were considering lowering interest rates at the regularly scheduled meeting on Tuesday of the Open Market Committee, which sets monetary policy. Such a move would follow a pattern — the Fed lowered rates after the Sept. 11 attacks and after the crash of 1987 to help calm the markets — though a rate cut is far from a certainty.

34 The Fed also took steps to ease rules separating banks and investment banks, a move intended to make it easier for healthy companies on Wall Street, like Goldman Sachs, to buy up troubled institutions. Wall Street was still reeling on Monday from a tumultuous weekend in which Treasury and Fed officials told top bank executives that they needed to work together to resolve the financial industry’s problems, because the government did not intend to bail out Lehman, a decision that led to Lehman’s bankruptcy filing. Dispirited employees of Lehman arrived at work in Midtown with little to do, with many spending their time polishing their résumés and sharing dark humor. Traders at other firms arrived at work before dawn to brace themselves for a heavy day and continued to limit their losses by unwinding their trading positions with Lehman. Nervous investors around the nation logged onto their investment accounts on the Internet to see what toll the financial tumult had taken on retirement and college-education funds. Workers at Merrill Lynch, stunned by the respected institution’s demise as an independent brokerage firm, came to work after learning about the sale on Sunday of the company to Bank of America. While the acquisition may have saved Merrill from what some worried would be a fate similar to Lehman’s, it will come at a cost to Merrill workers. Bank of America said it planned to wring $7 billion in costs from Merrill over four years from the consolidation, a plan that could result in thousands of layoffs. At a news conference on Monday, Kenneth D. Lewis, Bank of America’s chairman, would not discuss job losses, but he repeatedly praised Merrill’s 16,000 financial advisers, calling them “the crown jewel of the company.” Merrill employees who are laid off will have plenty of company, as many financial workers have lost jobs in the last year, leaving many without a paycheck. Appearing briefly in the morning before reporters in the Rose Garden, Mr. Bush characterized the recent events as short-term market adjustments that would have a limited effect on an otherwise sound economy. “I know Americans are concerned about the adjustments that are taking place in our financial markets,” Mr. Bush said at a ceremony to welcome the president of Ghana. He added: “In the short run, adjustments in the financial markets can be painful — both for the people concerned about their investments, and for the employees of the affected firms. In the long run, I’m confident that our capital markets are flexible and resilient, and can deal with these adjustments.” But, seeking safer places for their money, investors drove down the yields of Treasury notes. Widening spreads in the credit market indicated deep skepticism about mortgage-backed securities. The price of crude oil dropped more than $5 a barrel to close to at $95.71, as investors seemed to conclude that an economic decline would cause a significant decrease in the demand for energy. A senior administration official, recounting the fall of Lehman, said that for weeks Mr. Paulson had been pressing Richard S. Fuld Jr., the company’s chief executive,

35 to sell the company, but that ultimately no one in the market wanted it because of billions of dollars in bad investments the company had made in subprime mortgages and real estate. They said that Mr. Paulson told Mr. Fuld after the company reported dreadful second-quarter earnings that Lehman had to be sold or it would not survive. The official said that, several weeks ago, Mr. Paulson had a list in his mind of major institutions that might not be able to resolve their huge investments in troubled real estate and that the list consisted of Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch and Washington Mutual. The official said that Mr. Paulson also decided that it was paramount to first resolve the problems at Fannie Mae and Freddie Mac, the two huge mortgage finance companies, before turning to the others. In addition to A.I.G., the difficulties of Washington Mutual, the nation’s largest savings and loan, remain unresolved. On Monday, the shares of Washington Mutual closed down nearly 27 percent, to $2. Mr. Paulson concluded that the financial system could survive the collapse of Lehman, which has shown signs of weakness for months. The rapid deterioration of Bear Stearns, in contrast, took top officials by surprise last March. And Fannie and Freddie are government-created companies that are simply too large to fail — together they own or guarantee nearly half of the nation’s residential mortgages. As throughout most of the year, Mr. Bush and the White House left most of the details about the crisis to Mr. Paulson, who told reporters at a White House briefing that the problems in the housing markets at the heart of the financial crisis would take months to resolve themselves. “I believe that there is a reasonable chance that the biggest part of that housing correction can be behind us in a number of months,” Mr. Paulson said. “I’m not saying two or three months, but in months as opposed to years.” Mr. Paulson sought to distinguish the government’s decision to provide financial assistance to Bear Stearns last March, as well as to rescue Fannie Mae and Freddie Mac last week, from its rejection of aid requests from Lehman Brothers and A.I.G. “The situation in March and the situation and the facts around Bear Stearns were very, very different to the situation we are looking at here in September,” he said. “I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.” He called the discussions on assisting A.I.G. “a private sector effort.” Still, Mr. Paulson did not reject any future Washington bailouts.

36 Business September 16, 2008 TALKING BUSINESS On Wall Street as on Main Street, a Problem of Denial By JOE NOCERA How can this be happening? How can it even be possible that we wake up on a Monday morning to discover that Lehman Brothers, a firm founded in 1850, a firm that has survived the Great Depression and every market trauma before and since, is suddenly bankrupt? That Merrill Lynch, the “Thundering Herd,” is sold to Bank of America the same weekend? Just months ago, Lehman assured investors that it had enough liquidity to weather the crisis, while Merrill raised some $15 billion over the last year to shore up its balance sheet. Now they’re both as good as gone. Last week, it was Fannie Mae and Freddie Mac that needed a government bailout. This week, it looks as though American International Group and Washington Mutual will be on the hot seat. We have actually reached the point where there are now only two independent investment banks left: Goldman Sachs and Morgan Stanley. It boggles the mind. But it really shouldn’t. Because after you get past the mind-numbing complexity of the derivatives that are at the heart of the current crisis, what’s going on is something we are all familiar with: denial. Indeed, it is not all that different from what is going on in neighborhoods all over the country. Just as homeowners took out big loans and stretched themselves on the assumption that their chief asset — their home — could only go up, so did Wall Street firms borrow tens of billions of dollars to make subprime mortgage bets on the assumption that they were a sure thing. But housing prices did drop eventually. And when people tried to sell their homes in this newly depressed market, many of them had a hard time admitting that their home wasn’t worth what they had thought it was. Their judgment has been naturally clouded by their love for their house, how much money they put into it and how much more it was worth a year ago. And even when they did drop their selling price, it never quite matched the reality of the marketplace. They’ve been in denial. That is exactly what is happening on Wall Street. Ever since the crisis took hold last summer, most of the big firms have been a day late and dollar short in admitting that their once triple-A rated mortgage-backed securities just weren’t worth very much. And, one by one, it is killing them.

37 Take Richard Fuld, the chief executive of Lehman Brothers. Last summer, as the credit crisis first gripped Wall Street, Mr. Fuld’s firm, which was fundamentally a bond-trading firm, concluded that the problems would be short-lived — and that those firms willing to take big risks would be the ones that would reap the big rewards once things calmed down. So Lehman doubled down on mortgage-backed derivatives — not unlike a Florida condo owner buying a second one to flip 18 months ago. Big mistake. Ever since then, Lehman has had a terrible time admitting the magnitude of its mistake — or properly pricing its securities. As mortgage derivatives became increasingly toxic, they also became increasingly illiquid. So firms were left to set their own “mark-to-market” price. And just like so many homeowners, they kept pricing their securities higher than they should have. Earlier this year, for instance, when the hedge fund manager David Einhorn was making his public case against Lehman (he now refuses to talk about the firm), he stressed his belief that Lehman was valuing its securities too high. He turned out to be exactly right. Every time the market was roiled — especially after the Bear Stearns collapse — every firm on Wall Street had to re-mark their securities to reflect the new reality. That’s why you saw firms taking billion-dollar write-off after billion-dollar write- off, long after they thought they had taken care of the problem. And it is also why the write-offs will continue now that Lehman is bankrupt. “Selling begets more selling,” said Sean Egan of the independent bond-rating firm Egan-Jones. And yet, even as they lowered the value of their mortgage-backed securities, firms like Lehman had still priced them too high. Back when he was talking publicly about Lehman, Mr. Einhorn used to cast Lehman’s mark-to-market pricing as an act of dishonesty. I tend to think it was more like wishful thinking. Either way, the result was the same. A week ago, even as the government was bailing out Fannie and Freddie, Mr. Fuld went off to seek new capital — something Lehman desperately needed to shore up its decimated balance sheet — from the Korea Development Bank. Why did those talks break down? Because Mr. Fuld wanted more for Lehman than the Koreans thought it was worth. He simply couldn’t face the reality that his firm wasn’t worth what he thought it was. Now look at his next-door neighbor, John Thain at Merrill Lynch. To be sure, Mr. Thain owned a better house — although Merrill Lynch also had billions in toxic securities, its bread-and-butter is its brokerage arm. It is fundamentally a gatherer of assets, not a bond-trader. But there is another big difference between the firms. Unlike Mr. Fuld, who had run Lehman since 1993 and is the architect of the modern Lehman, Mr. Thain had been at Merrill Lynch just since December, when he was brought in to stanch the bleeding. He didn’t have the same pride of ownership in Merrill that Mr. Fuld had in Lehman. That is why he was willing to sell $31 billion worth of mortgage-

38 backed derivatives for 22 cents on the dollar in late July — far lower than many firms had been pricing those securities. And that is also why, seeing what had happened to Bear Stearns, Fannie and Freddie, and Lehman Brothers, he took the pre-emptive step of selling Merrill Lynch to Bank of America. In the process, he got $50 billion for Merrill’s shareholders. True, that was half of what Merrill was worth a year ago, and a once- proud name is about to be swallowed up by a commercial bank. But he also got $50 billion more than Mr. Fuld got for his shareholders — and being sold is a lot better than being liquidated. It is unlikely that the worst is over. The market Monday dropped more than 500 points, and the government is now trying to keep A.I.G. from going the way of Lehman Brothers, even asking Goldman Sachs and JPMorgan to make some $75 billion in loans available to the struggling insurance giant. And then there’s Washington Mutual. And then ... well, who knows where it will end? Clearly the government is no longer willing to put the taxpayers’ money at risk to save firms that took on too much risk buying securities that they didn’t understand. As painful as it is to see Lehman employees lose their jobs, that is probably a good thing. That is the final parallel that exists between the housing market and Wall Street: the issue of moral hazard. For over a year now, many Wall Streeters have complained about government efforts to forestall foreclosures, saying that it would create the expectation that everyone should be bailed out, and that consequently no one would learn important lessons about the dangers of taking more risk than they could handle. Besides, they added, the housing market was never going to improve until housing prices found their natural bottom. And that wouldn’t happen until the government stopped trying to prop up housing prices. But in truth, you can say the same of Wall Street — it won’t learn any lessons, either, until firms that took foolhardy risks start to fail. One reason Lehman could not find a buyer over the weekend is because potential buyers were insisting on the same kind of taxpayer guarantees that the government had given JPMorgan when it bought Bear Stearns, or when it took over Fannie and Freddie. That’s the essence of moral hazard. When Treasury Secretary Henry Paulson refused to do so, the potential buyers went away. With the government refusing to prop up Wall Street anymore, maybe now mortgage-backed derivatives will find their natural bottom. Something to look forward to, I guess.

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Economist's View

Endgame? by Tim Duy: September 15, 2008 News is flowing in faster than the ability to process the implications. When I went to bed Saturday night, the only sure thing looked like the liquidation of Lehman Monday morning. A scant 24 hours later, to that liquidation is added the sale of Merrill Lynch to Bank of America and, later the possibility of a collapse of AIG by midweek. The Fed and Treasury suddenly play hardball, and the floodgates break open. Fed officials likely now understand the can of worms they opened with the Bear Sterns bailout. At that point, Wall Street realized that attempting to solve their own problems was a sucker’s bet – better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain. Arguably, this is one reason the Lehman issue was allowed to fester for another six months. Moral hazard. With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk). It is looking like the endgame is finally here. To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event. Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost. By now, however, officials probably realize this is a solvency crisis. Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable. A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis). Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around. Instead, the questionable assets need to be eliminated, and some agent needs to accept the loss. Who will that agent be? Wall Street obviously prefers that the taxpayer ultimately absorbs that loss; the Bear Sterns bailout provides the precedence for such an outcome via the Fed’s financial backstop. Repeated Bear Sterns type bailouts would eventually force taxpayers to absorb the losses of the entire crisis and, more importantly, do so without legislative approval. We can cordially debate the appropriateness of taxpayer support, but we should all be clear that that decision needs to be made in a democratic fashion. It is too big an issue for an “ends justify the means argument,” a justification that Bernanke & Co. need to do whatever is necessary to make the trains run on time. Bernanke & Co. likely understand this now, encouraging their hesitation to continue down that road. Of course, if Lehman is forced to liquidate assets, that too has obvious consequences, such as setting prices for those assets that further destabilizes the investment banking community, pushing financial markets

41 to an end game in the crisis. Still, even with that crisis in the making, the Fed has already pushed their legal boundaries; some would argue they have stepped well beyond those boundaries. And it hasn’t stopped – the Fed expanded the collateral it will accept in repo operations, putting taxpayer dollars at risk in a less explicit manner (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?). Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector. Some version of the Resolution Trust Corporation is the most likely outcome. I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation. But to what extend will Congress be willing to perform a hard look as an industry that has brought the illusion of wealth that hides gaping and undeniable equity flaws in the US? The FOMC is gathering this week for a decision on interest rates. I imagine all bets are off regarding the outcome; indeed, we may get an emergency rate cut by the time I get to the office. As of Friday, policymakers were widely expected to keep rates steady; only the language of the statement is in doubt. Specifically, market participants will be looking to validate growing expectations of a rate cut later this year. At issue is the use of the term “significant” to qualify the inflation threat. Given the collapse of commodity prices, there appears to be room to remove that qualifier. I suspected they would be wary, however, of giving hints that a rate cut is in the making – they are probably just now breathing signs of relief that Dollar/commodity dynamic is no longer working against them. They do not need to trigger a fresh run on the Dollar; moreover, Chinese policymakers likely are happy that they foreign currency value of their Dollar assets is on the rise, and do not want a reversal of that situation. After last week’s nationalization of Freddie and Fannie, we can no longer hew to the illusion that policy is based only on domestic considerations. Cutting interest rates, I suspect, will make little if any difference at this juncture. That said, the Fed has delivered a rate cut at each critical juncture of the past year. I am at a loss to convincingly explain why this week is any different. http://economistsview.typepad.com/economistsview/2008/09/fed-watch-end-g.html

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September 15, 2008 What if Lehman files for bankruptcy and nothing much happens? by Willem H. Buiter FT

It now looks likely that, unless the US Treasury blinks and makes public resources available to support a private take-over of Lehman brothers, the investment bank will have to file for bankruptcy. The argument for putting public money into the rescue/take-over by JP Morgan Chase of Bear Stearns was that Bear Stearns was ‘too interconnected to fail’. As the smallest of the investment banks, its systemic significance was argued to derive from the damage that would be done to the rest of the financial system if Bear Stearns were to attempt a last-gasp escape from oblivion through a desperate fire sale of its illiquid assets. A vicious downward spiral of market illiquidity and funding illiquidity could have resulted, dragging down potentially viable financial institutions and causing unnecessary harm to the real economy. Lehman Brothers is larger than Bear Stearns, so what’s different now? One obvious difference is that since the demise of Bear Stearns in March, the Fed has created the Primary Dealer Credit Facility and the Term Securities Lending Facility. These facilities permit financially distressed primary dealer (both Bear and Lehman are/were primary dealers) to use illiquid collateral to borrow from the Fed (overnight Fed reserves in the case of the PDCF, up to a month Treasury Bills in the case of the TSLF). With these market support facilities in place, the threat of a fire-sale of illiquid assets is less daunting. The presence of a market maker of last resort makes it easier for the Fed, the other regulators and the Treasury, to let even household names in the banking world fail. The second obvious difference is that since Bear Stearns crashed, the US Treasury has, through its de-facto nationalisation of Freddie and Fannie, taken an additional $1.7 trillion of debt on its balance sheet, as well as a $3.7 trillion exposure to mortgage- and MBS-guarantees, with a fair value of around $350 bn. The mortgage and MBS assets the Treasury acquired in the deal should not be ignored, of course, but are subject to non-trivial default risk. In addition, the pressures from Congress are mounting already, for the Treasury to restructure these mortgages to minimise the hardship and financial discomfort of the mortgage borrowers. The argument (made by the Congressional leadership) that forgiving part of the mortgage debt (or equivalent measures) would actually increase the present discounted value of the cash flows the Treasury would derive from these mortgages

43 is deeply suspect. I have never seen any evidence that subprime- and alt-A mortgage borrowers are in a debt-trap to such an extent and in such a way that Fannie and Freddie are on the wrong side of the mortgage debt Laffer curve, where the fair value of the debt would increase if part of the notional debt were foregiven. If the US Treasury, either directly or indirectly (say, through the kind of off- balance-sheet vehicle created by the Fed for $30bn of Bear Stearns’ most toxic assets) were to offer financial support for a rescue of Lehman or for any other investment bank (or commercial bank, for that matter), the floodgates could open and the fiscal-financial position of the US Federal government could be materially affected. Japan not that long ago shared a sovereign credit rating with . A trillion here, a trillion there and the US Federal debt could lose its triple-A rating. Another explanation is that the argument in support of the Bear Stearns bail out is wrong, or at any rate is no longer considered true in the US Treasury. If an investment bank is like any other business with a comparable value added, and if the size of an institution’s balance sheet, or the magnitude of its exposure in the contingent claims markets (including the CDS markets), are not the right metrics for the damage to the financial intermediation process and to the real economy that would be caused by the bankruptcy of the institution, then there is no argument for tax payer support for Bear Stearns, Lehman or any other (investment) bank. Or at any rate, no stronger argument than for the tax payer to support US automobile manufacturers, steel manufacturers or manufacturers of garden gnomes threatened with bankruptcy. We may have a test as early as tomorrow morning (Tuesday, 15 September 2005), of whether there are signficant systemic externalities from the failure of a household-name investment bank. I am optimistic that investment banks will turn out to be more like normal businesses than like the negative-externalities-on- steroids painted by the Fed and the Treasury during the Bear Stearns rescue. The frantic attempts by the Fed and the Treasury to broker a private sector rescue/takeover of Lehman sugggest that the monetary and fiscal authorities are not too confident that a household-name investment bank can fail without causing signficant systemic damage. If that is indeed the case, one wonders why, six months after Bear Stearns went belly-up, there still is no special resolution regime (SRR) for investment banks, along the lines of the SRR for commercial banks admininstered by the FIDC and the SRR for Fannie and Freddie admininstered by the Federal Housing Finance Agency (FHFA, the regulator of the GSEs). The Treasury and the US Congress have much to answer for.

44 http://robertreich.blogspot.com/2008/09/why- wall-street-is-melting-down-and.html 15 September 2008

Robert Reich: Why Wall Street is Melting Down, and

What to Do About It by Guest Blogger Robert Reich Hank Paulson didn't blink, so Lehman Brothers went down the tubes. The end of socialized capitalism? Don't bet on it. The Treasury and the Fed are scrambling to enlarge the government's authority to exchange securities of unknown value for guaranteed securities in an effort to stave off the biggest financial meltdown since the 1930s. Ironically, a free-market-loving Republican administration is presiding over the most ambitious intrusion of government into the market in almost anyone's memory. But to what end? Bailouts, subsidies, and government insurance won't help Wall Street because the Street's fundamental problem isn't lack of capital. It's lack of trust. Ironically, a free-market-loving Republican administration is presiding over the most ambitious intrusion of government into the market in almost anyone's memory. The sub-prime mortgage mess triggered it, but the problem lies much deeper. Financial markets trade in promises -- that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, Wall Street can't function. But it's turned out that many promises like these weren't worth the paper they were written on. That's because, when the market was roaring a few years back, many financial players had no idea what they were buying or selling. Worse, they didn't care. Derivatives on derivatives, SIVs, credit default swaps (watch this one!), and of course securities backed by home loans. There seemed no limit to the leverage, the off-balance sheet liabilities, and what credit rating agencies would approve by issuers who paid them to. Two years ago I asked a hedge fund manager to describe the assets in his fund. He laughed and said he had no idea. This meant almost no limit to what was promised. Regulators -- Alan Greenspan in particular -- looked the other way. It worked great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.

45 What to do? Not to socialize capitalism with bailouts and subsidies that put taxpayers at risk. If what's lacking is trust rather than capital, the most important steps policymakers can take are to rebuild trust. And the best way to rebuild trust is through regulations that require financial players to stand behind their promises and tell the truth, along with strict oversight to make sure they do. We tell poor nations they have to make their financial markets transparent before capital will flow to them. Now it's our turn. Lacking adequate regulation or oversight, our financial markets have become a snare and a delusion. Government only has two choices now: Either continue to bail them out, or regulate them in order to keep them honest. I vote for the latter. http://www.guernicamag.com/blog/733/robert_reich_why_wall_street_i/

46

The fruit of hypocrisy Dishonesty in the finance sector dragged us here, and Washington looks ill- equipped to guide us out

Joseph Stiglitz Tuesday September 16 2008 Houses of cards, chickens coming home to roost - pick your cliche. The new low in the financial crisis, which has prompted comparisons with the 1929 Wall Street crash, is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers. We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures - yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail. Eventually, however, we were always going to learn how big the safety net was. And a sign of the limits of the US Federal Reserve and treasury's willingness to rescue comes with the collapse of the investment bank Lehman Brothers, one of the most famous Wall Street names. The big question always centres on systemic risk: to what extent does the collapse of an institution imperil the financial system as a whole? Wall Street has always been quick to overstate systemic risk - take, for example, the 1994 Mexican financial crisis - but loth to allow examination of their own dealings. Last week the US treasury secretary, Henry Paulson, judged there was sufficient systemic risk to warrant a government rescue of mortgage giants Fannie Mae and Freddie Mac; but there was not sufficient systemic risk seen in Lehman. The present financial crisis springs from a catastrophic collapse in confidence. The banks were laying huge bets with each other over loans and assets. Complex transactions were designed to move risk and disguise the sliding value of assets. In this game there are winners and losers. And it's not a zero-sum game, it's a negative-sum game: as people wake up to the smoke and mirrors in the financial system, as people grow averse to risk, losses occur; the market as a whole plummets and everyone loses. Financial markets hinge on trust, and that trust has eroded. Lehman's collapse marks at the very least a powerful symbol of a new low in confidence, and the reverberations will continue. The crisis in trust extends beyond banks. In the global context, there is dwindling confidence in US policymakers. At July's G8 meeting in Hokkaido the US delivered assurances that things were turning around at last. The weeks since have done nothing but confirm any global mistrust of government experts.

47 How seriously, then, should we take comparisons with the crash of 1929? Most economists believe we have the monetary and fiscal instruments and understanding to avoid collapse on that scale. And yet the IMF and the US treasury, together with central banks and finance ministers from many other countries, are capable of supporting the sort of "rescue" policies that led to economic disaster in 1998. Moreover, it is difficult to have faith in the policy wherewithal of a government that oversaw the utter mismanagement of the war in Iraq and the response to Hurricane Katrina. If any administration can turn this crisis into another depression, it is the Bush administration. America's financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing - for instance creating products that help Americans manage critical risks, such as staying in their homes when interest rates rise or house prices fall - and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system - toxic mortgages and the practices that led to them - were exported to the rest of the world. It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America's best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system. Unfortunately, they were far too successful, and we are all - homeowners, workers, investors, taxpayers - paying the price. · Joseph E Stiglitz is university professor at Columbia University and recipient of the 2001 Nobel prize in economics josephstiglitz.com http://www.guardian.co.uk/commentisfree/2008/sep/16/economics.wallstreet?gusrc=rss&feed =commentisfree

48

Lehman v Argentina by Brad Setser http://blogs.cfr.org/setser/2008/09/16/lehman-v-argentina/#comment-112661 Posted on Tuesday, September 16th, 2008 I am guilty of instinctively comparing large defaults to the Argentina’s default. That is the largest default that I know well. And Lehman qualifies as a large default. John Jansen reports one of Lehman’s bonds now trades at 35 cents of on the dollar. That a bit above the levels that Argentina’s bonds traded at after Argentina’s default in late 2001. But Argentina’s bonds also eventually proved to be worth something like fifty cents on the dollar, at least to investors who participated in Argentina’s exchange and got the GDP warrant.* Lehman’s bankruptcy filing indicates that Citi is a trustee for $138b of Lehman bonds, and the Bank of New York is a trustee for another $17b. The resulting $155b in outstanding bonds significantly exceeds Argentina’s outstanding stock of bonds at the time of its default. And investors had far longer to adjust their portfolios in anticipation of Argentina’s default than in anticipation of Lehman’s default. I continue to believe that the credit markets’ reaction to Lehman will ultimately matter more than the reaction of the equity markets. John Jansen reports that the spreads on Morgan Stanley and Goldman have widened significantly. Evans-Pritchard reports (hat tip naked capitalism): The interest rate on Tier 1 debt for typical banks has jumped by 125 basis points since Friday. “This is a violent effect,” said Willem Sels, credit strategist at Dresdner Kleinwort.

Michael Lewis seems to be thinking along similar lines. As important as it seems right now on Wall Street, this isn’t a day that most Americans will remember as all that big of a deal. When Lehman Brothers Holdings Inc. goes out of business, the reaction of the average citizen is either “Lehman who?” or, “I heard of them! What do they do?” It is a big deal, however, but not because some bond traders are out of work, or that puff pieces in business sections about Dick Fuld’s survival skills turned out to be wrong. It’s a big deal because this is the day that American financiers, from the point of view of the Asians who sit on top of the world’s biggest pile of mobile capital, became a bad risk. And yes, the Bank of China seems to have a bit of exposure to Lehman. It also presumably has additional exposure to other US financial institutions (The BoC has by far the largest external portfolio of the Chinese state banks)

49 Widening spreads though only really bite when debt actually has to be refinanced. AIG seems to be facing some rather more immediate pressure from its swap counterparties. More in the morning … UPDATE: John Jansen reports Morgan Stanley’s credit spread has widened significantly and LIBOR is way way up. LIBOR may now be the rate that banks don’t lend to each other at, but the banks do need funding. * I am doing this from memory; I have not checked the recent price for Argentina’s par bond and its GDP warrant recently. Do not hold me to an exact number. Argentina’s spread has widened recently, so I wouldn’t be surprised if Argentina’s par is now worth somewhat less than it was at some points in the past. This entry was posted on Tuesday, September 16th, 2008 at 1:32 am and is filed under Systemic Risk. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. Responses to “Lehman v Argentina” moldbug3 (September 16th, 2008 at 2:55 am ) Says: I never thought I’d say this, but Paul Krugman is right. As I said here something like a year ago: nationalize it. Nationalize it all. There is no other cure. If you just let the system try to liquidate itself, there is not a bank, a shadow bank, not any maturity-transforming entity or credit insurer, which is solvent. I admire Paulson’s courage, but he is cutting off his face to spite his face. Unfortunately, it’s our face too. Nationalization is just a recognition of reality. When first the conventional banking system, then the shadow banking system, was permitted to borrow short and lend long,

3 Mencius Moldbug es un blogista “anarco-digital”, cuyo manifesto político (inspirado en Richard Dworking, pero mucho más radical) se resume así: “The basic idea of formalism is just that the main problem in human affairs is violence. The goal is to design a way for humans to interact, on a planet of remarkably limited size, without violence. ... The key is to look at this not as a moral problem, but as an engineering problem. Any solution that solves the problem is acceptable. Any solution that does not solve the problem is not acceptable. ... A further difficulty is that the definition of “violence” isn’t so obvious. If I gently relieve you of your wallet, and you chase after me with your Glock and make me beg to be allowed to give it back, which of us is being violent? Suppose I say, well, it was your wallet – but it’s my wallet now? This suggests, at the very least, that we need a rule that tells us whose wallet is whose. Violence, then, is anything that breaks the rule, or replaces it with a different rule. If the rule is clear and everyone follows it, there is no violence. In other words, violence equals conflict plus uncertainty. While there are wallets in the world, conflict will exist. But if we can eliminate uncertainty – if there is an unambiguous, unbreakable rule that tells us, in advance, who gets the wallet – I have no reason to sneak my hand into your pocket, and you have no reason to run after me shooting wildly into the air. Neither of our actions, by definition, can affect the outcome of the conflict.”

50 it was nationalized. The Fed issued informal options which guaranteed holders of bank liabilities that they held risk-free securities. The spread of this informal protection - the Greenspan put - to all liabilities of major financial institutions was inevitable. And extremely profitable, while it lasted. Basically, the Fed needs to issue FRNs corresponding to the present market value of all the informal Greenspan puts it issued. If you held a liability from a bank or shadow bank, that liability was hedged by an informal Greenspan option. There is one simple way to close out these securities: buy the entire public financial industry, banking and shadow banking and double-secret super-shadow banking, at its present market cap. Ie, take it onto the Fed’s book. It should have been there all along. When Americans borrowed to buy a house, they were borrowing from Uncle Sam. When they lent to a bank, they were lending to Uncle Sam. For those who think that any such massive nationalization must be “inflationary,” consider: nationalization of any asset class at the current market price is portfolio-neutral. Everyone’s statement will show the same number it showed on September 16, or whatever day is chosen as the flag day. (It could even be a day in the past.) It is only the positions that will change: from non-cash to cash. Since this increases no one’s purchasing power, how can it cause any price increase? Who is bidding up what? Nationalizing the financial industry by printing new dollars would not really be a dilution of the dollar. It would be a recognition of the existence of a large number of informal dollar options that were issued, in the form of the Greenspan put, over the last n years. (Arguably, n = 314. But I digress.) It is those options that were the dilution. That horse is long out of the barn. The Greenspan options are now in the money. They are getting more in the money. The Fed can either dishonor them, leaving its partners in the scheme to hold the bag and causing massive societal suffering, or honor them, accepting its own ultimate responsibility for the excesses it promoted and protected for so many years. I wouldn’t bet on it being taken, but I think the righteous choice is clear. Paulson and Geithner’s Mellonian liquidation strategy, while obviously sincere and in fact incredibly brave, especially by the standards of Washington today, is more or less the equivalent of a drug lord getting off by turning state’s evidence against his distributors. True responsibility for the crisis starts at the center. Even more courage is needed. Of course, if nationalization signals an intention to repeat the process ad infinitum, and print the dollar into toilet paper, speculators will anticipate the degringolade. But if it signals a new era in which there will be *no* official protection of lenders, formal or informal, and the quantity of dollars outstanding is permanently fixed, gold will hit $100. And it will suck to be me, but who cares? Of course, if the present hyperdeflation is allowed to run its course, gold will hit $100 anyway. But it won’t. You simply can’t have 1000 bank failures. Congress will act, if no one else does. So what we’re looking at is more carnage, more bandaids, and an eternal future of lending in which the loan officer is Uncle Sam. Or possibly Barney Frank. Interest rates will fall, not rise as they would in a true liquidation. And what we’ll see is not hyperinflation or hyperdeflation, but hyperstagflation. Does anyone want this? If so, why do we seem to be going there?

51

First Men, Then New Rules Can Rescue Wall Street Commentary by Amity Shlaes

Sept. 16 (Bloomberg) -- Paulson. Merrill Lynch. Lehman. Bernanke. Names are what investors start talking about at moments like this. Names, the faith is, will rescue Wall Street and by extension the U.S. economy. When a market crash is big enough, people are too panicked to think about the technicalities of reform. They think about the names they are losing and the names who, they hope, will save the day. Names certainly have their uses in tense moments like this one. But only rules can bring the markets back in the longer run. Consider the analogy most mentioned as markets take in Treasury Secretary Henry Paulson's decision to cut off Lehman Brothers Holdings Inc.: the Panic of 1907. Then a name, J.P. Morgan, pulled fellow bankers and the Treasury together, putting forward a plan to supply cash so banks wouldn't fail. The Lehman of the day was Knickerbocker Trust. The Dow Jones Industrial Average lost about half its value, and Knickerbocker Trust faded. But the Wall Streeters succeeded. Men, it was said, had saved the Street. But what made World War I and the 1920s more manageable was the existence of new institutions, not men. The Federal Reserve Act became law in 1913. The Fed's initial structure was imperfect, a fact that would become more than apparent in the early 1930s. But the Fed did help stabilize the economy in the critical intervening decade and a half since 1913. Then new names could rise to take the place of the old in the U.S. economy. Among the most important of these was Henry Ford. Heroic Roles Today, too, men have played heroic roles. Paulson will go down in history as the Treasury secretary who could say ``no.'' But maybe it was too many heroes on the stage that got us to this point. Former Federal Reserve Chairman Alan Greenspan assumed the rank of deity in the last decade of his tenure. In hindsight, his task would have been simpler and more transparent had he not been required to advance the Fed's two conflicting mandates: keeping employment high and inflation low. Another set of big names, Moody's Investors Service and Standard & Poor's, were at the heart of the buddy-buddy system that led to problematic credit ratings.

52 And while Paulson stood firm with Lehman, he has courted conflict by formatting Treasury's takeover of Fannie Mae and Freddie Mac as a conservatorship, a legal structure to keep the businesses open. Three Rules Conservatorship, as Peter Wallison of the American Enterprise Institute has pointed out, suggests a postponement of the reckoning of Fannie's and Freddie's value. Had Paulson insisted on a receivership instead, the shock of Fannie's and Freddie's takeover by the government might have been greater at first. As markets have since shown, even conservatorship didn't provide stability. At least three rules-based reforms cry out for implementation: First, no more bailouts. Otherwise, it is already clear, the auto companies will be next. The airlines are also in line. Heck, you can even give this reform a name: The Lehman Rule -- and then hope that the Treasury abides by it. One reason the Dow drooped during Paulson's press briefing yesterday was that he seemed to be indicating he might break the rule soon. Second, clean up the rating system so that numbers speak something closer to the truth. Death of Banker Third, make the U.S. more competitive by lowering corporate taxes and other levies so foreign firms will want to fill our new vacuum. The worst thing about John McCain's new ``crisis'' advertisement is that it suggests a strong man -- and not a strong country -- is the answer. Here President George W. Bush's response, that he had faith in our economy, was more useful. Back in the 1990s, when life had a much different texture, the financial historian Ron Chernow published a book called ``The Death of the Banker.'' His thesis was that market securitization had replaced the need for the individual relationship with one's trusted adviser at the desk. There will be some now who call for the return of the banker. Sure, we need heroes at this hour. But it's probably best to keep that old fellow in the morgue. Better rules will lay the quickest path to recovery, and keep markets alive. (Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.) To contact the writer of this column: Amity Shlaes at [email protected] Last Updated: September 16, 2008 07:39 EDT http://www.bloomberg.com/apps/news?pid=20601039&sid=aVYZYAiyc0Gw&refer=home

53

Bailouts Revisited September 15, 2008

Author: Lee Hudson Teslik

Analysts wonder whether U.S. Treasury Secretary Henry Paulson's bailout of mortgage giants Fannie Mae and Freddie Mac will be the Treasury's last in the current upheaval. (AP/Susan Walsh) Earlier this year, with Bear Stearns teetering on the verge of collapse, Uncle Sam stepped in. The New York Federal Reserve provided the investment bank an emergency loan, saying the money would prevent an all-out collapse—and whatever market turmoil might follow. It wasn't an investment so much as an insurance policy, and global markets generally reacted positively to the cautious approach. Six months later, Lehman Brothers, an older and significantly larger bank, found itself in a similarly dire predicament. This time around, however, the Treasury declined to help. The refusal sent Lehman reeling. On September 15, the firm announced it would make the biggest bankruptcy filing in history (Bloomberg) after a handful of prospective buyers signaled they were no longer interested in a buyout. Meanwhile, Merrill Lynch, another of Wall Street's behemoths, agreed to a snap $50 billion takeover bid (WSJ) from Bank of America. The Financial Times called it "one of the most radical reshapings in Wall Street history."

Washington's cold shoulder leaves two major questions for market watchers:

1) Why is the U.S. government taking a hands-off approach with Lehman when it was quick to bail out Bear?

54 2) What will the aftermath of Lehman's collapse look like, and what will it mean for global markets?

The answer to the first question, experts say, relates mostly to nitty-gritty market mechanics. The Financial Times reported last week that Bear Stearns, despite being a smaller firm, in fact posed a greater risk to financial stability than did Lehman. The reasons for this included Bear's deep involvement in the credit default swap market, its prime brokerage business, and its role in the financial clearing system.

A more basic factor also comes into play, and helps answer question #2 as well as question #1. Since Bear's collapse, a variety of reforms have been made that alter how the Treasury and the Federal Reserve operate. The FT's Peter Thal Larsen noted in a video analysis before Lehman's collapse that the six months following Bear Stearns allowed global markets to factor in the idea of a large bank collapsing, so the impact of losing Lehman is potentially less devastating than the shock of Bear's rapid demise. Even so, the news of Lehman's bankruptcy shook global markets on September 15, sending equities worldwide falling sharply (WSJ), particularly in the financial sector. The collapse also spotlights the high level of insecurity among other major U.S. financial institutions. Washington Mutual has been hobbled of late (Forbes) by loan defaults, and on September 15 the insurance giant AIG required emergency government authorization to loan itself $20 billion (NYT) in order to stabilize its operations. Above and beyond lingering concerns over liquidity and mortgage-backed debt, the collapse of Lehman could create new problems for financial firms. Analysts say unwinding all the financial contracts tied to the bank in an orderly manner will be no small task.

The current upheaval also gets at a broader question. Following the federal bailout of mortgage finance companies Fannie Mae and Freddie Mac, when are U.S. taxpayers best served by letting dying companies die naturally, and when is an intervention advisable? Lehman's struggles seem to show the limits of the Treasury's willingness to use taxpayer money to protect a private institution. Analysts, including CFR's Sebastian Mallaby, have argued convincingly (WashPost) that the Fannie-Freddie nationalization was advisable, given the collateral damage the demise of those firms could have wreaked on markets. In a panel analysis of the Fannie-Freddie bailout, another CFR scholar, Amity Shlaes, argued the success of the move would be largely determined by whether the Treasury and White House were able "to draw a bright line that says, 'no more bailouts after this point.'" Lehman's downfall appears to represent the government attempting to draw just this line.

55

No alternative to nationalisation By Martin Wolf Published: September 8 2008 18:13 | Last updated: September 8 2008 18:13 A Republican administration has nationalised Fannie Mae and Freddie Mac, though it is nationalisation with US characteristics. As a result, US housing finance has been brought under direct government control and, in the process, the gross liabilities of the US government, properly measured, have increased by $5,400bn (€3,800bn, £3,000bn), a sum equal to the entire publicly held debt and 40 per cent of gross domestic product. Yet the administration is merely recognising the reality that these “government sponsored enterprises” were undertaking a public purpose, at the public’s risk, though not without dispensing vast rewards to management along the way. That is a scandal. Whether the body politic will recognise it remains unclear. Since this is a bipartisan mess, the likely answer is No. So what has the administration done? Was there an alternative? Will it work? What lessons should be learned? Formally, the Treasury has put the two institutions into a “conservatorship”, which means they are no longer run in the interests of the shareholders; it has established “preferred stock purchase agreements”, to ensure that each company retains a positive net worth; it has created a new secured lending credit facility for the GSEs and the Federal Home Loan Banks; and, finally, it is initiating a “temporary program to purchase GSE mortgage-backed securities (MBS)”. The aim, in the words of Henry (Hank) Paulson, US Treasury secretary, is “to protect the stability of the financial market, and to protect the taxpayer to the maximum extent possible” (the latter being notably ominous words). More specifically, the hope is that the “GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 per cent per year”. Was there an alternative to such measures? I am talking here not of the precise details, but of the broad decision. The answer is No, for two reasons. First, the institutions were unable to raise the capital they needed to offset the losses on their lending in the collapsing US housing market. This threatened their access to finance. That, in turn, would have drastically curtailed their lending, which accounted for more than 80 per cent of US housing finance earlier this year. The result would have been even swifter declines in house prices and a deeper decline in domestic spending. The former might be no bad thing; the latter surely would be. Second, the liabilities of these enterprises were held widely abroad, particularly by central banks and governments. A failure to guarantee these liabilities would have shaken confidence in the US government and currency, possibly to a devastating extent.

56 Will the measures work? If the aim is to sustain the creditworthiness of the GSEs, the answer is Yes, unless there is a general flight from all US government liabilities. The latter is possible, but extremely unlikely. If the aim is to sustain lending to the housing market, it will, again, work. But it will also slow the needed correction in prices, so creating new losses for those who are persuaded to buy now. Some of those losses will ultimately fall on taxpayers. As the needed correction is slowed, the assumption that the GSE portfolios can be reduced from 2010 seems a fantasy. What, finally, are the lessons, beyond the obvious one that it is idiotic to believe that the prices of any asset class can only go up? It is that the US unwillingness to recognise that socialised risk demands public control has created not just a scandal, but a gigantic mess. The US public has ended up with an open-ended guarantee of the liabilities created by supposedly private entities. It is a bad place to be. As Mr Paulson says: “There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form.” Amen to that. At some point, they will have to be broken up and sold off. Given the state of the housing market, that happy day is a long way off.

Ec

57 Economist's View

September 17, 2008 "Paradigms of Panic" Before getting to the main point, "Paradigms of Panic," it will be helpful to start with some definitions. First, not all bank runs are alike:

Bank runs come in two kinds. In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire. In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We also need to distinguish traditional bank runs from their modern counterparts. Traditional bank runs are fairly familiar and are described in more detail below, but what do modern bank runs look like? Here's an example involving hedge funds from something I wrote in the past. (It's slightly edited. The term "bank-like function" in the first sentence means financial intermediation. Most of the discussion of financial intermediation is about temporal intermediation, i.e. borrowing short and lending long, but intermediaries can also aggregate and smooth risk, aggregate small deposits into large loans, and lower transactions costs):

Entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs. For example, hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market, rumors, etc. But like a bank who lends out most of the deposits it receives and only keeps a fraction of the deposits on hand as reserves, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio maintaining some as a cash reserve. But unless it has substantial cash reserves on-hand, when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off. But if nobody will purchase mortgage-backed securities you are offering, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount. And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems spread as funds try to sell assets to raise the needed cash.

58 So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

And they have been created. Next, the "New World Order" and how to save the free world:

Paradigms of Panic Asia goes back to the future, by Paul Krugman: There were warning signs aplenty. Anyone could have told you about the epic corruption--about tycoons whose empires depended on their political connections and about politicians growing rich in ways best not discussed. Speculation, often ill informed, was rampant. Besides, how could investors hope to know what they were buying, when few businesses kept scrupulous accounts? Yet most brushed off these well-known vices as incidental to the real story, which was about economic growth that was the wonder of the world. Indeed, many regarded the cronyism as a virtue rather than a vice, the signature of an economic system that was more concerned with getting results than with the niceties of the process. And for years, the faint voices of the skeptics were drowned out by the roar of an economic engine fueled by ever larger infusions of foreign capital. The crisis began small, with the failure of a few financial institutions that had bet too heavily that the boom would continue, and the bankruptcy of a few corporations that had taken on too much debt. These failures frightened investors, whose attempts to pull their money out led to more bank failures; the desperate attempts of surviving banks to raise cash caused both a credit crunch (pushing many businesses that had seemed financially sound only months before over the brink) and plunging stock prices, bankrupting still more financial houses. Within months, the panic had reduced thousands of people to sudden destitution. Moreover, the financial disaster soon took its toll on the real economy, too: As industrial production skidded and soared, there was a surge in crime and worker unrest. But why am I telling you what happened to the United States 125 years ago, in the Panic of 1873? And I should break in and note this explanation of how bank panics happen is from 1998. But if you think in terms of modern bank runs rather than bank runs on traditional institutions, the same basic mechanisms apply: ...The logic of financial panic is fairly well understood in principle, thanks both to the old literary classics and to a 1983 mathematical formalization by Douglas Diamond and Philip Dybvig. The starting point for panic theory is the observation that there is a tension between the desire of individuals for flexibility--the ability to spend whenever they feel like it--and the economic payoff to commitment, to sticking with long-term projects until they are finished. In a primitive economy there is no way to avoid this tradeoff--if you want to be able to leave for the desert on short notice, you settle for matzo instead of bread, and if you want ready cash, you keep gold coins under the mattress. But in a more sophisticated economy this dilemma can be finessed. BankBoston is largely in the business of lending money at long term--say, 30-year mortgages--yet it offers depositors such as me, who supply that money, the right to withdraw it any time we like. What a financial intermediary (a bank or something more or less like a bank) does is pool the money of a large number of people and put most of that money into long-term investments that are "illiquid"- -that is, hard to turn quickly into cash. Only a fairly small reserve is held in cash and other "liquid" assets. The reason this works is the law of averages: On any given day, deposits and withdrawals more or less balance out, and there is enough cash on hand to take care of any difference. The individual depositor is free to pull his money out whenever he wants; yet that money can be used to finance projects that require long-term commitment. It is a sort of magic trick that is fundamental to making a complex economy work. Magic, however, has its risks. Normally, financial intermediation is a wonderful thing; but now and then, disaster strikes. Suppose that for some reason--maybe a groundless rumor--many of a bank's depositors begin to worry that their money isn't safe. They rush to pull their money out. But there isn't enough cash to satisfy all of them, and because the bank's other assets are illiquid, it cannot sell them

59 quickly to raise more cash (or can do so only at fire-sale prices). So the bank goes bust, and the slowest-moving depositors lose their money. And those who rushed to pull their money out are proved right--the bank wasn't safe, after all. In short, financial intermediation carries with it the risk of bank runs, of self-fulfilling panic. A panic, when it occurs, can do far more than destroy a single bank. Like the Panic of 1873--or the similar panics of 1893; 1907; 1920; and 1931, that mother of all bank runs (which, much more than the 1929 stock crash, caused the Great Depression)--it can spread to engulf the whole economy. Nor is strong long-term economic performance any guarantee against such crises. As the list suggests, the United States was not only subject to panics but also unusually crisis-prone compared with other advanced countries during the very years that it was establishing its economic and technological dominance. Why, then, did the ... crisis catch everyone by surprise? Because there was a half-century, from the '30s to the '80s, when they just didn't seem to make panics the way they used to. In fact, we--by which I mean economists, politicians, business leaders, and everyone else I can think of--had pretty much forgotten what a good old-fashioned panic was like. Well, now we remember. ... Yet governments are no more stupid or irresponsible now than they used to be; how come the punishment has become so much more severe? Part of the answer may be that our financial system has become dangerously efficient. In response to the Great Depression, the United States and just about everyone else imposed elaborate regulations on their banking systems. Like most regulatory regimes, this one ended up working largely for the benefit of the regulatees--restricting competition and making ownership of a bank a more or less guaranteed sinecure. But while the regulations may have made banks fat and sluggish, it also made them safe. Nowadays banks are by no means guaranteed to make money: To turn a profit they must work hard, innovate--and take big risks. Another part of the answer--one that Kindleberger suggested two decades ago--is that to introduce global financial markets into a world of merely national monetary authorities is, in a very real sense, to walk a tightrope without a net. ... But what worries me ... is the thought that we may have to get used to such crises. Welcome to the New World Order. Update: How to save the free world: Why AIG Must Be Bailed Out, Unsettling Economics: Suppose somebody wants to make a bet with me that the San Francisco 49ers will win the next two Super Bowls. He gives me $100 today, and I have to give him $100 million in case he’s right. The chances of this happening are very small, but just in case the impossible happens I want some backup. I buy insurance from my next-door neighbor. I offer to give him a nickel every week in return for his promise to cover my bet. My neighbor sees that he has a good thing going — getting money for nothing. After a while he takes on more and more bets until others follow in his footsteps. Soon, a market develops. In effect, people can bet on bets. Eventually, the total potential amount of money builds up into the billions and trillions of dollars. Unexpectedly, the San Francisco 49ers win two Super Bowls in a row. My neighbor does not have $100 million on hand to cover my loss. The nickels I have been giving him have been wasted. I don’t have $100 million either. Suddenly everybody in the market is worried about people’s ability to back up their bets. The Federal Reserve steps in and takes over the market. The free world is saved.

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