Tuesday, September 30, 2008

Roundup: September 30


Obama and McCain are shilling for the bailout plan, and making silly proposals about increasing the limit on FDIC insured accounts to $250k, ostensibly to help small businesses.

Interfluidity is pitching a modified debt-for-equity bailout that would partially preserve bank creditors. Credit Slips says the executive compensation limits in the bailout bill that failed to pass yesterday were a "fraud". Buiter says Congress is cutting off our collective noses to spite our faces. Lo and behold, members of Congress who voted for the bailout got more campaign contributions from banks than those who voted against.

Murder on the dance floor, erm, in the money markets. Overnight dollar Libor was fixed at 6.875% yesterday in advance of the quarter (and, for some, fiscal year) end. No interbank lending.

Ireland has guaranteed EUR400bn of liabilities at six banks in order to ease short-term funding pressures. Fitch put Citibank’s AA- rating on negative watch.

Calculated Risk has a great graph breaking down the Case-Shiller house price index declines from the peak by city, and graphs the indices from 1987 to date. Rough estimates of the number of households with negative equity give an estimate of total mortgage losses for lenders between $800bn and $1.3tr.

Steven Davidoff looks at the provisions of the AIG bailout -- structured to avoid any meaningful shareholder say on the fate of the company.

Bain Capital and Hellman & Friedman are buying Lehman's asset manager, Neuberger Berman, for $2.15bn. Lehman was expecting to get $8bn for the unit in the week before its collapse..

Taiwan has banned short-selling of all equities until October 14.

The UK economy did not grow in Q2. Real consumer spending in the US fell 2.7% in Q3.


Ha'aretz comments that Ehud Olmert's interview yesterday, in which he said Israel must withdraw from the occupied territories, is too little and comes too late to make a difference.

Mullah Mohammad Omar has urged US and NATO troops to leave Afghanistan before they face the fate of the Soviet occupation.

There is hope the new administration in Zimbabwe will allow a more sane AIDS policy as NGOs are allowed to resume work. Morgan Tsvangirai has warned that if a government is not established soon the country faces the risk of famine. The CFR has notes on "Planning for a post-Mugabe Zimbabwe."

Mikhail Gorbachev and Alexander Lebedev are forming an independent political party in Russia.


Germany is lobbying for certain heavy industries to be exempt from the new auction format for the European ETS. Partial free allocation of permits threatens to undermine the entire reform of the ETS framework, as national lobbying is the dominant force in strangling EU policy.

The Los Angeles Times publishes an important editorial on the "bursting of the green bubble," which, though misguided in its approach, illustrates the danger that the current economic crisis poses for carbon regulation.

A simple and cheap device can increase the fuel efficiency of diesel engines by as much as 10% and reduce their particulate emissions by as much as 90% by reducing the viscosity of fuel before it is injected.

The Oil Drum runs a good overview of methane capture from coal seams, a practice that reduces greenhouse gases and produces a substantial amount of energy.

The Economist is running a (slightly stacked) debate on water pricing.

It may be snowing on Mars.

Simple Sustainability (2)

Did you know?

The average adult American spends 90% of his daily life indoors. Concentrations of indoor air pollutants usually greatly exceed the maximum tolerances for outdoor ambient air.

Keeping houseplants can improve the quality of your home or office's air, and NASA uses houseplants to filter air on the space shuttle missions.

Further Reading:

A list and brief discussion of houseplants that NASA found effective in cleaning air.
NASA's original paper on houseplants and air quality.

Readings: Tag Murphy

"The lowering of capital costs to industry in Japan is a responsibility of the economic bureaucracy, not of the individual firm. This is in sharp contrast with the American experience, in which, with one glaring exception, the cost of capital to particular sectors of the American economy -- as opposed to a generalized concern about the level of interest rates -- is deemed the province of 'market forces.' The exception is the American housing industry, in which, from the 1930s to the early 1980s, an entire panoply of regulations, artificial interest rate controls, special classes of banks, and favorable tax treatment was employed to achieve the essentially political goal of bringing homeownership within reach of the American middle class. Two generations after the American housing and Japanese industrial policies were initiated, one country had the finest housing on earth and run-down plants suffering from inadequate investment. Meanwhile the citizens of the other country lived in 'rabbit hutches' -- the term used in a notorious European Community study -- and went to work in the world's most automated, well-equipped factories. That this should surprise anyone is itself puzzling."
R. Taggart Murphy, The Weight of the Yen (1997)

Monday, September 29, 2008

Roundup: September 29

The TARP failed to pass in the House today.


Three banks to rule them all: Citigroup, B of A, and JPMorgan now control over 30% of U.S. deposits; the cardinal rule of US bank regulation, that no single bank should control more than 10% of deposits, looks set to pass into history. For all the talk of Wall Street and Main Street, precious few have questioned a bailout strategy that, when the dust settles, will leave an anointed few institutions at the head of a vastly more consolidated banking system -- profit-taking institutions with implicit government guarantees and formidable market power.

The Federal Reserve has increased the size of the TAF by $150bn, and extended its currency swap lines with other central banks by $330bn (to $620bn). The Fed will also hold two special TAF sales in November for a total of $150bn. Money markets are still frozen, however, with Across the Curve reporting there is virtually no term lending available.Tomorrow is the end of many banks' fiscal years, and the end of the calendar quarter; it is also pay day for many corporates which are finding the commercial paper markets closed. The FT reports banks are looking at invoking "market disruption" clauses in their agreements on undrawn credit facilities in order to charge higher rates, as suspicion that Libor is failing to reflect actual funding costs grows. Treasury today opened its Temporary Guarantee Program for money market funds.

Wachovia endured a partial nationalization-cum-takeover by Citigroup, which agreed to buy it over the weekend in a deal brokered by the FDIC. Citi will pay around $2bn for Wachovia's stock ($1/share), will assume its senior and subordinated debt (about $53bn), and, crucially, will take over Wachovia's $312bn loan portfolio, including loans inherited from Golden West. Citi will only be liable for $42bn of losses on the loan portfolio, and the FDIC, in exchange for $12bn of warrants, will insure the rest of the portfolio. Citi will cut its dividend to help finance the deal. AG Edwards is independent again. Paulson said that a failure of Wachovia would have posed a "systemic risk." Charlotte may have seen its days as a financial center pass.

Fortis has been given a EUR11.2bn capital injection by the Benelux governments in exchange for 49% of the bank's operations in their countries. Fortis has been weighed down with debt ever since the ABN Amro buyout last year. Fortis is the largest non-government employer in Belgium, and the largest bank. Willem Buiter has his eye on the prize: this is the most important news today, as it shows Eurozone authorities can work together effectively in a crisis situation. Fears of EMU collapsing after bank failures should be at least slightly allayed.

UK mortgage lender Bradford & Bingley failed over the weekend. Its branch network and retail operations have been bought by Banco Santander, but its 40bn pound mortgage portfolio will be at least partially nationalized and may be merged with the government-owned remnants of Northern Rock. A shocking 85% of its mortgage book was made up of buy-to-let or no-doc loans.

Glitnir Bank, Iceland's third-largest, has been nationalized. Mitsubishi UFG will buy 21% of Morgan Stanley (common and convertible preferreds), with protections against dilution below 20%, for $9bn. German mortgage lender Hypo Real Estate has received emergency loans from the Federal Republic to the tune of EUR35bn, in advance of a rescue package. Dexia's stock fell almost 29% today, leading France's Finance Minister Christine Lagarde to say the government would "take its responsibilities as a stockholder" of the Franco-Belgian bank. (The French government holds 11% of Dexia through the Caisse des Depots.) Belgian Finance Minister Didier Reynders said that the state was ready to help Dexia if necessary.

Ireland's main stock market index was down almost 13% today, with Anglo Irish Bank off 46%. Ireland and Spain are among the European markets most plagued by bad mortgage loans; the European recession has struck there first.

The Big Picture points up another fantastic graphic from the NYT about the bailout, comparing the magnitude of each element of the bailout to normal spending measures in the federal budget.

Econbrowser has a good introduction to the TED spread, a measure of strain in the money markets.

There are substantial practical differences between Gross Domestic Product and Gross Domestic Income, despite their theoretical equivalence. Econbrowser has a primer on the two metrics and explains why our reliance on GDP not GDI may be masking the recession.

Hindsight is 20-20, and consensus is growing that recent dislocations in the credit markets are due to the Lehman failure. Information Processing revisit their previous argument that firms can be too interconnected to fail. Bronte Capital argue the FDIC's seizure of WaMu denied senior debtholders' rights to an orderly liquidation and will make it that much harder for banks to eventually raise funds in the wholesale market -- further delaying the return of private capital to bank business.

Kommersant reports on a new measure that shows real inflation in Russia pushing 40% year-to-date.

The end of the month means it's time for more hedge fund redemptions - even as some funds have pending trades, a total of $13.9bn worth, frozen by the Lehman bankruptcy.


Russia may begin restricting output from its oil reserves, the second-largest in the world, in an effort to prop up prices. Robert Amsterdam publishes an overview, with links, of the history of the energy cooperation between Gazprom, Russia, and Venezuela. It is a must-read primer on the subject, which has led to a major violation of the Monroe Doctrine. Amsterdam also links to an article from the Nezavisimaya Gazeta, in which President Medvedev describes the current organization of the executive branch in Russia as too centralized. The CFR has an interesting video interview between Russian Foreign Minister Sergei Lavrov and New Yorker Editor-in-Chief David Remnick.

Venezuela wants to join the nuclear club, and Russia may help her.

Morgan Tsvangirai continues to hold out hope that a compromise can be reached between the MDC and ZANU-PF parties on ministerial posts, and that the Zimbabwe power-sharing agreement is not doomed. But others are reporting talks are on the brink of failure, particularly with Thabo Mbeki, who brokered the deal, out of office. With 5mn of the country's 12mn expected to require WFP food to forestall famine this year, a dire situation is developing. Even after the redenomination of the Zimbabwe dollar (by 10,000,000x) , the central bank is being forced to print ever higher denomination notes as inflation continues to run rampant and people queue outside banks to withdraw their daily quotas of $20 equivalent.

UNHCR says as many as 20k people have fled across the Afghan border amidst fighting in Pakistan.

Fighting between insurgents and African Union troops in Mogadishu has forced eighteen thousand to flee their homes.


The Senate energy bill, which extended all of the major renewables tax subsidies for one to eight years, was fully funded by the House on Friday. But because of the way in which the bill was packaged, it will have to be reconfirmed by the Senate, which also has the Paulson bailout to think about. This may be the doom of the renewables bill, which would be a disaster for industry, consumers, and the environment alike. In years in which these tax credits have lapsed, we have seen one year declines in investment in the industry of 80% to 90%. Harry Reid was quoted on the Senate floor after passing the first version of this bill that there was no chance of the Senate passing it again.

The Arctic sea ice retreated at the fastest rate in known history for August, melting so fast that, despite a mild June and July, the extent of the sea ice nearly matched last year's historical minimum.

One of Nature's blogs takes a more reasonable look at last week's two press releases about methane clathrates being released in the Arctic. As we pointed out last week, and as this piece does, the actual releases from these two papers indicate that these two incidences of methane plumes are almost certainly long-standing phenomena. Far from confirming that warming is releasing massive amounts of stored methane right now, these papers belong to the process of mapping and understanding exactly what goes on with these deposits.

Walmart plans to cut its plastic bag use by 33% worldwide by 2013, resulting in an annual savings of 9 billion plastic bags and a reduction of 135 million pounds of plastic waste over the next five years.

The Forced Migration Review runs a special issue on displacement due to climate change. "Our generation has failed to live up to its obligations to prevent climate change. We need urgently to prepare now for the human consequences of climate change," writes Craig Johnstone, UNHCR Deputy High Commissioner. One imagines what $700bn, in the right places, in 2002, could have done -- and what, in the right places, today, it might yet do.

The New Scientist describes a policy mistake that has ensured the collapse of the North Atlantic cod fishery for the forseeable future.

An Irish government report stongly urges a carbon tax on fuels and congestion pricing in major cities throughout Ireland. Hear, hear.

Bailout roundup for September 29

The TARP failed to pass in the House today. We review below last-minute responses to the plan.

HSBC analysts say that there are $3tr of troubled assets which might be bought under the TARP.

Nouriel Roubini's critique of the bailout is on point. Steven Davidoff is his usual judicious and skeptical delight. Naked Capitalism and Clusterstock say the changes in the bailout bill are "cosmetic" (and they are).

Interfluidity says at least Paulson was honest about what he wanted. And no financial legerdemain can solve the problems the country faces -- if the TARP passes and the depression still comes, what then?

Brad DeLong argues in favor of straightforward nationalizations. And Carl Icahn argues for more restrictions on executive compensation and corporate governance.

The Economist carries a mealy-mouthed article on the TARP, lamely arguing that it is better to pass a flawed plan now than to force Congress to stay in session for another week. We would underscore the extent to which panic around the TARP has been generated, self-servingly, by Congress and the Administration.

The FEI Financial Reporting Blog looks at the consequences for mark-to-market accounting.

Becker and Posner have lost the thread.

Building Blocks: Introduction to RGGI

Building Blocks aims to provide detailed primers on technical subjects for a non-specialist audience. If there is anything we can do to make them more informative or clearer, please leave a comment.

What is RGGI?

The Regional Greenhouse Gas Initiative (RGGI) is a CO2e cap-and-trade system established for utilities (defined as power generators of 25MW peak capacity or more, about 225 plants) in the Northeastern United States. One permit carries the right to emit one ton of CO2e. Ten states are participating (New York, Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, Rhode Island, and Vermont).

How does the cap work?

Each state gets a certain discretion in setting its own rules for the auctions, but every state has committed to auctioning substantially all of the permits issued, instead of allocating them to different utilities. This is a major difference between the European cap-and-trade system, which allocates substantially all of the permits issued, and, as a result, the European system has depressed prices, made the allocation of permits a political issue subject to lobbying and abuses, and undermined the efficiency of a cap-and-trade system in distributing economic costs. All revenue raised by the auctions is distributed to the states for energy efficiency and renewables development projects.

What is the level of emissions reduction required in RGGI?

Utilities represent about 20% of the CO2e emissions both in the Northeast, and in the U.S. as a whole. As a result, the RGGI is a substantial step toward a comprehensive Northeastern cap-and-trade plan, and it will be hugely important both to prove that cap-and-trade can work in the U.S. and as a model for the nation and the world. Unfortunately, the cap is not very strict, with emissions frozen at 2006 levels until 2014. Then the cap will contract by 2.5% of 2006 levels from 2015-2018, resulting in a drop in emissions of 10% in this sector.

How did the first auction go?

The first RGGI auction for carbon permits was held over the weekend, and results were announced today. It went smoothly, at least. Several states did not finalize rules in time to participate, and will participate in the December auction for the first time. The six states that did participate auctioned off permits that ended up worth about $3.07 per ton of CO2e emitted, roughly one-tenth normal European prices. The $39mn the auction raised for these six states will go for subsidies and investment in renewables and renewables research. The auction sold every permit, against fears that the auction might be undersubscribed because of over-allocation (2006, the baseline year for the cap, turns out to have been a particularly bad year for CO2e emissions).

What is RGGI's role in the future of U.S. carbon regulation?

RGGI is a well-designed model for a U.S. cap-and-trade system, with a good software infrastructure, state-by-state enforcement and discretion, and almost total auctioning of permits. It is already being used as a model for the Western Climate Initiative, a regional cap-and-trade system in the western U.S. and northwestern Canada, comprising seven states and four Canadian provinces. RGGI must prove that: 1) cap-and-trade is highly economically efficient, particuarly on a large scale; 2) the markets can run smoothly and not impact the efficiency of the intraday electricity markets; 3) cap-and-trade can mitigate the economic costs of higher energy prices while redoubling the positive effects of the cap on domestic energy consumption by using its revenues for efficiency and investment.

Further Reading:

The executive summary of RGGI
News from RGGI
The model regulation that the states are following

Simple Sustainability (1)

Did you know?

The standard bathroom faucet uses 2.2 gallons of water per minute (GPM). Switching to a low-flow faucet aerator can reduce this to 0.5GPM, a savings of almost 80%. Under normal daily consumption patterns, this would save 8.5 gallons of water per day for each person using the faucet, or over 12,000 gallons of water in a year for a family that retrofits its faucets with low-flow aerators.

Further Reading:

Here's a quick overview on faucet aerators. It's cheap, easy, and saves loads of water and energy (to heat the water) without placing any burden on you.

Secretary Paulson's enabling act (7)

Nancy Pelosi's news release on the draft bailout bill:


Significant bipartisan work has built consensus around dramatic improvements to the original Bush-Paulson plan to stabilize American financial markets -- including cutting in half the Administration's initial request for $700 billion and requiring Congressional review for any future commitment of taxpayers' funds. If the government loses money, the financial industry will pay back the taxpayers.

3 Phases of a Financial Rescue with Strong Taxpayer Protections

Reinvest in the troubled financial markets … to stabilize our economy and insulate Main Street from Wall Street

Reimburse the taxpayer … through ownership of shares and appreciation in the value of purchased assets

Reform business-as-usual on Wall Street … strong Congressional oversight and no golden parachutes


Democrats have insisted from day one on substantial changes to make the Bush-Paulson plan acceptable -- protecting American taxpayers and Main Street -- and these elements will be included in the legislation

Protection for taxpayers, ensuring THEY share IN ANY profits

Cuts the payment of $700 billion in half and conditions future payments on Congressional review

Gives taxpayers an ownership stake and profit-making opportunities with participating companies

Puts taxpayers first in line to recover assets if participating company fails

Guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit

Allows the government to purchase troubled assets from pension plans, local governments, and small banks that serve low- and middle-income families

Limits on excessive compensation for CEOs and executives

New restrictions on CEO and executive compensation for participating companies:

No multi-million dollar golden parachutes

Limits CEO compensation that encourages unnecessary risk-taking

Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate

Strong independent oversight and transparency

Four separate independent oversight entities or processes to protect the taxpayer

A strong oversight board appointed by bipartisan leaders of Congress

A GAO presence at Treasury to oversee the program and conduct audits to ensure strong internal controls, and to prevent waste, fraud, and abuse

An independent Inspector General to monitor the Treasury Secretary's decisions
Transparency -- requiring posting of transactions online -- to help jumpstart private sector demand

Meaningful judicial review of the Treasury Secretary's actions

Help to prevent home foreclosures crippling the American economy

The government can use its power as the owner of mortgages and mortgage backed securities to facilitate loan modifications (such as, reduced principal or interest rate, lengthened time to pay back the mortgage) to help reduce the 2 million projected foreclosures in the next year

Extends provision (passed earlier in this Congress) to stop tax liability on mortgage foreclosures

Helps save small businesses that need credit by aiding small community banks hurt by the mortgage crisis—allowing these banks to deduct losses from investments in Fannie Mae and Freddie Mac stocks

Readings: Labour

"The Conservatives' failure on housing has been twofold. The two thirds of families who own their homes have suffered a massive increase in insecurity over the last decade, with record mortgage arrears, record negative equity and record repossessions. And the Conservatives' lack of a housing strategy has led to the virtual abandonment of social housing, the growth of homelessness, and a failure to address fully leaseholder reform. All these are the Tory legacy. Labour's housing strategy will address the needs of homeowners and tenants alike. We will reject the boom and bust policies which caused the collapse of the housing market."
New Labour's 1997 manifesto

Friday, September 26, 2008

Roundup: September 26


"There is no disagreement that something substantial must be done," Bush said in this morning's very short address to the markets. "We will rise to the occasion." John McCain, having successfully saved capitalism, will debate Obama tonight.

Washington Mutual will go down as the largest bank failure in history after the FDIC engineered the sale of its deposits and some branches to JPMorgan for $1.9bn last night. Biggest in nominal terms, anyway, and, what's more, the FDIC's insurance fund will not take a hit from the failure. JPMorgan offered $7bn for WaMu a few months ago. It seems CEO Killinger may have pulled a "Fuld." Relatedly, Wachovia CDS movements indicate that it may be the next to fall, as many have speculated for months.

Bloomberg runs its second of two pieces in an excellent series on the role of the ratings agencies in the fraudulent or incompetent ratings of MBS. This is crucial reading for anyone interested in the financial history of the last seven years.

Brad Setser points out that the Fed has loaned out on the order of $300bn+ in the past two weeks. Australia's Office of Financial Management will buy as much as AUD4bn of RMBS to try to unfreeze the market in those assets.

Nearly 20% of the S&P 500 -- and 1 in 7 of all listed stocks -- is now covered by the short-selling ban, including IBM and Ford. The convertible bond market has effectively shut down as dealers in convertibles are no longer able to hedge against the underlying. "The short ban is the new Borg." Steven Davidoff picks up some of the pieces from the last week.

California house prices fell 41% in August, pushed down by foreclosure sales. Calculated Risk looks at the house price estimates JPMorgan used to calculate its writedowns on the Washington Mutual purchase -- these include worst-case forecasts of up to 8% unemployment. There's a great chart of house prices against household income too.

The Hudson Institute published its useful monthly overview of major economic indicators. This is one-stop shop for the past month's critical economic statistics.

The Dry Ships Index bodes ill for the world economy.


It is the anniversary of the monks' uprising in Burma.

Poland, Ukraine, and a variety of other formerly Soviet countries are calling for the UN and NATO to keep closer tabs on Russia.

Robert Mugabe spoke to the United Nations, blaming sanctions for Zimbabwe's economic collapse, as opposed to state-imposed famine, a massive unrecognized AIDS epidemic, or any of the various other crimes he has perpetrated as President. The New York Times carries a revealing interview with Mahmoud Ahmadinejad.

There is some speculation that the ruling ANC in South Africa may split in the wake of Thabo Mbeki's resignation from the presidency.

US troops exchanged fire with Pakistani forces yesterday on the Afghan border, in the continuation of what has been an under-reported near-shadow war along the border in the last month.

The ongoing shortage of gasoline in the Southeast in the wake of Hurricane Ike has led to more panic buying and long queues.


World CO2e emissions were up 3%in 2007 over 2006, worse than the worstcase scenario from the IPCC's last report. Under this scenario, temperatures could rise by as much as 11 degrees Fahrenheit by 2100, far beyond the catastrophic threshold of 3 to 4.

More methane plumes have been discovered in the Arctic, on the tail of Wednesday's reports of methane bubbling up in Siberia. If the Arctic permafrost begins to melt, it is possible enough methane will be released to trigger a positive feedback loop whose contribution to warming might quickly outpace all human greenhouse gas production -- this is the most important of the doomsday climate change scenarios. It must however be mentioned that some Arctic methane release is normal at all times. It is unknown where these normal sources of arctic methane are or what their sensitivity is to Arctic environmental conditions.

The EU will ban mercury exports from all of its member states starting in 2011.

The Brookings Institution looks at the presidential candidates' stances on transportation.

The Oil Drum runs a primer on winter gasoline blends and why gas prices drop in cooler weather.

This graph of CO2 emissions per passenger mile for various forms of transport provides a fantastic resource for non-specialists to look at their transportation emissions.

Readings: Keynes (1)

"The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market."
John Maynard Keynes, The General Theory of Employment, Interest and Money (1936)

Secretary Paulson's enabling act (6)

There are reports this morning that John McCain was the sticking point in yesterday's bailout talks. Below is the text of a draft agreement on principles published by the WSJ's economics blog. Everything rests on the specific provisions of 1.b., of course; and yet it's 1.a. that is likely to get the drums beating.

1. Taxpayer Protection
a. Requires Treasury Secretary to set standards to prevent excessive or inappropriate executive compensation for participating companies
b. To minimize risk to the American taxpayer, requires that any transaction include equity sharing
c. Requires most profits to be used to reduce the national debt

2. Oversight and Transparency
a. Treasury Secretary is prohibited from acting in an arbitrary or capricious manner or in any way that is inconsistent with existing law
b. Establishes strong oversight board with cease and desist authority
c. Requires program transparency and public accountability through regular, detailed reports to Congress disclosing exercise of the Treasury Secretary’s authority
d. Establishes an independent Inspector General to monitor the use of the Treasury Secretary’s authority
e. Requires GAO audits to ensure proper use of funds, appropriate internal controls, and to prevent waste, fraud, and abuse

3. Homeownership Preservation
a. Maximize and coordinate efforts to modify mortgages for homeowners at risk of foreclosure
b. Requires loan modifications for mortgages owned or controlled by the Federal Government
c. Directs a percentage of future profits to the Affordable Housing Fund and the Capital Magnet Fund to meet America’s housing needs

4. Funding Authority
a. Treasury Secretary’s request for $700 billion is authorized, with $250 billion available immediately and an additional $100 billion released upon his or her certification that funds are needed
b. final $350 billion is subject to a Congressional joint resolution of disapproval

Writing blank checks

As the nation debates giving $700bn of emergency authorization to an executive agency in a situation of extremely asymmetric information, let's take a look back at the way this administration has spent money in Iraq to stabilize another grave and uncertain situation. Just for kicks. Ed Harriman covered the story for the LRB:
On 12 April 2004, the Coalition Provisional Authority in Erbil in northern Iraq handed over $1.5 billion in cash to a local courier. The money, fresh $100 bills shrink-wrapped on pallets, which filled three Blackhawk helicopters, came from oil sales under the UN’s Oil for Food Programme, and had been entrusted by the UN Security Council to the Americans to be spent on behalf of the Iraqi people. The CPA didn’t properly check out the courier before handing over the cash, and, as a result, according to an audit report by the CPA’s inspector general, ‘there was an increased risk of the loss or theft of the cash.’ Paul Bremer, the American pro-consul in Baghdad until June last year, kept a slush fund of nearly $600 million cash for which there is no paperwork: $200 million of this was kept in a room in one of Saddam’s former palaces, and the US soldier in charge used to keep the key to the room in his backpack, which he left on his desk when he popped out for lunch. Again, this is Iraqi money, not US funds.
Ed Harriman, Burn Rate (LRB, 6 September 2007)
Ed Harriman, The Least Accountable Regime in the Middle East (LRB, 2 November 2006)
Ed Harriman, Cronyism and Kickbacks (LRB, 26 January 2006)
Ed Harriman, Where has all the money gone? (LRB, 7 July 2005)

Thursday, September 25, 2008

Secretary Paulson's enabling act (5)

With his characteristic lucidity, Lucian Bebchuk has written a very short paper (13pp) which says (almost) everything that needs to be said about the Paulson bailout proposal from a policy perspective. If you read only one thing this week about the bailout, make it this.

Edit: Bebchuk makes his case in Friday's WSJ.

Bebchuk limits himself to the premises and scope of the action proposed this week by Treasury: given, in other words, that the plan is proposed in good faith (i.e., it is not an attempt to distribute largesse to selected firms or actors, it is not a power-grab by Treasury or Paulson personally, it is not an attempt to buy the election for McCain, etc.), how ought it to be designed?

The pricing problem
Bebchuk states plainly the fundamental hypothesis about the state of the financial markets that underlies the policy proposal:
Because of the substantial presence of these illiquid troubled assets on the balance sheets of financial firms, the Treasury believes, financial firms have difficulty raising capital, are subject to risks of creditor runs, and are reluctant to carry out fully their role in financing the real economy....

The Treasury believes… that financial firms cannot currently sell these assets even at their reduced fundamental value… money managers that would otherwise be willing to purchase financial assets at any price below their fundamental value do not have sufficient liquidity to keep prices at fundamental values.
Given this premise, the problem is then, straightforwardly, a) whether government should introduce the needed liquidity into the markets (as opposed to private actors), and, b) how the assets to be purchased are to be priced.
The current plan gives Treasury the “freedom to confer massive gifts on private parties,” and so Bebchuk suggests at a minimum that the statute be altered to require Treasury to pay no more than fair value for troubled assets.

That begs the practical question, though, how fair value is to be assessed. “A situation in which a Treasury in-house official bargained one-on-one with a financial firm over the value of an asset would raise serious concerns.” It is nearly impossible to imagine how Treasury could assess the hold-to-maturity value of $700bn in complex securities under the time constraints supposed to be operative — Paulson has in his testimony to Congress suggested that Treasury might need to exercise the full $700bn of authority during the Congressional recess — even were the distribution of the performance of the underlying assets known. In this case, to value the underlying requires an additional prospective judgment about the macroeconomy (and in the case of individual mortgage pools, of particular market segments or regions) at a time of profound uncertainty: that is, at a time when Bush is going before the American people to warn, essentially, of the Great Depression. And exercising any effective oversight over those judgments would be difficult or impossible.

Nor do the sellers of these assets need to misrepresent their value in order to game an auction process. Even if Treasury bids as often overestimate as underestimate the value of assets for sale, sellers need only accept the high bids and reject the low.
And, realistically, the feasibility of and incentives for collusion are high: these assets are concentrated in the hands of relatively few actors, who are capable of coordinating their auction behavior.

Bebchuk therefore proposes dividing the pool of liquidity to be injected into the market among perhaps twenty managers: that is, rather than Treasury acting as a single buyer, funding an artificial market for the assets to be purchased. Competition amongst the managers could serve as a check on the price of the assets; and each manager could be incentivized based on the final profits of their fund. Bebchuk even suggests that qualified managers be asked to bid the profit cut they would be willing to accept for the privilege. Since Bill Gross has said in public he would manage Treasury’s fund for free, it shouldn’t be hard to find qualified people.
The point, of course, is that it’s possible to write stronger — much stronger — protections of taxpayers into legislation that accomplishes Paulson’s stated aims.

The capital problem
Bebchuk asks us to separate the asset-pricing question — a question, if Treasury is correct, of liquidity — from the question whether, independent of the illiquidity of asset markets, financial firms are undercapitalized. Providing capital to those that are is a legitimate aim of policy, but should be done “directly, aboveboard, and for consideration.” Capital infusions, in other words, should be and can be priced separately from asset purchases.

Bebchuk therefore proposes allowing Treasury to purchase newly issued securities from financial firms. This is superior to providing capital by overpaying for assets because it would compensate taxpayers for their transfers to banks; but also because the capital firms require may not be in proportion to their holdings of illiquid assets.

Bebchuk appears not to have read the Dodd proposal — since the equity participation granted to government under that plan would vest after the final asset sales, in a proportion of 125% of the shortfall, it is not subject to his criticism that under plans which give government equity, “government would still need to assess how much it is overpaying for the purchased troubled assets and what new equity tickets would provide adequate consideration for the amount overpaid.” But other problems (like the consequences of outstanding, hard-to-value, undilutable Dodd obligations on the books of financial corporations that might wish to undertake corporate actions) make his plan to untie equity from asset purchases preferable.

The problem is, of course, that while it is true that “some financial firms would need a capital infusion but would not wish to make significant use of the government’s willingness to purchase troubled assets,” this is precisely what Paulson’s plan is designed to obfuscate. Which is why Bebchuk does a third, greater service in setting things out so plainly.

Persecution and the art of writing
Hobbes writes:
Feare, without the apprehension of why, or what, PANIQUE TERROR; called so from the fables that make Pan the author of them; whereas in truth there is always in him that so feareth, first, some apprehension of the cause, though the rest run away by example; every one supposing his fellow to know why. And therefore this Passion happens to none but in a throng, or multitude of people.
Bebchuk’s criticism is constructive, in that his plan is designed to Treasury’s stated objectives better than Paulson’s. But it is also illustrative: of the hasty and unclear thinking which is dominating a hasty and unclear legislative effort; of the disparity between the rhetoric of crisis employed by the administration and the actual shape of their plan.

That is, in times of panic it can be useful to write as if panic were not a factor in human affairs: because it is only then that one can begin to ask how, and to what ends, that panic has been fostered and turned. Make no mistake that President Bush’s address to the nation was on the order of shouting fire in a crowded theater; as the old Leninists used to say, it was an attempt to “sharpen the contradictions:” and railroad Paulson’s plan through Congress.

Qui bono?

Abu Ghraib

It is worth revisiting the TED talk by Phillip Zimbardo if only to see a few of the photos from Abu Ghraib again, to remember exactly what this country, under this administration, has done.

Phillip Zimbardo organized the Sanford Prison experiment in 1971, and the talk also contains an interesting run-through of the study, as well as a good runthrough of Stanley Millgram's electrocution study from the early '60s.

If you only have five minutes, skip to the middle of the Abu Ghraib section on the video and watch it twice. We are also linking the two seminal New Yorker features, the article by Seymour Hersh that first exposed the abuses and the photos associated with that article.


Seymour M. Hersh's "Torture at Abu Ghraib"
Photos associated with the article

Roundup: September 25


John McCain hasn't even read the two-page Paulson Plan, but he has suspended campaigning to return to Washington and fix the economy.

The Big Picture has a useful roundup of some of the different bailout ideas proliferating on the web.

Interfluidity says that the AIG/GSE model might be suitablefor further bailouts. But buried in the piece is a useful insight that points deep to the heart of the mis-management of the crisis for the past year by Bernanke and Paulson. The lack of a stable framework in which to think about failed institutions has given the entire process an ad hoc character; and the medley of bailout options proposed and enacted has undermined confidence in the markets instead of supporting confidence. If no one knows what will happen when a given company fails, then no one can even trade on the certainty of a bailout. Bill Gross's big gains on the GSE bailout and big losses on the Lehman bankruptcy give us some clue why no one wants to lend between banks.

Soros blames Paulson for last week's chaos, saying the refusal to save Lehman destroyed the debt markets. Conditions remained bad in the money markets, with the TED spread up to 3.27% this morning; and the US Mint is suspending sales of one-ounce gold bullion coins after demand outstripped supply.

Willem Buiter calls for a complete review of the way the UK Treasury and Bank of England manage liquidity in the market. The SLS should be extended, should be taken out of the Bank of England's control and moved to Treasury, and the UK should have its own program to deal with downgraded assets on banks' asset sheets. Buiter also reviews the Paulson Plan and finds it inadequate over at VoxEU.

A former adviser to the Chinese central bank says that foreign holders of US government debt must reach an agreement to prevent panic selling.

Bloomberg publishes the first part of a two-part series on the role played by the ratings agencies in the meltdown.

The U.S. has authorized $25bn in loans to help Detroit modernize its car lineups. This is an automakers' bailout by another name.

GE has warned on profits and will suspend its stock buybacks. (The New York Times reports that Lehman asked GE for help before its bankruptcy.) Washington Mutual is reportedly looking at a possible private equity buyer.

Initial unemployment claims were up to 493k, spurred in part by Hurricanes Ike and Gustav -- the four-week moving average has crept above 450k. August new home sales were the lowest since 1982. Advance durable goods orders were down very sharply, by 4.5%. Meanwhile, the Eurozone recession is picking up pace: Ireland's economy shrank 0.5% in Q2.


Russia's Foreign Minister says that, far from finding itself isolated in the aftermath of the Ossetian war, Russia is seeing more entreaties for bilateral deals at the UN than in recent memory.

North Korea has expelled IAEA monitors and says it will resume plutonium reprocessing.

World Politics Review looks at the challenges that will face Tzipi Livni if she becomes Israel's prime minister, and speculates on the horse-trading between Ehud Barak and Benjamin Netanyahu that might stand in her way.

Kgame Molanthe gave this speech at his inauguration as South Africa's president.


The WHO publishes this year's World Malaria Report.

The Regional Greenhouse Gas Initiative (RGGI or "Reggie"), a carbon cap-and-trade program for utilities in the Northeastern U.S., goes on line today with its first auction for permits. Two flaws in the system bring the price down drastically. First, the number of permits was allocated on the basis of 2004 emissions, the highest in history, and second, substantial reductions will not be required for several years. As a result, prices seem to be hovering around $4/tonCO2, or one-fifth to one-tenth of normal prices in the EU.

The UN publishes its report on investment and trade.

Nature reviews the U.S. Presidential candidates' stated positions on climate change. Uncritical, but a useful reference.

Readings: Hayek (1)

"There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that, by reversing the deflationary process, we can regain lasting prosperity."
Friedrich Hayek, Monetary Theory and the Trade Cycle (1933)

Secretary Paulson's enabling act (4)

We continue our review of Sen. Dodd's competing bailout proposal.

Dodd would establish a Special Inspector General for the TARP
It shall be the duty of the Special Inspector General for the Troubled Asset Program to conduct, supervise, and coordinate audits and investigations of the purchase, management, and sale of assets by the Secretary of the Treasury
He would require the Fed to report on any use of its discounting authority under 12 USC 343
(1) the justification for exercising the authority; and
(2) the specific terms of the actions of the Board, including the size and duration of the lending, the value of any collateral held with respect to such a loan, the recipient of warrants or any other potential equity in exchange for the loan, and any expected cost to the taxpayer for such exercise.
Provides for a study of financial leverage
(A) an analysis of the roles and responsibilities of the Board, the Securities and Exchange Commission, the Secretary of the Treasury, and banking regulators with respect to monitoring leverage and acting to curtail excessive leveraging;
(B) an analysis of the authority of the Board to regulate leverage, including by setting margin requirements, and what process the Board used to decide whether or not use its authority; and
(C) recommendations for the Board and Congress with respect to the existing authority of the Board.
And an impact assessment of the TARP
The Comptroller General shall conduct a study to assess the impact of the program authorized by this Act, including—
(A) whether it has—
(i) provided stability or prevented disruption to the financial markets or the banking system; and
(ii) protected taxpayers;
Dodd sets (gentle) executive compensation limits
(1) limits on compensation to exclude incentives for executives to take risks that the Secretary deems to be inappropriate or excessive;
(2) a claw-back provision for incentive compensation paid to a senior executive based on earnings, gains, or other criteria that are later proven to be inaccurate; and
(3) such limitations on the entity paying severance compensation to its senior executives as are determined to be appropriate in the public interest in light of the assistance being given to the entity.
Funds money-market fund insurance out of the TARP (and forbids the use of the Exchange Stabilization Fund)
And makes slight changes to the mortgage modification code

Wednesday, September 24, 2008

Secretary Paulson's enabling act (3)

Sen. Dodd's competing proposal is now available. We review the terms of his proposal in two posts.

Dodd retains the wide grant of authority
The Secretary is authorized to establish a program to purchase, and to make and fund commitments to purchase troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with policies and procedures developed by the Secretary
And even extends it
designating appropriate entities as financial agents of the Federal Government, authorized to perform in such capacity all such reasonable duties related to this Act as may be required;
But sets up an office to administer the program
The Secretary shall implement any program under paragraph (1) through an Office of Financial Stability... which office shall be headed by an Assistant Secretary of the Treasury.
Subject to the oversight of an Emergency Oversight Board to include the Fed, FDIC, and SEC chairmen
(A) reviewing the exercise of authority under a program developed in accordance with this Act, including—
(i) all actions taken by the Secretary and the office created under section 2, including the appointment of financial agents, the designation of asset classes to be purchased, and plans for the structure of vehicles used to purchase troubled assets; and
(ii) the effect of such actions in assisting American families in preserving home ownership, stabilizing financial markets, and protecting taxpayers; and
(B) making recommendations, as appropriate, to the Secretary regarding use of the authority under this Act.
Treasury will receive a contingent equity (or senior debt) stake when it makes a loss
In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares, which shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to 125 per cent of the dollar amount of the difference between the amount the Secretary paid for the troubled assets and the disposition price of such assets. The Secretary may demand payment of such contingent debt instrument under such terms and conditions as determined appropriate by the Secretary....
In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares.
And will be immune to dilution
The instrument representing the contingent shares shall contain anti-dilution provisions of the type employed in capital market transactions, as determined by the Secretary, to protect the Secretary from transactions such as stock splits, stock distributions, dividends, and other distributions, mergers, and other reorganizations and recapitalizations.
The FDIC will manage mortgages and RMBS to limit foreclosures and will modify the underlying mortgages
the Corporation shall utilize a systematic approach for preventing foreclosures and ensuring long-term, sustainable homeownership through loan modifications and use of the HOPE for Homeowners Program established under section 257 of the National Housing Act and any other programs that may be available for such purposes.
And acquisitions of pooled MBS will be geared to acquire control over the underlying
The Secretary shall, to the
extent practicable, acquire—
(A) sufficient ownership or control of pooled residential mortgage loans, or a securitization vehicle for such loans so that the Corporation has authority to modify the underlying residential mortgage loans, either directly or through a designee; and
(B) whole residential mortgage loans, so that the Corporation may use its authority to modify the underlying residential mortgage loans, either directly or through a designee.
With foreclosed houses being made available to local government
Each Federal property manager shall make available to any State or local government that is receiving emergency assistance under section 2301 of the Foreclosure Prevention Act of 2008 (Public Law 110-289) for purchase at a discount, any properties that it owns through foreclosure in that State or locality, in order to facilitate the sale of such properties and to stabilize neighborhoods affected by foreclosures.
And 20% of the profits from asset sales going to fund the GSEs
(A) 65 percent shall be deposited into the Housing Trust Fund established under section 1338 of the Federal Housing Enterprises Regulatory Reform Act of 1992 (12 U.S.C. 4568); and
(B) 35 percent shall be deposited into the Capital Magnet Fund established under section 1339 of that Act (12 U.S.C. 4569).

Roundup: September 24


The cauldron continues to boil in Washington, as the pricing of mortgage securities becomes a major issue in the bailout plan. Bernanke as much as admitted that there would be no true reverse auction of securities to be bought by the TARP when he brought forth caveats about price floors and fair value. But a reverse auction is not suitable for this situation, with or without a price floor. The opportunities for collusion by participants abound; the auction would greatly favor Morgan Stanley and Goldman Sachs (which seem to be relatively healthy) over every other bank; and if a genuinely fair price were achieved then the price would be sufficiently low that no "confidence" would be instilled in the market at all. Adding a price floor merely ensures this will be a taxpayer giveaway. Of course, Bernanke seems to want to do a reverse-reverse auction in which the Treasury sets the price.

Bailout talk hasn't unfrozen the money markets. Calculated Risk reports that the TED spread is again above 3.0%, some six times its normal level of 0.5%, indicating that the new Fed lending facilities are inducing substitution effects: rather than promoting interbank lending, the facilities are decreasing it, as banks confident the Fed will swap them Treasuries hoard their capital. Overnight Libor is also up significantly, though below last week's crisis levels, and there are renewed reports of T-bills trading with negative or zero yield. Possibly worse, Caterpillar came to the market yesterday with a 5-year note at Treasury + 320bp. FT Alphaville looks at the collapse in the commercial paper market.

The Fed has extended another $30bn of dollar swap lines to the Australian, Swedish, Danish, and Norwegian central banks.

The Big Picture points out how expensive Buffett's $5bn was for Goldman. (How, the question goes, can Treasury be looking to strike a worse deal with the worst banks than Buffett just struck with the best?) Sumitomo Mitsui is said to be considering its options after Buffett beat them to the punch. Meanwhile, Goldman is raising $5bn in a common stock issue and looking at failed IndyMac's assets as a possible first foray into retail banking.

JC Flowers -- the individual, not the investment company -- has bought a small bank ($14mn assets) in Missouri personally. Anyone's guess, but he may intend to use it as a platform for further acquisitions.

Frederic Mishkin says in the FT that inflation targeting should not be abandoned.

The Kremlin has authorized the state-owned Development Bank to bail out the 20th largest bank in Russia, Syvaz Bank. Syvaz failed to meet margin calls late last week.

Angry factory workers beat an executive in India to death yesterday. Maybe Dick Fuld's recent secrecy is all that saved him from a horde of Greenwich bond traders.

August US existing home sales (seasonally adjusted) were down 2.2% MoM in August, but were down 10.7% YoY; housing inventory decreased slightly to 10.4 months. Lowe's said it would cut down on new store openings next year. Chrysler reveals it has lost $400mn so far this year, with sales slipping 24% in the first 8 months of the year.


President Bush's speech to the UN General Assembly included unexpected digs at Russia over the Ossetian war. Mahmoud Ahmadinejad is blaming Zionists (for what, exactly, it's hard to tell).

The White House has no plans to declassify the new National Intelligence Estimate on Afghanistan that reportedly paints a "grim" picture of the situation in that country.

China launches its third manned spaceship today, Shenzhou VII. Zhai Zhigang is set to be the first Chinese national to walk in space.

At least a hundred are dead in Mogadishu after renewed fighting between insurgents and African Union peacekeepers.


The Independent published today the first evidence that methane stored in the arctic permafrost is beginning to bubble up. This is the most important of the doomsday scenarios for climate change -- if the permafrost begins to melt, it is possible that enough methane would be released to trigger a positive feedback loop, leading to more arctic warming and in turn to more permafrost melting and the release of more methane. The possible contribution of such a loop -- which could be triggered by anthropogenic warming, and which may have occurred in known paleoclimatological history -- to global warming is an order of magnitude greater than current human contributions to warming. We covered a paper last week that showed evidence that the permafrost may be more difficult to melt than people might think.

The Senate passed the big renewable energy bill today 93-2. The bill extends the ITC (the tax credit for solar installation) for eight years, and it extends the PTC (the tax credit for renewable energy production) for one year. It also extends the renewable R&D credit. The House passed a similar bill last week, so investment in renewables should not drop beyond what the economic climate indicates. However, Senate Democrats appear to have let the moratorium on new offshore drilling lapse in advance of going into recess, under pressure from President Bush.

Readings: RNC

Homeownership remains key to creating an opportunity society. We support timely and carefully targeted aid to those hurt by the housing crisis so that affected individuals can have a chance to trade a burdensome mortgage for a manageable loan that reflects their home’s market value. At the same time, government action must not implicitly encourage anyone to borrow more than they can afford to repay. We support energetic federal investigation and, where appropriate, prosecution of criminal wrongdoing in the mortgage industry and investment sector. We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself. We believe in the free market as the best tool to sustained prosperity and opportunity for all.
Republican National Committee, 2008 Platform

Tuesday, September 23, 2008

Roundup: September 23


Markets held their breath while they watched Bernanke and Paulson testify before Congress today.

The Fed issued new guidelines allowing for minority investors in bank holding companies to take larger equity stakes and receive greater board representation than had previously been allowed, in a bid to make it easier for U.S. banks to receive foreign (and perhaps private equity) capital.

The OTS is reportedly urging WaMu to find a solution, with TD, Citi, JPMorgan, Wells Fargo, and Santander considering buying all or parts of the bank. Moody’s downgraded Washington Mutual to E from D+ -- and says “WaMu’s capital is insufficient to absorb its mortgage losses.” FT Alphaville point out the FDIC’s insurance fund might be insufficient too.

In the first sign of any real upwards pressure on wages, IG Metall’s union is demanding 8% wage increases. And Buiter says now is the time for Britain to join the EMU.


Tariq Ali links the bombing of the Marriott in Islamabad -- the "Pakistani 9/11" -- to the failures of the U.S. war in Afghanistan and the U.S.'s recent violations of Pakistani sovereignty in the Northwest. The Age (Australia) covers much of the backstory of the conflict in northwestern Pakistan. An IHT editorial urges a major strategic shift in U.S. policy in the region.

There is confusion in South Africa after 11 members (around one-third) of the Cabinet resigned today in the wake of former President Mbeki's resignation.


The Senate prepares to renew the ITC, PTC, and other renewables subsidies today and tomorrow. These are being merged into a bipartisan compromise that includes an AMT waiver and other tax measures. The House renewed these subsidies last week, and this Senate version is expected to pass easily. The Washington Post comments.

The New Scientist reports on a recent study describing an atmospheric boundary in the Antarctic ocean that prevents air pollution from crossing into the air over the southernmost continent.

The Western Climate Initiative (WCI), a CO2 cap-and-trade program for 4 Western Canadian provinces and 7 Western States, released its final proposal for cap-and-trade today. Sightline has commentary. Unfortunately, unlike RGGI, the WCI plans to auction only a minimal number of the permits issued, and it plans to allocate the rest by fiat. All other features of the plan are an order of magnitude less important than this choice. Later this month we’ll feature an in-depth analysis of cap-and-trade plans by auction and by allocation, citing examples. At least the WCI is a step in the right direction.

Accounting arbitrage

Why is it so urgent that Goldman Sachs and Morgan Stanley become banks that even the normal five-day waiting period was waived? They were already well enough capitalized to meet the bank holding company requirements, so what's the added benefit? It might have something to do with a rushed bailout coming soon.

Sept. 22 (Bloomberg) -- Goldman Sachs Group Inc. and Morgan Stanley may be among the biggest beneficiaries of the $700 billion U.S. plan to buy assets from financial companies while many banks see limited aid, according to Bank of America Corp.

"Its benefits, in its current form, will be largely limited to investment banks and other banks that have aggressively written down the value of their holdings and have already recognized the attendant capital impairment," Jeffrey Rosenberg, Bank of America's head of credit strategy research, wrote in a report dated yesterday, without identifying particular banks.

Many banks may not participate in the Troubled Asset Relief Program because they haven't had to write down as much assets under accounting rules, meaning decisions to sell into the program would cause them to lose capital, Rosenberg wrote. Investment banks operate "under a mark-to-market accounting model while commercial banks hold assets at cost until realizing a loss (or until they reasonably expect one)," he wrote.

Essentially, because of the differences in accounting standards for commercial banks and investment banks, the investment banks have been forced to write down the value of their holdings aggressively, where the commercial banks have held on to the assets without taking the paper losses and the attendant capital impairment.

Since BofA and the rest of the commercial banks are carrying these securities at higher prices on their books, in order for them to exchange their assets at the same prices as Goldman or Morgan they would have to take another series of massive writedowns.

What's the bottom line? If Goldman and Morgan can participate in the TARP, then they may be able to exchange these under-performing illiquid assets for the US Treasury's cash at the same prices at which they are already valuing these securities.

Bloomberg points out the difficulties Japan had in trying to force viable banks to sell off their illiquid assets in the 1990s:

In the 1990s, a Japanese government effort to buy troubled assets from banks to free up lending failed because sellers weren't willing to accept the prices offered, said L. William Seidman, a former chairman of the Federal Deposit Insurance Corp. He said that wasn't a problem he had as chairman of the Resolution Trust Corp. in the U.S., which sold off failed lenders' assets after the savings-and-loan crisis of the 1980s.

"If you're talking about institutions that haven't failed, then you have the question of whether they want to sell at a low price, particularly if that price depletes their capital," Seidman said in a telephone interview today.

"In Japan, we did all kinds of things, trying to have a mediator who would set a price and other kinds of methods to get around that," he added. "It never really got done, so it was not successful, but here we probably have a more urgent need for more institutions to do something."

As BHCs, Morgan and Goldman will be able to raise money more easily while selling their illiquid paper to the Fed at no further discount. It's an accounting arbitrage.

Readings: Pope (1)

Blest paper-credit! last and best supply!
That lends corruption lighter wings to fly!
Gold imp'd by thee, can compass hardest things,
Can pocket states, can fetch or carry kings;
A single leaf shall waft an army o'er,
Or ship off senates to a distant shore;
A leaf, like Sibyl's, scatter to and fro
Our fates and fortunes, as the winds shall blow:
Pregnant with thousands flits the scrap unseen,
And silent sells a king, or buys a queen.
Alexander Pope, Epistle to Bathurst (1733)

The mother of all short squeezes (3)

Broc Romanek's TheCorporateCounsel.net blog was the first to point out the importance of companies' Standard Industrial Classification (SIC) codes in determining which stocks were and were not subject to the SEC's emergency order. His post is well worth reading for a sense of the contingencies involved in this kind of emergency, ad hoc action.
I received a number of emails from panicky members whose financial service companies were not part on the SEC's list. Some of these companies have SIC codes covered by the SEC's emergency order, but they were not listed by name in the SEC's order. For example, this situation applies to AllianceBernstein Holding, Invesco and Legg Mason. They've all filed Form 8-Ks stating that they believe they should be on the list since they were covered by the SIC code used by the SEC...

Others believe their companies are financial services companies and should be on the list, but their companies don't have SIC codes - at least, as they show up in the SEC's database (however, EDGAR shows their SIC code) - that correspond to the range of SIC codes covered by the SEC's "No Short List." To illustrate, CNBC reported that several companies - like General Electric - may be added to the list because their financial services businesses are substantial. GE's SIC code in the EDGAR database shows up as "SIC: 3600 - Electronic & Other Electrical Equipment (No Computer Equip)."
The SEC has since formally recognized the inadequacy of its first "best efforts" and has assigned responsibility for preparing an appropriate list to the exchanges. From yesterday's revised order:
In light of the familiarity of the exchanges listing financial institutions with the nature of their respective businesses, the Commission has determined to amend this Order to provide that the listing markets shall select the individual financial institutions with securities covered by the Order. The Commission expects each national securities exchange listing financial institutions to immediately publish a list, on its internet Web site, of individual listed companies with common equity that will be covered by the Order’s prohibition on short sales. The Commission expects these lists to cover banks, savings associations, broker-dealers, investment advisers, and insurance companies, whether domestic or foreign, and the owners of any of these entities.

To the extent an issuer chooses not to be covered by the Order’s prohibition on short sales, we have authorized the applicable national securities exchange to exclude that issuer from its list of covered financial firms.
Will this voluntary opt-out position separate the wheat from the chaff? If enough companies opt out of the SEC's protection, the ones left will be the obvious targets for speculative attacks.

The mother of all short squeezes (2)

One of the remaining prime brokers sent the following out yesterday to its clients:
The SEC has imposed emergency rules for short sale and economically similar dealing in approximately 800 financial services companies. Part of the new rules impact options trading strategies that can lead to a short sale, even if temporarily. The following limitations on option trading have been put in place to conform to the SEC regulations.

(A1) purchase of call options and exercise of long call positions
(A2) sale of call options against an existing long stock position in a ratio less than or equal to 1 call per 100 shares
(A3) purchase and sale of put options
(A4) purchase of single stock futures

Not Allowed:
(NA1) exercise of puts that would lead to a short stock position
(NA2) selling uncovered calls or uncovered single stock futures (coverage via stock)
(NA3) selling long stock if so doing will expose an uncovered short call position

Please be aware that the actual rules and interpretations on the rule are being refined by the SEC on an ongoing basis.
In our original commentary on the short-selling restrictions Friday, we pointed out the impact the order would have on the market-making ability of ETF issuers. By the end of the day, the SEC had issued "technical amendments" to its original order (see the full text of theamended order). These include a specific exemption for ETF and ETN market-makers:
bona fide market making and hedging activity related directly to bona fide market making in exchange traded funds and exchange traded notes of which Covered Securities are a component.
The SEC has also extended the exemption for options market-makers for the duration of the emergency order, but included as a condition a virtually unenforceable requirement that market-makers not contribute to increasing their customers' net short positions in financial stocks..

What we saw yesterday in the markets -- a slow but deep slump, including in financial stocks, after Friday's manic short-covering rally, but with option implied volatility collapsing and thin volumes -- was a consequence of removing liquidity from a market in which an artificial price floor was set without inducing any real confidence or conviction in market participants. As long as no one is permitted to short financials, it will be hard to find real, committed buyers for them, confident that a bottom has been marked in their prices.

And with uncertainty around the nature of the hedging activities that are (or will remain) permissible, a host of ordinary -- that is, non-manipulative, bona fide -- trading practices will remain severely constrained.

In situations where options issuers are constrained, where prime brokers are limiting or banning options transactions, and where transactions costs for short sales of whatever kind (even as part of net long positions) are increased -- even if only because of the added time it takes to confirm that the sales are permissible -- we should expect strategies involving algorithmic and portfolio trading and hedging to be hit especially hard. And those strategies are major sources of liquidity.

Horseman, pass by

The Federal Reserve Board has waived the five-day statutory antitrust waiting period for Goldman and Morgan's applications to become bank holding companies.
In light of the unusual and exigent circumstances affecting the financial markets, and all other facts and circumstances, the Board has determined that emergency conditions exist that justify expeditious action on this proposal.
The banks are well capitalized:
The Board consistently has considered capital adequacy to be an especially important aspect in analyzing financial factors. Morgan is adequately capitalized and all the Morgan entities that are subject to regulatory capital requirements currently exceed the relevant requirements. In addition, MS Bank and MST are currently well capitalized under applicable federal guidelines. MS Bank and MST also would be well capitalized on a pro forma basis on consummation of the proposal.

The Board consistently has considered capital adequacy to be an especially important aspect in analyzing financial factors. Goldman is adequately capitalized, and all the Goldman entities that are subject to regulatory capital requirements currently exceed the relevant requirements. In addition, Goldman Bank currently is well capitalized under applicable federal guidelines. Goldman Bank also would be well capitalized on a pro forma basis on consummation of the proposal.
Anyone's guess what the rush is?

The Federal Reserve has issued a press release. Also see the Goldman order and the Morgan order.