Subprime

The FDIC Does It Again

Ellen Seidman — Wed, 07 May 2008 21:28:00 -0400

FDIC Chairman Sheila Bair has struck again-with yet another creative response to the ongoing mortgage crisis. Chairman Bair has a history of being ahead of just about everyone else in Washington with proposals to respond to the crisis in a manner that is doable and fair. This time it's the Home Ownership Preservation or HOP loan, and the FDIC estimates about one million loans-make that one million homeowners in trouble-might be eligible.

Any mortgage loan taken out between January 1, 2003 and June 30, 2007 by an owner-occupant at a level below the FHA conforming loan limit that was unaffordable at origination would be eligible. What does "unaffordable at origination" mean? According to the FDIC website, it means that when the borrower took out the loan, his or her total housing payment-for principal and interest on the loan, taxes and insurance-exceeded 40% of income. And, according to an FDIC conference call May 7, that does not mean that the amount the borrower actually paid at origination exceeds 40%; it means that the amount the borrower would have paid had escrows for taxes and insurance been included and had the initial payment been for both principal and interest, at the fully-indexed rate, not the teaser rate. This makes the proposal far more powerful than it appears at first glance.

The way HOP would work is that a servicer would apply to Treasury for a loan to the borrower that would pay down 20% of the current mortgage. In exchange, the servicer would agree to modify its loan into a fully-amortizing fixed rate mortgage for the balance of the mortgage term, with interest set so that the borrower's monthly mortgage payment, including taxes and insurance, would not exceed 35% of the borrower's verified current income. Interest on the modified loan could be no higher than Freddie Mac's published rate for 30-year fixed rate mortgages, and if that interest rate were not low enough to get down to 35% of income, the lender would have to set a lower rate. And no negative amortization, prepayment penalties or deferred interest would be allowed.

The lender would pay the Treasury the first five years of interest on the Treasury loan up front, and would also subordinate its interest to the Treasury's. Thus, if the borrower defaulted or the property was transferred, the Treasury would get paid first-giving the lender a real incentive to make the loan work. The borrower would not pay anything on the Treasury loan for the first five years, and then would pay off the entire principal (with interest at Treasury's rate) during the remaining 25 years of the larger mortgage.

In addition to creating affordable mortgages the appeal of the HOP program lies in three primary characteristics:

It leaves the mortgages in their existing pools, and, according to the FDIC, requires alterations that are totally consistent with current Pooling and Servicing Agreements (PSAs)
It does not affect the interest of subordinate lien-holders, which means they can't hold up the process of modification
The amount of and interest rate on the modified mortgage are not dependent on appraisal of the property, but rather only on the borrower's verified current income

Like all proposals that attempt to deal with this difficult situation, HOP has its flaws:

Eligibility is dependent on information that lenders should have in their files, but may well not, at least not accurately, as we know that at origination of many loans now in trouble there was either no verification of income, and/or the amount "verified" was incorrect
To retain consistency with the PSAs, this proposal, like many before it, requires the servicer, not the borrower or someone acting on the borrower's behalf, to initiate the process; so far, servicers have been slow on the draw, to put it mildly
The Treasury loan could, in some circumstances, generate an unaffordable "payment shock" in the fifth year when the borrower needs to start paying it down; the FDIC's own examples would take the borrower up to a 40% debt to income ratio, even assuming that the borrower's income grew 1.5% annually

But HOP is a creative, constructive addition to the dialog. Maybe its largest flaw is one that Chairman Bair desperately wanted to avoid: it requires legislation. Let's hope it gets serious consideration by Congress and a fair hearing by the White House.

Is London Loosing its Edge?

Ian McAllister — Wed, 07 May 2008 18:35:00 -0400

A proposal by Gordon Brown's government to up the taxes paid by resident foreigners and demand greater transparency in their offshore dealings has many fearing an exodus of London's international financiers. This comes at a time when increasing numbers of businesses in London are also moving their headquarters to countries with lower taxes. Layoffs by banks in the wake of the subprime crisis are further damaging the City's reputation as a vibrant financial center. A loss of foreign residents and international business would be devastating for a city that has emerged as New York's greatest rival for global preeminence.

Snapshot asks, could New York reclaim the top spot if London falls?

The Times - Nondom Raid will Lead to Capital Exodus
Financial Times - Big Companies Consider Domicile Status
International Herald Tribune - Job Losses Feared in British Financial Sector
Financial Times - City Job Vacancies Down by a Quarter
Bank for International Settlements -Intl. Financial Centers: A Network Perspective

Getting the Housing Mess Right

Ellen Seidman — Mon, 21 Apr 2008 16:50:00 -0400

With a sense of irony and amazement that Congress actually might be getting the housing mess right, Sebastian Mallaby's column in today's Washington Post hits the nail on the head. It's interesting that it took a writer whose major beat is international economics to see the point about negative externalities and the collective public good. As several of us, through many forums--I've been working with the Center for American Progress on the Save America's Family Equity or SAFE proposal--have been saying for months, this is not a matter of bailing out either borrowers or lenders or of preventing house prices from falling. This is a matter of cushioning the blow for all the rest of us--the communities that will pay dearly from declining tax revenues and increased demand for services; the homeowners whose mortgages are long-since paid off or who have been paying faithfully and can and will continue to do so; the renters who have lost their homes because their landlord can't afford to pay the mortgage any more.

Mallaby points to the positive steps Congress is taking to enable loan servicers to sell or refinance their loans after taking a substantial haircut and to enable borrowers to get new loans that they can support--with upside to the government to compensate for taking the risk. I wish he'd included the proposal outlined in Congressman Frank's bill for bulk transfers of loans, because I believe that ultimately that will be necessary. But the essential points are there. As is the point that the tax giveaways in the Senate's "housing" bill are outrageous.

'Sub Sub Sub Subprime' Borrowers 100 Million Strong Worldwide and Growing

Jamie Zimmerman — Thu, 17 Apr 2008 12:00:00 -0400

It's all we hear about these days: The U.S. subprime mortgage bubble -- created by poor and at times predatory lending practices and lax banking regulation and creative investment products -- has burst. Of the approximately 7.7 million subprime loans outstanding, over 2 million are at risk of foreclosure and 600,000 borrowers are expected to lose their homes this year. The majority of us are left in shock as we watch the devastation unfold, the bubbles aftermath wreaking havoc on the U.S. (and increasingly global) economy, ensuing fears of recession and economic pain to come, and leaving politicians, economists, and regulators all scrambling to pick up the pieces.
However, in the meantime, the 2006 Nobel Peace Prize winner on Tuesday proudly hailed microfinance -- the innovation of providing small loans to poor, traditionally financial excluded individuals, mainly women -- as "sub sub sub subprime" lending. That means that globally, more than 3300 microfinance institutions provide such "super-subprime" loans to over 100 million clients and growing. Just to be clear: I'm a huge fan of microfinance. However, I'm left perplexed by this dichotomy: How can a lending practice that is almost singlehandedly dragging the whole of the U.S. economy in to a hole simultaneously and sustainably end third world poverty?

Well according to Yunus, the answer is simple - the U.S. subprime crisis was fueled by "sloppy business practices" and complex product, which simply don't exist in the microfinance industry. Finding ways to extend access to credit and financial services to those with less than stellar or no credit or financial history, if done properly, can provide asset-building opportunities to those traditionally excluded and economically disadvantaged. In that sense (and this may come as a shock to those who only know of subprime as it related to the current crisis), subprime lending is not inherently a bad thing.

However, when discussing this issue last night at a CGAP cocktail reception, the answer seemed to be about as complicated as a 5/1 balloon ARM disclosure. Expert discussants, considering the similarities and differences between these sub-prime markets, concluded that microfinance products and services are indeed different from the complex mortgages and bundled securities of the U.S. mortgage market. However, they all cautioned the microfinance industry to take a close look at how certain similarities - the perverse incentives for quantity over quality; the potential of similar "irrational exuberance" of both clients and lenders; the growing influx of new players, products and dis-intermediated capital that could lead to predatory products and practices; similarly, competition among providers that could lead to "race to the bottom" practices and products; the risk of information asymmetries and moral hazard created by increase in disintermediation (which creates distance between borrowers and lenders), and finally, the lack of regulation in many markets -- indeed mirrors characteristics of the sub-prime mortgage market in the United States.

So, my original question remains unanswered, but these new insights beg related, and perhaps more pertinent questions. In our haste to extend the power of micro-credit to the millions living in poverty around the world, how much, if at all, should we head the warnings derived from the subprime crisis? Can light-touch regulation and more concerted efforts enhance consumer awareness provide the balance between providing as much access as quickly as possible to as many as possible and quality of products and practices? Would putting such regulatory brakes on this exploding industry help us to avoid the possibility of a global sub-prime bubble or just deprive the needy of access to finance?

If some predictions are right, then the tightening of capital in the global financial markets -- essentially the effect of failing to address these issues U.S. until it was too late - may inadvertently apply those brakes before we get the chance to answer the question. But with others predicting the opposite (even more capital being diverted into more lucrative, global markets (i.e., microfinance investment)) then we may need to look at these issues more closely, ASAP.

No, Larry, CRA Didn’t Cause the Sub-Prime Mess

Ellen Seidman — Tue, 15 Apr 2008 14:55:00 -0400

It has lately become fashionable for conservative pundits (Larry Kudlow, George Will) and disgruntled ex-bankers (Vernon Hill, for example, in his March 7 American Banker editorial) to blame the current credit crisis on the Community Reinvestment Act. This is patent nonsense. The sub-prime debacle has many causes, including greed, lack of and ineffective regulation, failures of risk assessment and management, and misplaced optimism. But CRA is not to blame.

First, the timing is all wrong. CRA was enacted in 1977, its companion disclosure statute, the Home Mortgage Disclosure Act (HMDA) in 1975. While many of us warned against bad subprime lending before the turn of the millennium, the massive breakdown of underwriting and extension of risky products far down the income scale-without bothering to even check on income-was primarily a post-2003 phenomenon. To blame a statute enacted in 1977 for something that happened 25 years later takes a fair amount of chutzpah.

It's even more outrageous because of the good CRA clearly did in between. The 1990s were the heyday of CRA enforcement-for a variety of reasons including the raft of mergers and acquisitions that followed the 1994 Riegle-Neal Interstate Banking and Branching Act, increased scrutiny of lending practices by the media and activism by housing advocacy groups and tougher enforcement by the Clinton Administration.That period saw increased home mortgage lending to lower income households and in lower income communities by the banks and thrifts covered by CRA, and a steady increase in the homeownership rate, especially for lower income and minority families. (See The Joint Center for Housing Studies ). In addition, there was significant investment in affordable rental housing, community facilities and broader community economic development, directly by banks and thrifts earning investment credit under CRA or indirectly through bank investment in Community Development Financial Institutions and other community-based organizations.

New research by Ingrid Gould Ellen and Katherine O'Regan of NYUWagner, presented at a conference sponsored by the Philadelphia Federal Reserve Bank, convincingly demonstrates that property values went up dramatically in low and very low income urban census tracts during the 1990s, reversing severe declines during the prior two decades. While Ellen and O'Regan point out that this does not necessarily mean that everyone in those communities benefited, relating the improvement in home values in distressed communities to the effects of a statute designed to increase access to mortgage credit in those communities, during a period when the statute was vigorously enforced, is a reasonable connection.

Second, CRA does not either encourage or condone bad lending. Bank regulators were decrying bad subprime lending before the turn of the millennium (see Interagency Guidance on Subprime Lending), and warning the CRA-covered institutions we regulated that badly underwritten subprime products that ignored consumer protections were not acceptable. Lenders not subject to CRA did not receive similar warnings.And we also explained to those we regulated how to serve lower income communities and borrowers in a manner that was good for the borrower, good for the bank, and earned CRA credit.

For example, in October 2000, when I spoke to the National Association of Affordable Housing Lenders, a group of CRA-covered lenders, I said, "key to successful community reinvestment activity is being a responsible lender. Being responsible means making loans on responsible terms to people who can afford to pay them back, and making certain borrowers both understand the terms of the loan and have the opportunity to get the best terms available given their credit and financial position. But it also means expanding both the market for and affordability of loan products. It means working with customers to make them more bankable, helping families find the loan that is right for them, and investing in their success and yours by supporting organizations that assist you by counseling these individuals on the front and the back end of a loan."

CRA enforcement became a lower priority for bank regulators after 2001. My successor at the Office of Thrift Supervision, in fact, led an effort-eventually thwarted-to unilaterally loosen CRA regulations for institutions with more than $1 billion in assets. See 70 Fed. Reg. 10023. Nevertheless, CRA regulations were eased more generally in 2005. See 70 Fed. Reg. 44256.

The years that coincided with reduced CRA enforcement are also the years when CRA-covered entities wandered deeper into "higher priced loans," a category that includes, but is not limited to, "exploding ARMs" and other particularly pernicious kinds of loans. Thanks to the valiant efforts of late Fed Governor Ned Gramlich, starting in 2004 we have data about "higher priced loans." In that year, bank, thrifts and their subsidiaries-the entities covered by CRA-made about 37% of high cost loans. By 2006, the bank, thrift and subsidiary percentage was up to 40.9%. That a lack of interest in CRA enforcement coincided with CRA-covered entities getting into higher priced lending does not seem to me an argument for less CRA enforcement. Rather, it's an argument for better enforcement of a statute that, when well enforced, had proven its worth in helping both borrowers and communities.

Finally, it is nevertheless the case that CRA-covered lenders are not the source of the problem. One of CRA's major failings, in fact, is that it only applies to banks and thrifts. Remember all the investment banks who demanded product and then sliced and diced loans until it was impossible to understand their quality?They're not covered. Neither are the independent mortgage banks, the kinds of firms that have gone bankrupt or nearly so because of their abysmal lending practices, who regularly made about 50% of the high cost loans. Bank affiliates, another uncovered group, made about 12% of the high cost loans.

Janet Yellin, President and CEO of the Federal Reserve Bank of San Francisco recently made this point, saying "Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans, and studies have shown that the CRA has increased the volume of responsible lending to low- and moderate-income households." And a recent study by Traiger & Hinckley LLP (See also the addendum).

CRA is not perfect. It doesn't cover a substantial portion of the financial services landscape. It has become complex, and the primary focus is on numbers of loans, with less attention to the quality of those loans. Asset-building depository and other services are given short shrift. And banks and thrifts have been allowed to "count" loans made by affiliates that are not subject to effective regulatory scrutiny. Governor Gramlich was right when he said that these entities-like the independent mortgage bankers-should be subject to far greater regulatory scrutiny, for many reasons. Certainly banks should not be allowed to count loans made by these affiliates for CRA purposes without such scrutiny.

But these are not reasons to repeal CRA or blame it for a mess caused primarily by those not subject to its reach during a period when even those under its umbrella were not encouraged to take it seriously. Rather, our challenge is to respond to the ongoing credit crisis in part by modernizing CRA, expanding its reach and making it even more effective than it was in the 1990s.

Greenspan’s Gaff?

Sam Sherraden — Wed, 09 Apr 2008 16:36:00 -0400

Alan Greenspan wrote in Monday's Financial Times that he was blameless for the development of the real estate bubble, echoing his dismissal of blame during the popping of the tech bubble. Greenspan is right to point out that the ability of regulators to foresee crises are exaggerated and housing bubbles in other countries have risen despite tight monetary policy. However, he is wrong that tighter monetary policy, further regulation over both mortgage lending and complex financial instruments would not have helped slow soaring housing prices. As Martin Wolf points out in his column linked below, a rise in interest rates of 1% would not lead to market collapse if people expected their houses to rise in value by 10%.

Alan Greenspan - The Fed is blameless on the property bubble
Martin Wolf - Why Greenspan does not bear most of the blame
Desmond Lachman - The Economic Consequences of Mr. Greenspan

George Soros's New Paradigm: Behind and Beyond the Superbubble

Patrick Doherty — Mon, 07 Apr 2008 14:29:00 -0400

Steve Clemons, director of the American Strategy Program here at the New America Foundation held a media conference call Friday with George Soros to discuss his new book, New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. The book is available in electronic form, here. To listen to the MP3 of the call, click here.

In the book, Soros examines the financial roots of the current financial crisis and what to do about it. After the call on Friday, my colleague Sam Sherraden looked at Soros' market analysis and policy prescriptions in this special edition of Global Economic Snapshot. I will take a little more time to examine the geopolitical roots of the crisis, focusing on his concept of the Superbubble and extracting some strategic lessons for the United States.

Bubble of Damocles

According to Soros, the Superbubble is the product of a 25-year feedback loop. That loop involves market fundamentalists, who rose to power in the Reagan administration, acting on their belief that markets generally tend toward equilibrium if left alone by the government. In the process, over-deregulating markets and producing a long series of speculative bubbles.

Ironically, those fundamentalists pioneered a new cocktail of government intervention--usually some combination of monetary policy, Keynesian fiscal stimulus, targeted re-regulation, and some kind of geopolitical adjustment, to stabilize the markets and correct for "minor" busts like the 1987 crash, Long-Term Capital Management, the Internet bubble and now the housing bubble.

According to Soros, each succeeding bailout, instead of calling into question the wisdom of continued de-regulation, further entrenched market fundamentalists in their belief. The Fed, led for most of this period by Alan Greenspan, a market fundamentalist himself, became the trusted steward of not only banks, but of market stability more broadly. Without a regulator supervising these new markets and assuring investors that some minimum standards necessary for stability were being met, markets began to securitize risk at a dramatic rate in the mid-1990s. With Greenspan at the Fed, market institutions knew they were playing with an implicit government safety net and it led to signficant excesses. Nevertheless, until a few months ago, many believed that they had tamed the beast of risk in a voluntary, market-based way.

The subprime bubble was part of this hedging of risk. With loads of offshore dollars looking to invest in the rock-solid American housing market, institutions turned to collateralized debt obligations as a means to mitigate the risk incurred by expanding the mortgage market to home buyers with below-standard credit ratings. With no regulation, however, CDOs became untethered from the actual risk in the U.S. housing market, making it impossible to accurately value the securities once the underlying mortgages started defaulting at unexpected rates. Without a way to value the security, institutions are now in the process of simply having to write off billions of dollars of securities, creating a solvency question that is freezing up corporate lending, and impacting the real economy.

Leo Hindery, speaking here at New America last week, believes there is approximately $850 billion in bad subprime mortgages out there, and only a little more than $200 billion have been written off so far. Large though that is, there is an even larger bubble, the ultimate product of twenty-five years of market fundamentalism, looming on the horizon.

Called credit-default swaps, this unregulated derivative market has a total estimated value of $45 trillion dollars. Soros calls this a "Damocles sword" hanging over the global markets. Writing in the New York Times about similar concerns, Gretchen Morgenson observed that, "JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively." If that Superbubble bursts, the financial system really could collapse.

Roots in Cold War Grand Strategy

For the American grand strategist, this is clearly a major concern. American economic vitality is essential in any conception of U.S. grand strategy and this kind of risk cannot be allowed to continue. But, large though it is, the Superbubble is still a symptom of a larger strategic dysfunction. To understand that, it is essential to recognize that the Superbubble, which Soros argues was started in the early 1980s by Reagan's economic policies, was a product of the final stage of the Cold War.

At the end of the Carter Administration, our Cold War grand strategy was fraying. Containment, of course, established that since America could not win a military confrontation with the Soviet Union, we must keep the East-West struggle primarily one of economic and political systems. In effect, we said our economy would do the strategic heavy lifting.

In 1980, our economy was in significant trouble, and Containment was at risk. We found ourselves in a perfect storm of two oil shocks, the arrival of Europe and Japan as economic competitors, the end of the Baby Boom, and the massive deficits incurred during the Vietnam War. In short, the post-war economic engine that produced the halcyon decades of the 50s and 60s had run out of fuel--before America had won the economic contest with the Eastern bloc. Jimmy Carter's new Federal Reserve Chairman, Paul Volcker, had to raise interest rates to tame inflation. Combined with Carter's well-intentioned but incomplete efforts at energy conservation, the American economy went into a deep recession.

At the same time, in the wake of Vietnam and the failed hostage rescue mission, Desert One, American military capability and morale was at an historic nadir. In addition, the Soviets had invaded Afghanistan and the Shah, our agent in the Persian Gulf, had fallen to the Islamic Revolution.

At some level, Reagan and his advisors knew these complex geopolitical stakes. Their agenda, combining a feel-good domestic PR campaign, pressure on the Saudis to open the oil spigot, military spending, aggressive covert operations in Eastern Europe and Central Asia, and a shift toward market fundamentalism provided the social, economic and political lift that America needed to shore up Containment for long enough to let the Soviet system collapse -- first.

This was the geo-strategic context in which Soros' Superbubble was born. The prescription of market fundamentalism was part of a larger package to salvage Containment and finish off the Soviet Union. With no pathway to rebuild the asset-based and middle-class post-war economy, Reagan and his team chose the financial equivalent of steroids, debt. It was a gamble purpose-built for this finite strategic mission.

Strategic Drift

After the collapse of the Soviet Union, neither the George H.W. Bush administration nor the Clinton Administration could find a new grand strategy for America. Instead, Bush 41 dealt with Cold War clean-up issues like reuniting Germany, stopping Iraqi aggression in the Persian Gulf, and facilitating a peaceful transition of power in Moscow. The Clinton team remained in crisis management mode while trying to expand America's Cold War economic engine and balance the budget. Aided by a genuine increase in productivity driven by information technology, the combination appeared to work. Riding out the crashes in Mexico, Asia, and Russia, America, it seemed, had figured out how to tame a market economy and now our role was to expand that economy globally while defending its choke points.

It was a false positive that reinforces Soros's theory of reflexivity in both markets and geopolitics as well. In reality, Rubinomics allowed the Superbubble to continue its speculative ways with the rise of the internet bubble. The broader culture of laissez-faire also contributed to perfidy in corporate accounting houses and the spectacular collapse of Enron. Meanwhile, our fascination with the rise and fall of the Asian Tigers blinded us to the long-term implications of the slow but massive export- and urbanization-driven Chinese growth engine. Meanwhile, our stability policy in the Gulf gave new energy to a little-known band of extremists name al-Qaeda. When 9/11 hit, our economic and political myopia allowed a home-grown group of extremists known as neo-conservatives, allied with domestically-focused Karl Rove, to use another innaccurate set of narratives to push us into further economic and military distress.

Back to Basics

It is now time to get back to grand strategic basics--and the Soros narrative helps us get there. Despite the $45 trillion in credit default swaps, the rise of Asia, our overstretched military and the spectre of al-Qaeda, there is plenty of opportunity for the United States to find a new direction. We obviously have to fix the problem of the Superbubble--figuring out a way to stabilize the pool of credit default swaps and then creating a new generation of efficient market management institutions to ensure a prosperous and competitive balance of stability, assurance, agility and innovation.

But simply strapping a new set of regulations on the remnants of America's Cold War economic engine is the ultimate in futility. This no more than what Reagan did in the 1980s and what got us into the Superbubble in the first place--a collective inability or unwillingness to envision a new era of domestic growth based on something other than SUVs and Exurbs paid for with home equity loans or subprime mortgages.

Soros implicitly understands this when he said in the conference call that he believes America needs to turn to climate change to find a new source of economic growth. Climate change, of course, is just the tip of the iceberg, a leading symptom of our macroeconomic dysfunction.

Driving climate change but also our trade imbalances, energy insecurity, and myriad other major challenges, is the unavoidable reality that the world needs to bring 4 billion people into a global economy that is crashing with the 2 billion already in it. Indeed, the McKinsey Global Institute last month released a major report saying that the primary global economic opportunity of the coming era will be helping China's urban population grow to 1 billion, a project that requires massive investment and innovation in energy, transportation, land use and resource use. And behind the Chinese are another billion Indians and 2 billion other low- and medium-income people around the world whose needs and dreams are driving them into the global economy.

This is where our future lies. America is at its best when it sets out to address the driving challenge of the era. With five percent of the world's population and 25 percent of global GDP, we will always be stronger economically than militarily. So once again, our economy will have to do the heavy lifting. That means leading the innovation in energy, transportation, land use and resource use here at home, then exporting America's cutting-edge products, infrastructure, and services into increasingly compatible markets in Asia and around the world.

Soros' new book is a major contribution to our understanding of the financial system and the bubbles that threaten us. But the next administration needs to integrate strong sectoral recommendations such as these into a broader grand strategy for the present era. Then and only then will our economy will be on a sound, sustainable footing.

George Soros Conference Call

Sam Sherraden — Fri, 04 Apr 2008 21:22:00 -0400

The New America Foundation hosted a conference call with financier and author George Soros this morning during which he shared ideas from his recent book, A new Paradigm for Global Financial Markets: The Credit Crisis of 2008 and What it Means. Soros said, albeit with some chagrin, that the current financial crisis "pulled him out of retirement." Apparently it pulled him far enough to write a new book about boom and bust cycles, regulation of credit, and the current financial turmoil. I wonder whether his book was due to some sense of social obligation or he was just drawn by the excitement of the current crisis. Given his philanthropic efforts, I suspect it was a combination of both.

I want to make three comments after listening to the call. First, George Soros came off as charming, self-effacing and brilliant. His analysis of booms and busts are correct and insightful, but not revolutionary. And finally, his prescriptions for policy action are not concrete, but they get at the heart of the problem of our current regulatory structure. There is little need to comment on the first topic, so I'll skip right to the second two.

As I understand he did in Alchamy of Finance, Soros incorporates a fair amount of philosophy into his new book. During the call, he spoke about the theory of reflexivity - in which those acting in the market and the market itself reflect on one another and create positive-feedback loops. Where reflexivity takes place, misconceptions are self-reinforcing and therefore cause unsustainable rises or falls in asset prices. In such an environment, he says, the market fundamentalist concept of general market equilibrium punctuated by random corrections is innacurate. Yet it was hard to gauge where Soros believes the economy currently stands--at the beginning middle or end of the current crisis? On the one hand, he mentioned that the "acute phase" of the crisis was over. On the other, he said the potential losses from synthetic financial products, especially credit default swaps, could still be disastrous.

Where ever we stand, Soros emphasized that rapid fluctuations in the markets are dangerous and should be moderated by central banks. Since Soros blames central banks for ignoring asset bubbles, he argues that the era of a singular focus on monetary policy must come to an end and be replaced by the "art" of preventing excesses. Here he is not alone. This call for increased regulation was echoed by the IMF chief economist Simon Johnson, in a recent report which said that central banks must pay closer attention to housing prices and attempt to avoid asset bubbles. I would add to Soros's argument that regulation on credit must also include policy that avoids huge current surpluses in foreign countries, which are recycled back in the United States in the form of cheap credit.

Two additional points of particular interest and insight during the Soros call. One, he believes that the U.K. housing bubble is like a "shoe waiting to drop." See John Authers of the FT on the short view. The evidence seems convincing. I will be doing more research on this over the weekend.

Also, Soros mentioned a worldwide move away from currencies. Many now believe that countries are moving away from the dollar, but fail to recognize that the euro and the pound sterling are not viable alternatives given their high prices. This is the beginning of what Soros thinks will be a dramatic move into other asset classes by sovereign wealth funds and institutional investors.

I am still waiting for Mr. Soros's response to a question on whether China is decoupled. I was told I should have an answer by next week. Like me, I believe he remains optimistic about China's contribution to global demand.

Paulson’s Plan

Sam Sherraden — Tue, 01 Apr 2008 03:12:00 -0400

The first proposal to reform the financial system since the subprime crisis was announced yesterday by Treasury Secretary Hank Paulson. The proposal aims to create a regulatory environment in which "capital can seek out its most productive uses in an efficient matter." Before his time as Treasury Secretary he worked as co-chief executive at Goldman Sachs, where he argued for reduced regulation and consolidation of regulatory agencies. Yesterday's proposal sought to combine regulatory agencies and expand the powers of the Fed.

Snapshot asks, what parts of the Paulson plan will survive?

Treasury Department - Paulson's Blueprint
Cumberland Advisors - The Paulson Report: "Something Old, Something New, Something Borrowed..."
Fortune - Fed Up with the FED
Wall Street Journal - Paulson Plan Begins Battle Over How to Police Market
Financial Times - Paulson's Gamble

Derivatives and Leveraging

Sam Sherraden — Tue, 25 Mar 2008 16:05:00 -0400

The upswing in market sentiment after the rescue of Bear Stearns may soon come to an end. Highly leveraged financial institutions, which use large amounts of borrowed money, may still face unexpected losses as the housing market and consumer confidence continue to fall. Institutions have taken more losses on underlying assets, causing them to be even more highly leveraged than before. As underlying assets fall in value, many derivative products will also be written down.

Derivatives, which allow financial institutions to derive what something will be worth in the future, are often overestimated in value by the people that issue them. Therefore, it is commonplace for institutions holding derivatives to be worth significantly less than they think.

Snapshot asks, what regulatory framework is appropriate for dealing with highly leveraged financial institutions holding derivatives?

Whitney Tilson - Dangers of Highly Leveraged Banks
Berkshire Hathaway 2002 Annual Report - Derivatives (pp 13-15)
Financial Times - Gloom set to worsen as threat of spiral grows
Financial Times - Securities firms' future
New York Times - It's Hard to Thaw a Frozen Market