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Capitalization

| Wed Oct. 8, 2008 6:23 PM EDT

CAPITALIZATION....A couple of days ago I complained about pundits and economists who (seemingly) couldn't make up their minds about whether the real problem preventing banks from making loans in the current market was (a) fear or (b) lack of capitalization. I got a few emails asking me what I was talking about, and it occurs to me that a lot of people are just assuming that all us non-economists understand why capitalization is important. But that's certainly not the case, so here's the kindergarten version of what it means.

Suppose that Acme Bank has $2 billion in capital and is leveraged at 20:1. This means they have $40 billion in assets, primarily consisting of loans of one kind or another.

Now, suppose that due to trading losses their capital is reduced to $1 billion. Unless they want to increase their leverage even further, that means they need to reduce their loan portfolio to $20 billion.

But it's worse than that. 20:1 is an insane amount of leverage. It ought to be closer to 10:1, and lots of banks are now in the process of deleveraging to get there. But with $1 billion in capital and leverage of 10:1, Acme can only have $10 billion in outstanding loans.

In other words, over the course of a few months, they need to reduce their loan portfolio from $40 billion to $10 billion (for example, by declining to roll over commercial paper when it comes due), and until they get there they can't loan out any more money. It doesn't matter if the borrower has a AAA rating. It doesn't matter if Acme's CEO is calm or frightened. Until they get their asset base down to $10 billion, they can't make any more loans.

(The grown-up version of this is way beyond my pay grade and includes a working knowledge of things like Basel risk-weighted asset requirements and our own local version of them. Obviously you're not going to get that from me. But hopefully the kindergarten story at least provides the basic picture.)

This is the theory behind recapitalizing banks rather than buying up their bad assets, as the Paulson plan does. If the government buys a bunch of preferred shares in Acme in return for $1 billion, then its capital is, once again $2 billion. They still need to deleverage, but that's going to happen regardless. The happy news is that even at 10:1, the extra capital expands their lending capacity by $10 billion.

Now, fear is obviously still a part of the picture. That capital injection doesn't do any good if Acme has so many toxic assets that it barely knows what its capital base is in the first place. Maybe it's so close to insolvency that it's going to go bust next week regardless. And even if that's not the case, they still won't want to lend money to other banks if they don't know how strong those banks are.

Still, one is primary and one is secondary. If capitalization is the fundamental problem, then calming down the markets won't do any good. There still won't be any money to loan out. If it's not, then confidence building measures are obviously of some value. Most likely, the story is somewhere in between. But it's kind of scary that nobody really seems to know for sure, isn't it?

UPDATE: Why do banks like high leverage? Because it allows them to make lots of loans, and therefore lots of money, with only a little bit of capital at stake. In good times, high leverage is a great way to make fantastic investment returns.

In bad times, though, it's not so great. The problem is that even small losses on a highly leveraged portfolio can wipe out your capital completely and make you insolvent. This is what's happening now, and it's why more stringent regulations on allowable leverage ratios are a good idea. Good times never last forever, after all.

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Attack Ads vs. Attack Debates

| Wed Oct. 8, 2008 5:46 PM EDT

ATTACK ADS vs. ATTACK DEBATES....A lot of people seem to be surprised that John McCain didn't pull out all the stops last night and lay down a barrage of attacks against Barack Obama for palling around with terrorists, taking loans from crooks, abandoning our troops, and so forth. But I think this misses something important: debates are a terrible place to do this.

TV ads are a different story. In fact, they've been practically conventionalized over the years with their grainy photos, creepy music, and scary sounding announcers. Sure, at the end you have to say "I'm John McCain and I approve this message," but that's not much. The ad still seems almost completely impersonal. It's an attack, but it's not really an attack from anyone.

But a debate is a whole different story. The stage is a small, intimate setting, and if you want to attack somebody, it has to come straight out of your mouth and it has to be directed against someone standing just a few feet away. People react way differently to that than they do to an ad, and for the most part they react badly. It's like watching married friends arguing with each other: it makes you uncomfortable and edgy. You just want it to stop.

That's probably why McCain didn't light into Obama last night. Despite what I said yesterday, it's not that he didn't want to, but that he's smart enough to know that unless you pull it off perfectly, all you accomplish is to make yourself unsympathetic. And whatever else you can say about him, John McCain is very much not a guy who can pull this off perfectly.

McCain Recommends Voters Review His Record Via Nonprofits Linked to His Campaign

| Wed Oct. 8, 2008 4:44 PM EDT

At Tuesday's town hall-style presidential debate at Tennessee's Belmont University, an audience member named Theresa Finch asked the candidates a question that has no doubt been weighing on the minds of many Americans: "How can we trust either of you with our money when both parties got us into this global economic crisis?" When it came time for McCain to respond, he said, "I can see why you feel that cynicism and mistrust, because the system in Washington is broken. And I have been a consistent reformer." He said he had a clear record of taking on special interests and reaching across the aisle to get things done in Washington. "So let's look at our records as well as our rhetoric," he said. "That's really part of your mistrust here. And now I suggest that maybe you go to some of these organizations that are the watchdogs of what we do, like the Citizens Against Government Waste or the National Taxpayers Union or these other organizations that watch us all the time."

It's not surprising that McCain directed Finch to Citizens Against Government Waste or the National Taxpayers Union. Both anti-spending organizations are ideologically aligned with the Arizona Senator and have ties to his presidential campaign. But if Finch were to take McCain's advice and visit the NTU's web site to look up its most recent congressional scorecard, she would find "N/A" next to the candidate's name, for he didn't vote on enough bills in the 110th Congress to qualify for a rating. (Obama receives an F. In past years, McCain's NTU rating has ranged from B-minus to A.)

Lies, Damn Lies, etc.

| Wed Oct. 8, 2008 4:07 PM EDT

LIES, DAMN LIES, ETC....Does intellectual property infringement really cost the United States 750,000 jobs and $250 billion? Where do these frequently cited estimates come from, anyway?

Julian Sanchez and Ars Technica investigated, and the answer turns out to be: (1) an offhand and completely unsupported estimate from Commerce Secretary Malcom Baldridge in 1986, and (2) an offhand and completely unsupported estimate from Forbes in 1993. For the full story on how these two figures have managed to achieve iconic status anyway, click the link.

The McCain Bailout Plan

| Wed Oct. 8, 2008 3:34 PM EDT

THE McCAIN BAILOUT PLAN....If Brad DeLong is right, John McCain's new plan for bailing out homeowners is actually a bailout of the banks who originated the housing bubble's most reckless loans: option ARMs, teaser packages, NINJAs, no-docs, and all the rest. Basically, McCain plans to buy up bad mortgages at full face value and then restructure them into cheaper FHA mortgages. Homeowners are indeed helped, but the banks who made the loans are paid off for the full amount of the loan.

Roughly speaking, Brad figures that out of the $300 billion McCain wants to dedicate to his program, a full third would go to mortgage lenders. "It means that John McCain wants to give $100 billion of taxpayers' money to America's worst-behaving mortgage financiers." This is worse than the Paulson bailout approach and far worse than recapitalizing troubled banks, as many liberals think we ought to do. Brad again:

There's a big difference here: Democrats want to prevent depression and support the financial markets by investing taxpayer money in banks with troubled assets. Republicans want to give taxpayers money away to the shareholders and managers of banks with troubled assets.

I would say that this is unbelievable, but I do believe it.

Somebody needs to ask McCain some very hard questions about the details of this plan.

I'd Just Like to Point Out that McCain's "Logo" is a Very Ironic Dingbat

| Wed Oct. 8, 2008 2:37 PM EDT

mojo-photo-campaignlogos.jpgLots of people have mentioned the loveliness of the Obama campaign logo, with its stripey field, rising sun, and handy reminder of the first letter of the candidate's name. While I've already spent some time analyzing and mocking the McCain campaign's terrible design work, something occurred to me watching another one of his angry mobs rallies on TV yesterday: his "logo," a shaded 5-pointed star, is nothing but a Zapf Dingbat. Zapf Dingbats, for the un-font-obsessed, was one of the original "symbol" fonts; instead of letters, typing on your keyboard gets you various shapes and doodads to spice up your PowerPoint presentation--snowflakes, squares, check-marks, and yes, stars. So, which letter do you think one must type while using the Zapf Dingbats font to create McCain's star, my friends? That's right: his crack team of designers came across this patriotic symbol by typing shift-O.

After the jump, the Zapf Dingbats character map, just as proof.

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Bailing out Homeowners

| Wed Oct. 8, 2008 1:50 PM EDT

BAILING OUT HOMEOWNERS....Last night, when John McCain mentioned his plan to directly rescue homeowners facing foreclosure, I wasn't paying attention. To be honest, I'm so hardwired to assume that presidential debates are just rehashes of old talking points that I thought McCain was merely tossing off another platitude — we need to protect the taxpayer, we must help distressed homeowners, we will focus on job creation, blah blah blah. I didn't realize he was serious about the homeowner part, complete with an actual new policy proposal and everything.

And apparently I wasn't the only one. Marc Ambinder reports that "The proposal certainly seemed to have caught even McCain's surrogates off guard; they had not been prepped to answer questions about it. The media didn't quite know what to think, and there hasn't been too much attention paid to this yet, even though it's a bold and expensive idea." So I don't feel quite so bad about missing this.

Of course, the devil is in the details in a plan like this. Who do you rescue? Everyone who's underwater? Everyone with a subprime loan? Everyone in foreclosure? Only people who are victims of fraud? How do you figure out who that is? And what does "rescue" mean? Restructuring their loan? Putting a halt to all repos? How do you prevent people from gaming the system? Will it prevent house prices from settling back to their natural level? Etc. etc.

Technically, most of those details can probably be worked out. But what interests me is that there's another potential hurdle: the public might not actually buy it. The only comment I did make in real time about McCain's proposal was an observation that CNN's focus group "against expectations, really didn't like McCain's idea of bailing out homeowners directly." And the reason for that appears to be straightforward: cautious, responsible homeowners who took out cautious, responsible loans and bought cautious, responsible houses, are not necessarily thrilled at the idea of their idiot profligate neighbors getting a federal bailout for the idiot profligate loans they took out on their idiot profligate house/remodel/HELOCs. After all, the bulk of the people who need help are not old friends who bought their houses 20 years ago, it's brand new neighbors who swept into the neighborhood in 2006 on a rising tide of debt and shiny new cars. Sympathy for these folks may not be nearly as high as many of us suppose.

Now, this may seem perverse in some ways. Obviously not everyone in foreclosure acted recklessly. And in any case, is bailing out a neighbor who acted recklessly really any worse than bailing out a bunch of Wall Street fat cats who acted recklessly? Maybe not, but the public is none too thrilled about bailing out the fat cats either. And let's face it: your next door neighbor is.....next door. If he seems like an undeserving sort, bailing him out might cause your blood pressure to go up way more than bailing out a bunch of distant banks. For better or worse, that's just human nature. Especially if your next door neighbor has a dog that drives you nuts by barking all night. Just take a look at the now-famous Irvine Housing Blog for a daily helping of exactly this schadenfreude-filled attitude.

So, technical issues aside, it's quite possible that this is not the political winner McCain thinks it is. I note that Obama hasn't really picked up on it, even though his speech today in Indianapolis was a perfect opportunity to do so. I wonder if he understands something the rest of us don't?

UPDATE: Brad DeLong points out that on a technical basis, the McCain plan sucks very, very badly because it directly bails out the banks that made all the bad loans. Details here.

Retired Building Supply Regional Manager Would Have Been King

| Wed Oct. 8, 2008 1:14 PM EDT

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George Washington gained such fame as the hero of the American Revolution that people literally begged him to become king of the United States. He declined, of course, and set a precedent for the peaceful transition of power when he voluntarily left the presidency after two terms. What if he had accepted? What if the United States had become a monarchy with power passed down through the generations? Who would be king today? Ancestry.com claims to have answered that question. Washington died without a direct heir, but genealogists tracked four different family lines that grew out the greater Washington clan and found 8,000 people, now living, who can trace their ancestry back to the first president. But there can be only one king, and according to Ancestry.com's Megan Smolenyak, a retired regional manager for a building supply company "won the sweepstakes." Paul Emerson Washington, 82, of San Antonio, Texas, is the man who would be king. Not that he's upset about losing the throne. "He's always been a modest, soft-spoken person," his son told the Associated Press, adding, "the idea of one individual having supreme power over all others is an antiquated idea."


Photo used under a Creative Commons license from cliff1066.

Bush Policies Help Bring the Financial Crisis Home

| Wed Oct. 8, 2008 1:12 PM EDT

With U.S. banks now partially nationalized, the government is struggling to hold the line, finally linking up in an international network to staunch the hemorrhaging that has been going on in financial markets here, and now around the globe. As the financial crisis spreads out across the world, it is also trickling down to state and local governments, and right up to the doorsteps of most Americans..

This dire picture is rendered even grimmer by the policies of the Bush administration, which has pushed for deep cuts in vital domestic programs amidst this crisis. This will place even more pressure on the states, whose budgets already are badly strained. The downsizing of federal support, combined with the financial crisis, will make it difficult for many states to continue providing basic services to their residents in the coming months and years.

The administration's crusade to cut spending on a wide array of domestic programs is revealed in studies by the usually reliable Center for Budget and Policy Priorities in Washington, an independent think tank that tracks and critiques federal spending with special attention to domestic programs. Under the administration's 2008 budget, the Center reported last year, "domestic discretionary programs—the programs that are funded each year through the annual appropriations process, other than defense and international programs—are slated for sizable reductions over the next five years."

This Campaign Could Get Really Fun...

| Wed Oct. 8, 2008 1:10 PM EDT

This photo restores some of the faith in mankind's creativity that I lost on Monday. Props to Kos for catching it.

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And, frankly, the signage isn't far off. Late last night, CNN flashed a poll that said not only did debate-viewers prefer Obama on the economy by double digits, they preferred him on Iraq by about four or five points. That has to signal the beginning of the end for McCain, doesn't it? Iraq is supposed to be the one issue he will always own; the fact that it's drifting away from him suggests that more and more Americans are talking themselves into a President Obama and his ability to handle all the tough issues.

For what it's worth, Obama won just about every category in last night's polls. Numbers here. I'm guessing Sarah Palin is really going to regret her brief excursion into national politics in a month or so.