Kevin Drum

Valuing the Toxic Waste

| Sun Mar. 22, 2009 2:45 PM EDT
The details of Tim Geithner's plan to buy up banks' toxic waste are still a little vague, but liberal reaction (Krugman, Baker, Smith) has mostly been pretty harsh regardless. Their primary criticism is simple: banks aren't willing to sell their mortgage-backed assets at market prices because they think the market is panicked and only willing to buy at fire sale prices. And fire sale prices will ruin them. But if the government buys at the price banks value this stuff at, they're almost certainly paying too much. It might rescue the banks, but only by essentially giving away lots of free money.

This is all true, but it's a little too glib. After all, if markets can overvalue assets on the way up — and obviously they can — then they can also undervalue them on the way down. There's a pretty good chance that the toxic waste in question really is worth more than the market is currently willing to pay for it.

I think this sometimes get obscured because of a lazy shorthand that a lot of us have fallen into: namely the notion that the value of mortgage-backed securities is certain to keep plummeting because home prices themselves still have another 20-30% to fall. But these securities aren't backed by the value of the homes they represent. They're backed by mortgage payments. Home prices could fall by half, but the value of the securities wouldn't drop by a dime if homeowners kept making their monthly payments. Their value only drops if default rates go up.

So what causes default rates to rise? Falling home prices are certainly a factor, since it's more tempting to mail in the keys when your loan is way underwater. Rising unemployment is an even bigger factor: if you lose your job, you're more likely to stop paying the mortgage. And the crappy lending practices at the height of the bubble produced a surplus of buyers who have always been more likely to default than average.

But there are also forces that can reduce default rates. Fannie Mae and Freddie Mac are buying up billions of dollars worth of mortgages and renegotiating their terms. Barack Obama has committed $75 billion in direct aid for distressed homeowners. Congress is likely to allow bankruptcy judges to rewrite the terms of mortgage loans. And the Fed is trying to reduce long-term interest rates, which will allow homeowners to refinance their loans at lower rates.

Obviously, then, there's tremendous uncertainty about future default rates. But the market appears to be valuing most mortgage-backed securities these days at something like 30 cents on the dollar. That's crazy. When you factor in recovery rates, it assumes that over three-quarters of all homeowners will default on their loans. That might be true of the absolute worst of the toxic waste, and it's certainly true of the equity tranches of even the better stuff, but on average? No way. 30 cents on the dollar simply doesn't represent a reasonable long-term value for most of this stuff.

But everyone is scared, and when there are no buyers prices get unreasonable. So maybe with some nudging (along with plenty of leverage from Uncle Sam), Geithner's plan will motivate private investors to spend more time really trying to figure out what this stuff is worth and making fair bids for it. It's true that there are tricky aspects to running the auctions that Geithner may or may not be able to solve, but if his plan works it will help clean up bank balance sheets and keep taxpayers from getting fleeced. And if it doesn't work? There's always nationalization.

So it's probably worth a try. In the meantime, I'll recommend again Brad DeLong's FAQ, which explains the mechanics of the plan pretty well (though it might be wrong on some of the details since it's based on conflicting press reports). And I'll also re-recommend James Galbraith's post suggesting that we might not have to guess so much about the value of all this toxic waste if banks were forced to allow independent examiners to look at the loan tapes and find out just how vulnerable all these mortgage are.

UPDATE: Robert Waldmann makes the case that the market is actually valuing this stuff pretty accurately. That certainly might be true.  But if it is, then Geithner's plan will fail, the value of the toxic waste will be settled beyond question, and insolvent banks will be exposed for what they are.  That's a good thing, no?

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Predator Update

| Sun Mar. 22, 2009 1:06 PM EDT
Greg Miller of the the LA Times reports that the CIA says its stepped up Predator attacks in Pakistan have been enormously successful:

An intense, six-month campaign of Predator strikes in Pakistan has taken such a toll on Al Qaeda that militants have begun turning violently on one another out of confusion and distrust, U.S. intelligence and counter-terrorism officials say.

....The stepped-up Predator campaign has killed at least nine senior Al Qaeda leaders and dozens of lower-ranking operatives, in what U.S. officials described as the most serious disruption of the terrorist network since 2001.

....Officials said that the surge in strikes has less to do with expanded capabilities than with the decision to skip Pakistani approval. "We had the data all along," said a former CIA official who oversaw Predator operations in Pakistan. "Finally we took off the gloves."Officials said that the surge in strikes has less to do with expanded capabilities than with the decision to skip Pakistani approval. 

....The effect was immediate....CIA officials had suspected that their targets were being tipped by Pakistani intelligence to pending U.S. strikes; bypassing the government ended that concern.  It also eliminated delays. Former CIA officials said getting permission from Pakistani authorities could take a day or more, sometimes causing the agency to lose track of the target.

I find this pretty believable.  There's really not much question that there are plenty of high-level ISI operatives who are sympathetic to al-Qaeda and likely to tip them off to upcoming attacks.  And as the article mentions, the Pakistani government knows this perfectly well.  Its objections to the drone attacks have been decidedly pro forma.

But even if this is all true, it's still not clear that the short-term success of the Predator program outweighs its long-term potential for blowback.  For now, though, I'll let smarter people than me try to figure that out.

Valuing the Toxic Waste

| Sun Mar. 22, 2009 2:47 AM EDT
A combination of user idiocy and lame blog software just wiped out a long post I wrote about the Geithner plan to buy up toxic waste, and I'm too tired and annoyed to try to recreate it tonight.  Instead, I'll just recommend two other posts for now: Brad DeLong's FAQ and James Galbraith's plea to open up the loan tapes.  As for the mechanics of the plan itself, who knows?  I've read three different articles about it, and since all three disagree on some of the details and are vague on others I'm not sure there's much point in getting too deeply into it at this point anyway.  So for now, just read those other guys and wait for Monday when the plan will be officially announced.

More on the Kindle

| Sat Mar. 21, 2009 9:02 PM EDT
Here's a couple more things about the Kindle that I wouldn't have guessed before I started using it.

#1: In the past, I'd go to the bookstore and buy several books at a time.  Naturally I meant to read all of them, and just as naturally, I didn't.  Another book would catch my eye before I'd finished them all, a review book would come in the mail, I'd get a few books for Christmas, etc. etc.  The upshot is that some of the books would fall to the bottom of the pile and never get read.

With the Kindle, though, there's no pile.  When I finish a book, all I have to do is decide at that moment what I feel like reading next.  Ten minutes later I have it.  I don't know for sure if this is good or bad in the long run, but it's certainly different.

#2: I have a floater in my right eye that can get pretty annoying when I read.  However, I only really see it against a bright white background.  Today my floater was in high gear, but I noticed that it wasn't bothering me while I was reading because the background of the Kindle is a soft gray.  When I first got it, that soft gray annoyed me, but now I see that it was a blessing in disguise

Friday Cat Blogging - 20 March 2009

| Fri Mar. 20, 2009 3:15 PM EDT
On the left, Inkblot is worried that Congress will consider him a fat cat and tax his evening dinner bonus away.  I told him it actually counts as straight salary in his case, so no worries.  On the right, we have a rare shot of Domino actually walking somewhere.  It's not that she never does this, just that it's hard to take a picture of it since she instantly makes a beeline for the camera if she sees it pointed in her direction.  This time I caught her just in time.

Debt, Debt, Debt

| Fri Mar. 20, 2009 2:54 PM EDT
The Congressional Budget Office released some new numbers today and the White House had this to say:

Responding to today’s new, more pessimistic CBO scoring of the president’s budget in light of the deteriorating economic situation, Peter Orszag was at pains to emphasize that deficit projections are highly sensitive to relatively small changes in assumptions. For example, suppose that first you project revenues of $100 and spending of $103 for a $3 deficit. Then you get some bad news about the economy so projected revenue drops by five percent. Well, suddenly you’re looking at a deficit of $8. The alarming way to put this is that the deficit has nearly tripled. The calm way is that revenue has fallen by 5 percent.

Well, yes, deficit projections are highly sensitive to small changes in assumptions, which is why presidents traditionally tweak their assumptions to produce rosy economic projections.  It doesn't take much.  Obama and Orszag actually did this less than most administrations in their initial budget proposal, I think, but they still did it.  And now it's coming back to bite them since, in fact, the alarming way of looking at this is also the correct one.

Now, given the current state of the economy, a larger deficit might be a feature, not a bug.  But if the deficit stays above 4% of GDP for an entire decade, as the CBO suggests, then we have a problem.  We can't keep that up forever any more than Wall Street could keep the subprime bubble going forever.  Someday we're going to pay.

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Happy New Year

| Fri Mar. 20, 2009 1:18 PM EDT
President Obama, showing his command of YouTube once again, wishes the Iranian people a happy Nowruz:

So in this season of new beginnings I would like to speak clearly to Iran's leaders.  We have serious differences that have grown over time.  My administration is now committed to diplomacy that addresses the full range of issues before us, and to pursuing constructive ties among the United States, Iran and the international community.  This process will not be advanced by threats.  We seek instead engagement that is honest and grounded in mutual respect.

You, too, have a choice.  The United States wants the Islamic Republic of Iran to take its rightful place in the community of nations.  You have that right — but it comes with real responsibilities, and that place cannot be reached through terror or arms, but rather through peaceful actions that demonstrate the true greatness of the Iranian people and civilization.  And the measure of that greatness is not the capacity to destroy, it is your demonstrated ability to build and create.

Unsurprisingly, the initial reaction from Iranian leaders wasn't very enthusiastic.  But it's still a constructive gesture.  Symbols matter, and they make the substance a little easier to address when the time comes to talk substance.  I just hope they got the Persian subtitles right.

Taxing the Bonuses

| Fri Mar. 20, 2009 12:55 PM EDT
This is a little embarrassing to admit, but by yesterday I'd gotten so tired of the AIG story that I barely even noticed the details of the House bill to claw back all the bonuses.  But it's a monster.  Taxing the million-dollar bonuses is one thing — I may be a little ambivalent about that, but overall I don't think it's all that problematic — but the bill that passed last night taxes away bonuses from anyone with a household income over $250,000.  That's a couple of mid-level analysts.  This is likely to hit tens of thousands of fairly ordinary workers who had nothing to do with AIG's troubles and who simply don't deserve this kind of treatment.

A friend of mine who describes herself as "Marxist at heart" but has nonetheless been trying to convince me all along that the tax clawback idea is a horrific idea, points me to this article in the Post today about how AIG employees are reacting to the death threats and armed security guards in the parking lots:

A sense of fear hung in the room -- the palpable, unsettling kind that flashes across people's eyes. But there was anger, too. No one would express it publicly, of course. Who wants to hear a wealthy financier complain? And yet, within those walls off Danbury Road lies a deep sense of betrayal — first by their former colleagues, now by their elected leaders.

The handful of souls who championed the firm's now-infamous credit-default swaps are, by nearly every account, long since departed. Those left behind to clean up the mess, the majority of whom never lost a dime for AIG, now feel they have been sold out by their Congress and their president.

"They've chosen to throw us under the bus," said a Financial Products executive, one of several who spoke on condition of anonymity, fearing reprisals. "They have vilified us."

They say what is missing from this week's hysteria is perspective. The very handsome retention payments they received over the past week were set in motion early last year when the firm's former president, Joe Cassano, was on his way out the door. Financial Products was already running into trouble on its risky credit bets, and the year ahead looked grim. People were weighing offers from other firms, and AIG executives feared that too many departures could lead to disaster.

So AIG stepped in with an offer to employees of Financial Products. Work through all of 2008, and you'd get a lump payment in March 2009. Stick around through 2009, and you'll get paid through 2010. Almost all other forms of compensation — bonuses, deferred payments and the like -- have vanished.

"People are trying to do the right thing," the same Financial Products executive said. "Guys have worked their [tails] off to try to get value for the taxpayer. This isn't money that's being advanced to us. People have performed the work and done it exactly as we asked them to do."

I don't know what the Senate will do with the House language, but they simply can't leave it the way it is.  A high marginal rate on million-dollar bonuses at bankrupt companies is one thing, but putting huge swathes of their professional staff in the same boat is another.  If this is where populist outrage is taking us, it's time for a timeout.

Unleash the Fed?

| Fri Mar. 20, 2009 12:18 PM EDT
Over at our main site, James Ridgeway remarks that "the Federal Reserve seems to be catching remarkably little blame for the current economic crisis."  This doesn't surprise me.  After all, in a lot of ways the Fed seems to be practically the only institution in Washington actually capable of taking dramatic action these days.  And something is better than nothing.

More interestingly, James points to a Nation piece by William Greider, a longtime Fed watcher, in which he climbs down slightly from some of his previous criticisms.  It's not that he suddenly thinks the Fed is doing a good job, but drawing on the work of progressive economist Jane D'Arista he suggests that part of the problem is that the Fed now has too little authority:

When deregulation began nearly thirty years ago, some leading Fed governors, including [Paul] Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer."

....The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets....In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.

The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly.

The problem, D'Arista argues, is that the Fed's control of short-term interest rates has less and less effect on long-term interest rates as the money supply moves outside the traditional banking system.  And fixed capital adequacy requirements, which require banks to slam the brakes on lending during bad times, make things even worse.

Read the whole thing.  I don't have the chops to fully evaluate what she says, but it's an intriguing argument and I'd be interested in hearing reaction from other blogospheric economists.  It's something to think about once we've put out the immediate fire.

Indispensable?

| Fri Mar. 20, 2009 1:19 AM EDT
Is it really true that the traders who created AIG's CDS mess in the first place are also the only ones with the knowledge to unwind it successfully?  Do we really need to pay millions of dollars to keep them around?  Simon Johnson, who certainly has the experience to know, says no:

If A.I.G. wants to argue that complex transactions, hedging positions and counterparty relationships require employees who are intimately familiar with those trades, it should at least provide evidence that the arguments for doing so are sounder than the ones made in Indonesia in 1997, when leading bank-owning conglomerates claimed that only they understood their financing arrangements, which certainly were complex. Or the Russian bankers in 1998 who were convinced that only they and their friends could possibly close the deals that they had taken on. We heard variants of the same idea in Poland in 1990, Ukraine in 1994 (and in the Ukrainian crises subsequently), and Argentina in 2002.

Any grain of truth in these arguments must be weighed against the costs of allowing discredited insiders to manage institutions after they have blown them up. Even if the conclusion is that a few experts need to be retained, offering guaranteed bonuses to virtually the entire operation is hardly the way to achieve the desired results. We should not let people think that the best way to guarantee job security is to lose lots of money in a really complicated way.

Charles de Gaulle said it best: “The cemeteries of the world are full of indispensable men.”  If the current crew isn't willing to work for anything less than a million bucks a year, I doubt that AIG will have much trouble replacing them with someone who will.