Kevin Drum

How the Repo Market Ate Wall Street

| Mon Mar. 1, 2010 3:05 PM EST

Several years ago I remember reading about the repo market for the first time. I had never heard of it before not because it didn't exist, but because I'm not a financial guy and I had simply never paid much attention to how Wall Street banks fund themselves. To make a long story short, the repo market is basically a market for short-term loans. Really short term: it's an overnight market, and if you have, say, $100 billion in repo funding, you have to roll over that funding every single day. If you can't, you're in big trouble.

To a layman, that sounds crazy. Investment banks weren't just using the repo market to gain a bit of additional flexibility, they were using it as a significant part of their funding base. They were literally dependent for their continued existence on a line of funding that had to be renewed daily.

I'm reminded of this by a paper from Yale's Gary Gorton that I just got around to reading today. It explains the role of the repo market in our recent economic collapse. Gorton estimates that the total size of the repo market had grown to about $12 trillion by 2007, and as the housing bubble started to burst investors began large-scale bank runs. Except that instead of the run being caused by individuals queuing up at local banks to cash out their savings accounts, it came from repo lenders calling in their loans:

For concreteness, let’s use some names. Suppose the institutional investor is Fidelity, and Fidelity has $500 million in cash that will be used to buy securities, but not right now. Right now Fidelity wants a safe place to earn interest, but such that the money is available in case the opportunity for buying securities arises. Fidelity goes to Bear Stearns and “deposits” the $500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset‐backed securities [with] a market value of $500 millions. These bonds are provided to Fidelity as collateral. Fidelity takes physical possession of these bonds. Since the transaction is overnight, Fidelity can get its money back the next morning, or it can agree to “roll” the trade. Fidelity earns, say, 3 percent.

....There’s another aspect to repo that is important: haircuts. In the repo example I gave above, Fidelity deposited $500 million of cash with Bear Stearns and received as collateral $500 million of bonds, valued at market value. Fidelity does not care if Bear Stearns becomes insolvent because Fidelity in that event can unilaterally terminate the transaction and sell the bonds to get the $500 million. That is, repo is not subject to Chapter 11 bankruptcy; it is excluded from this.

Imagine that Fidelity said to Bear: “I will deposit only $400 million and I want $500 million (market value) of bonds as collateral.” This would be a 20 percent haircut. In this case Fidelity is protected against a $100 million decline in the value of the bonds, should Bear become insolvent and Fidelity want to sell the bonds.

....For now, keep in mind that an increase in the haircuts is a withdrawal from the bank. Massive withdrawals are a banking panic. That’s what happened. Like during the pre‐Federal Reserve panics, there was a shock that by itself was not large, house prices fell. But, the distribution of the risks (where the subprime bonds were, in which firms, and how much) was not known. Here is where subprime plays its role. Elsewhere, I have likened subprime to e‐coli (see Gorton (2009a, 2010)). Millions of pounds of beef might be recalled because the location of a small amount of e‐coli is not known for sure. If the government did not know which ground beef possibly contained the e‐coli, there would be a panic: people would stop eating ground beef. If we all stop eating hamburgers for a month, or a year, it would be a big problem for McDonald’s, Burger King, Wendy’s and so on. They would go bankrupt. That’s what happened.

The evidence is in the figure [on the right], which shows the increase in haircuts for securitized bonds (and other structured bonds) starting in August 2007. The figure is a picture of the banking panic. We don’t know how much was withdrawn because we don’t know the actual size of the repo market. But, to get a sense of the magnitudes, suppose the repo market was $12 trillion and that repo haircuts rose from zero to an average of 20 percent. Then the banking system would need to come up with $2 trillion, an impossible task.

There's more in the paper, which is worth reading if you want to learn more about this stuff. In my own mind, I have a tendency to waffle back and forth between blaming the economic meltdown solely on a single fundamental (housing prices crashed, everyone panicked) and blaming it on a variety of other factors as well (mortgage fraud, the growth of credit derivatives, ratings agency conflicts, massive abuse of leverage, wild underestimation of risk, etc.). Overall, I tend toward believing that although the housing crash was clearly both the proximate and primary cause of the collapse, all the other stuff really did matter too, magnifying an asset bust far beyond what it could have done on its own. Without massive leverage, for example, even a huge housing bubble couldn't have caused the scale of the damage we saw.

Gorton has a slightly different take: the housing bubble was primary, but it was the fundamental structure of modern banking that turned it into a catastrophe: "The problem is structural," he says. "This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default....The economy needs banks and banking. But bank liabilities have a vulnerability."

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Reconciliation 101

| Mon Mar. 1, 2010 1:33 PM EST

Are American journalists idiots? No, don't answer that. Just go read Jon Chait's description of Sen. Kent Conrad trying to explain the budget reconciliation process to Bob Schieffer and then having the exchange picked up by Politico. Is it any wonder that the public doesn't understand this either?

So here it is in simple terms: the Democratic plan is not to pass healthcare reform via reconciliation. It never has been. The plan is to pass it via regular order (i.e., have the House approve the bill already passed by the Senate) and then amend it with a few modest modifications that are passed via reconciliation and therefore can't be filibustered in the Senate. Only the amendments would be passed via reconciliation, and the only open questions are what exactly the amendments would look like and whether they'll be passed at the same time as the main bill or as part of a later budget resolution. Capiche? Here's Chait:

Look, it would be okay for reporters and pundits to be obsessed with what legislative method is employed to pass health care reform if they boned up on the issue. Alternatively, it would be okay for them not to understand it at all if they deemed it an irrelevant issue. (Which, in my opinion, it is.) But obsessed and ignorant makes for a bad combination.

Good luck with that.

Chart of the Day: Long-Term Unemployment

| Mon Mar. 1, 2010 1:06 PM EST

Lots of people have been talking about this for months now, and I don't have anything new and unusual to add to the conversation. But it's worth keeping this chart front and center at all times: it's the number of people who are not just unemployed, but who have been unemployed for at least half a year. The red line is the key one, and it shows that the proportion of long-term unemployed during the current recession is nearly twice as high as it was during 1982, the previous record holder since the Great Depression.

What's worse is that we can't expect this to go away quickly. Paul Volcker deliberately created the recession of the early 80s by jacking up interest rates to unprecedented levels, and he dispensed with it just as easily by lowering rates in 1982. That's not going to happen this time because interest rates are already as low as they can go. At best, we're going to hit a plateau and then linger there before a slow, fitful recovery that takes years. At worst — well, things will get even worse.

Mass, long-term unemployment is one of the most corrosive things any country can go through. The fact that we're basically doing nothing about it is not just disgraceful, it's genuinely dangerous.

It's Not Just Congress That's Broken

| Mon Mar. 1, 2010 12:23 PM EST

David Frum argues today that the congressional revolution of the 70s — when the filibuster was made easier to use, the power of committee chairmen declined, Congress became more egalitarian, and campaign finance reform broke the power of the parties — has caused the legislative process to break down:

Take this quiz. Name the most important legislation enacted in the 30 years between 1950 and 1980.

Overwhelming isn’t it? Civil rights. Voting rights. Interstate highways. Medicare. Medicaid. The deregulation of the airlines, natural gas, trucking, rail and oil. The immigration act of 1965. Clean Air, Clean Water, and the Endangered Species Acts. Supplemental Security Income in 1974. I could fill the whole screen.

Now ... the next 30 years. There’s the Reagan tax cuts of course. Deregulation of the savings & loans in 1982. The Americans with Disabilities Act in 1990. Welfare reform in 1995. Medicare Part D. What else?

Leave aside whether you are liberal or conservative, whether you approve the measures mentioned above or disapprove. It’s hard to dispute: Congress just got a lot more done in the 1950s, 1960s and 1970s than in the 1980s, 1990s and 2000s.

Matt Yglesias points out that you can hardly talk about polarization and gridlock without mentioning the racial realignment of the parties that's affected politics so strongly in the post-Reagan, and I think that's right. But I'd add something else. The era between 1950 and 1980 was an essentially liberal one. That applies to the 60s and 70s pretty obviously, but even the 50s, underneath McCarthyism and the man in the gray flannel suit, was defined mainly by consolidation of the New Deal. Eisenhower wasn't called a New Republican for nothing.

The succeeding 30 years, famously, were primarily conservative. And that makes a fundamental difference. Liberals, by nature, want to change things. They want to pass big stuff. Conservatives, by nature, want to conserve. They want to prevent change. Occasionally this takes the form of rolling back liberal programs (tax cuts, welfare reform), but rolling back progress is hard and rare. For the most part, conservatism takes the form of not undertaking big legislative changes. So it's hardly any surprise that a conservative era is marked by lack of seminal congressional actions.

What's really noteworthy isn't that 1980-2010 was a marked by a conservative approach to legislation, but that we should be at the start of a new liberal era right about now. Maybe not a repeat of the 60s, but still something. Times change, cultures change, and problems change — and conservatives can keep the lid on this bottle just so long before it's ready to blow. By now, America ought to be ready for fundamental financial reform, healthcare reform, energy reform, and social reform.

But it's not, really. All of these things poll well in vague terms, but don't really garner a lot of deep support. It's this, even more than legislative maneuvering, that's allowed Republicans to stop Democratic plans in their tracks. We liberals just haven't made the case for change compellingly enough.

Reforming the Filibuster

| Mon Mar. 1, 2010 11:20 AM EST

OK, here's my idea: mend it, don't end it. How about if both parties agree to a limited number of cloture votes per congressional session? Let's say, 20 per session per party. Ditto for holds. Maybe one per senator per session. The minority would still have a broad ability to force a supermajority on major legislation like healthcare reform, or to hold a nominee who they considered truly noxious, but they wouldn't have the ability to simply bring the Senate to a grinding halt out of pique or pure partisan rancor.

I know, I know, it's not going to happen. But it would be interesting if it did! Maybe even better than pure majority rule, since it would introduce some genuinely intriguing strategy and maneuvering to Senate procedures. Sort of like coaches deciding when to burn timeouts or challenge rulings on the field during a football game. It would also give party leaders some much-needed additional power, since they'd necessarily be the clearinghouse for filibusters. Who's with me?

Corn Ethanol: Still a Boondoggle

| Mon Mar. 1, 2010 10:00 AM EST

Corn-based ethanol is supposedly a green alternative to gasoline. The corn farming lobby certainly thinks so, anyway, and they've persuaded Congress to mandate (and subsidize) increased corn ethanol production through the year 2015.

But is corn ethanol really greener than gasoline? If you analyze total lifecycle emissions directly (i.e., including the CO2 emissions involved not just in burning ethanol, but also in producing it), the answer is yes, though not by much. But there's more to it than just production. When you switch forest or pasture land to cropland in order to grow more corn, that releases CO2 as well, and you have to take that into account whether the farm lobby likes it or not. (And they don't.) The chart on the right shows the effects. So what's the conclusion? A new paper in BioScience1 takes a fresh look at what the market response is to increased corn production, including (a) reduction in food consumption due to higher food prices, (b) intensification of agricultural production, (c) land use change into cropping in the US, and (d) land conversion in the rest of the world. The paper suggests that previous estimates of induced land use changes (ILUC) have been too high, but:

Using straight line amortization over 30 years of production at current fuel yields [] results in ILUC emissions of 27 g CO2 per MJ....[A]dding our lower estimate of emissions to the direct emissions from typical US maize ethanol production (about 65 g CO2e per MJ) would nearly eliminate carbon benefit of this biofuel relative to typical gasoline (94-96 g per MJ).

(Note: MJ = megajoule, a unit of energy.) In other words, even giving corn ethanol the maximum benefit of the doubt, it's still no greener than gasoline: it releases about 92 grams of CO2 per megajoule of energy compared to 94-96 for gasoline. What's more, if you assume a more reasonable 20-year amortization period, corn ethanol's greenhouse gas emissions are even higher. And if you don't assume that people eat less thanks to increased corn ethanol production, but instead just spend more on food, it goes up even more.

Bottom line: corn ethanol is no greener than gasoline. In fact, it's almost certainly less green, and at the very least, there's no urgent need for the U.S. government to pay billions of dollars to subsidize its production. Too bad Iowa is the first state on the primary calendar every four years, isn't it?

1No link yet. I'll add one if and when it's available. UPDATE: It's not online yet, but the reference is BioScience, March 2010 / Vol. 60 No. 3.

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The Real Case for Broken Government

| Sun Feb. 28, 2010 11:17 PM EST

Over at MoJoBlog, Andy Kroll declares that "Sen. Chris Dodd (D-CT) has dealt the death blow to consumer protection." He's talking about the Consumer Finance Protection Agency, a proposed federal agency that would (in Elizabeth Warren's words) regulate financial products the same way we regulate toasters. Republicans have been opposed from the start to a CFPA with teeth, and Dodd has finally given in. Here's the PowerPoint version of his latest proposal:

  • Instead of being an independent agency, the CFPA has morphed into a Bureau of Financial Protection within the Treasury Department.
  • The BFP would regulate large banks and mortgage companies. However, it would have no authority over banks with assets of less than $10 billion and it would have no authority over other non-bank financial institutions. (The BFP can petition for authority over other financial sectors, but this is almost certainly a fig leaf. It would never get it.)
  • States that want to enforce higher consumer standards for financial products wouldn't be allowed to. The BFP preempts all state regulation.
  • The BFP would have to confer with existing bank regulators before making any new rules, and its rules could be overriden by the Systemic Risk Council.

I don't have a good sense of how much Dodd is to blame for this toothless state of affairs. After all, Republicans instantly rejected even this watered-down proposal, objecting to the "rule-writing power Dodd proposed for the consumer division." But if they're objecting to rule-writing power, then they're simply objecting to anything that might have even the slightest chance of being effective. It's all kabuki.

This, far more than healthcare reform, is the most disturbing evidence of America's broken politics. After all, healthcare was always bound to be brutally partisan. Democrats and Republicans have been disagreeing about national healthcare for decades and there was no reason to think it would be different in 2009. We liberals may not like the result so far, but it was hardly unexpected.

But financial reform is different. Sure, Republicans are generally less enthusiastic about corporate regulation than Democrats. This was never going to be a chorus of Kumbaya. But Republicans aren't philosophically opposed to preventing economic meltdowns, and if there's anything that should have inspired even conservatives into agreeing that Wall Street needed to be reined in a wee bit, it was the reckless financial excesses of the aughts and the unprecedented economic devastation it provoked. The entire country is suffering through a grueling economic downturn that's the worst since the Great Depression, the collapse of 2008 makes the case for regulation almost irresistable, and even the GOP's tea party base is ready to lynch bankers on sight. The political case for regulation could hardly be more powerful.

But that hasn't made a lick of difference. Not a lick. On an issue where the facts on the ground were so compelling that Democrats and Republicans should have been easily able to forge a consensus for serious change despite philosophical differences, there's been barely even a recognition from conservatives that anything went wrong. It's as if Democrats had responded to 9/11 by flatly opposing any action whatsoever to beef up our anti-terrorist capabilities.

So what now? Unlike healthcare, where a weak bill is still worth passing because it might lead to stronger reforms in the future, I don't think you can say that about this. An agency with no rulemaking authority isn't going to suddenly gain some later on. It will just be one of those indestructible bureaucratic barnacles, taking up space in some federal office building forever without ever accomplishing anything.

Writing a decent bill and making Republicans kill it might provide Democrats with some kind of partisan advantage. Maybe. But passing Dodd's current proposal, let alone something even weaker, would certainly have no substantive effect, either now or in the future. There's literally no point in bothering to bring it to the floor. After going through the greatest financial catastrophe of our lifetimes, brought on by forces we understand perfectly well, we're going to do nothing to keep it from happening again. That's a broken government.

UPDATE: Paul Krugman writes essentially the same thing here. At this point, no bill might be better than what it's possible to pass in the face of Republican opposition.

LA-SF Reality Check

| Sun Feb. 28, 2010 1:57 AM EST

Well, that didn't take long:

Despite a new $2.25-billion infusion of federal economic stimulus funding, there are intensifying concerns — even among some high-speed rail supporters — that California's proposed bullet train may not deliver on the financial and ridership promises made to win voter backing in 2008.

....New inflation-adjusted construction figures show that outlays needed to build the first 520-mile phase of the system have climbed more than 25%, from $33.6 billion to $42.6 billion....Under the new scenario, one-way fares between L.A. and San Francisco rise from $55 to $105, closer to the cost of an airline ticket. The change shows healthier surplus revenue, which may appeal to private investors. But estimated ridership falls by about one-third, to about 40 million annual boarders in 2030.

So in a mere two years, projected ticket prices have gone up 90%, ridership has gone down 30%,1 and construction costs have increased 25%. There's nothing yet about increasing the projected travel time from its original, very optimistic, 2.5 hours, but I'm sure that's coming too. Who could have predicted?

1Actually, my recollection is that the original studies were based on a fantasy ridership of 100 million. So ridership projections are actually down 60%.

Daniel Ellsberg on the Limits of Knowledge

| Sat Feb. 27, 2010 4:55 PM EST

Jay Ackroyd went to a conference last week where he heard Daniel Ellsberg speak. He apparently recounted one of my favorite Ellsberg stories, and since it's one of my favorites I'm going to repeat it in full below. It's from Ellsberg's book Secrets, and the setting is a meeting with Henry Kissinger in late 1968 when he was advising him about the Vietnam War. The idea of Kissinger seeking out Ellsberg for advice on Vietnam initially seems a bit unlikely, but in 1968 Ellsberg was a highly respected analyst on the war who had worked for both the Pentagon and Rand, and Kissinger was just entering the government for the first time. Here's what Ellsberg told him. Enjoy:

"Henry, there's something I would like to tell you, for what it's worth, something I wish I had been told years ago. You've been a consultant for a long time, and you've dealt a great deal with top secret information. But you're about to receive a whole slew of special clearances, maybe fifteen or twenty of them, that are higher than top secret.

"I've had a number of these myself, and I've known other people who have just acquired them, and I have a pretty good sense of what the effects of receiving these clearances are on a person who didn't previously know they even existed. And the effects of reading the information that they will make available to you.

"First, you'll be exhilarated by some of this new information, and by having it all — so much! incredible! — suddenly available to you. But second, almost as fast, you will feel like a fool for having studied, written, talked about these subjects, criticized and analyzed decisions made by presidents for years without having known of the existence of all this information, which presidents and others had and you didn't, and which must have influenced their decisions in ways you couldn't even guess. In particular, you'll feel foolish for having literally rubbed shoulders for over a decade with some officials and consultants who did have access to all this information you didn't know about and didn't know they had, and you'll be stunned that they kept that secret from you so well.

"You will feel like a fool, and that will last for about two weeks. Then, after you've started reading all this daily intelligence input and become used to using what amounts to whole libraries of hidden information, which is much more closely held than mere top secret data, you will forget there ever was a time when you didn't have it, and you'll be aware only of the fact that you have it now and most others don't....and that all those other people are fools.

"Over a longer period of time — not too long, but a matter of two or three years — you'll eventually become aware of the limitations of this information. There is a great deal that it doesn't tell you, it's often inaccurate, and it can lead you astray just as much as the New York Times can. But that takes a while to learn.

"In the meantime it will have become very hard for you to learn from anybody who doesn't have these clearances. Because you'll be thinking as you listen to them: 'What would this man be telling me if he knew what I know? Would he be giving me the same advice, or would it totally change his predictions and recommendations?' And that mental exercise is so torturous that after a while you give it up and just stop listening. I've seen this with my superiors, my colleagues....and with myself.

"You will deal with a person who doesn't have those clearances only from the point of view of what you want him to believe and what impression you want him to go away with, since you'll have to lie carefully to him about what you know. In effect, you will have to manipulate him. You'll give up trying to assess what he has to say. The danger is, you'll become something like a moron. You'll become incapable of learning from most people in the world, no matter how much experience they may have in their particular areas that may be much greater than yours."

....Kissinger hadn't interrupted this long warning. As I've said, he could be a good listener, and he listened soberly. He seemed to understand that it was heartfelt, and he didn't take it as patronizing, as I'd feared. But I knew it was too soon for him to appreciate fully what I was saying. He didn't have the clearances yet.

Friday Cat Blogging - 26 February 2010

| Fri Feb. 26, 2010 2:54 PM EST

This has felt like a long week. Was it just me? Either way, I need to emulate my cats and catch up on some sleep this weekend.

And speaking of cats, here they are, just in the nick of time. On the left, Domino, as usual, has staked out one of the roving patches of sunshine in the house (entryway in the morning, top of the stairs in the late morning, in front of the dining room table in the afternoon, etc.). On the right, Inkblot is pursuing one of his favorite non-sleeping activities, namely preventing me from blogging.

In other news, Carly Simon has revealed that the subject of "You're So Vain" is named David. Let the guessing games begin anew!