How did the credit rating agencies misfire?

A second view is that because the methodologies used for rating CDOs are complex, arbitrary, and opaque, they create opportunities for parties to create a ratings “arbitrage” opportunity without adding any actual value. It is difficult to test this view, too, although there are reasons to find it persuasive. Essentially, the argument is that once the rating agencies fix a given set of formulas and variables for rating CDOs, financial market participants will be able to find a set of fixed income assets that, when run through the relevant models, generate a CDO whose tranches are more valuable than the underlying assets. Such a result might be due to errors in rating the assets themselves (that is, the assets are cheap relative to their ratings), errors in calculating the relationship between those assets and the tranche payouts (that is, the correlation and expected payout of the assets appear to be higher and therefore support higher ratings of tranches), or errors in rating the individual CDO tranches (that is, the tranches receive a higher rating than they deserve, given the ratings of the underlying assets). These arguments are complex and subtle…

That is from a very interesting paper by Frank Partnoy.  The paper is not always easy reading but so far it is the best piece on its topic I have found.  This was another good section:

If the mathematical models have serious limitations, how could they support a $5 trillion market? Some experts have suggested that CDO structurers manipulate models and the underlying portfolio in order to generate the most attractive ratings profile for a CDO. For example, parties included the bonds of General Motors and Ford in CDOs before they were downgraded because they were cheap relative to their (then high) ratings.67 The primary reason that the downgrades of those companies had an unexpectedly large market impact was that they were held by so many CDOs.

Thus, with respect to structured finance, credit rating agencies have been functioning more like “gate openers” rather than gatekeepers. The agencies are engaged in a business, the rating of CDOs, which is radically different from the core business of other gatekeepers. No other gatekeeper has created a dysfunctional multi-trillion dollar market, built on its own errors and limitations.

There is also a good discussion of how the ratings agencies have claimed First Amendment protection for their activities, more or less successfully.  p.96 offers some good policy conclusions.

The Economic Organization of a Prison

A famous paper in economics showed how cigarettes became a medium of exchange in a POW camp (even leading to booms and slumps depending on Red Cross deliveries).  For a long time cigarettes were the money of choice in American prisons as well but today, according to a great piece in the WSJ, the preferred medium of exchange is mackerel.

There’s been a mackerel economy in federal prisons since about 2004,
former inmates and some prison consultants say. That’s when federal
prisons prohibited smoking and, by default, the cigarette pack, which
was the earlier gold standard.

Prisoners need a proxy for the dollar because they’re not allowed to
possess cash. Money they get from prison jobs (which pay a maximum of
40 cents an hour, according to the Federal Bureau of Prisons) or family
members goes into commissary accounts that let them buy things such as
food and toiletries. After the smokes disappeared, inmates turned to
other items on the commissary menu to use as currency…in much of the federal prison system mackerel has become the currency of choice.

I loved this point which raised the possibility of significant mack seignorage.

…Mr. Muntz says he sold more than $1 million of mackerel for federal
prison commissaries last year. It accounted for about half his
commissary sales, he says, outstripping the canned tuna, crab, chicken
and oysters he offers.

Unlike those more expensive delicacies, former prisoners say, the
mack is a good stand-in for the greenback because each can (or pouch)
costs about $1 and few — other than weight-lifters craving protein —
want to eat it.

Thanks to Brandon Fuller for the link.

Net worth certificates, from the FDIC

One alternative is a "net worth certificate" program along the lines of
what Congress enacted in the 1980s for the savings and loan industry.
It was a big success and could work in the current climate. The FDIC
resolved a $100 billion insolvency in the savings banks for a total
cost of less than $2 billion.

Here is more.  Here is an FDIC summary of the program, under the heading "Other Resolution Alternatives."  To the extent bank recapitalization is needed, this is the best way to do it.  As Andrew Sullivan will tell you, experience really does matter.  I would like to see more economists promote this idea as an alternative to Treasury warrants. 

What will happen with the dollar?

Keith asks, as do others:

I had been curious as to how this whole situation will effect the dollar…If you find the time, I would like to know or see the future of the dollar in this situation.

Please note that I am a "buy and hold" guy, not a trader, and I am certainly not a currency trader.  But I’ll cover the dollar vs. the Euro.

My inclination is to think the dollar will hold its value.  I don’t trust any of the macro models of currency values and we do know that purchasing power parity, while very approximate, and exerting its force only in the long run, does not imply a bearish stance toward the dollar.

Here is a list of European banks with assets greater than the gdp of their respective home countries.  And read this.

As for this country, the Chinese now regard us as "battle tested."  We have been through some truly major bumps, yet no major U.S. politician has called for "not paying back the Chinese."  We’ve even guaranteed the $350 billion in agency securities held by the Chinese central bank and without a stir.  I think the Chinese are shocked by that and in many ways they now trust their investments more than before, not less.

The Chinese do not have comparable trust in "Europe."  If something went wrong in the financial realm, who would they call up on the phone?  Which country?  What do they think is the power base of the head of the ECB?  What political party does that person belong to?  What favors can be traded and with whom?  Whose answer would count as definitive?  Keep in mind that for all of China’s modernity, their leaders are still communist party functionaries.

The negative scenario for the dollar is where the Chinese economy collapses, not where the Chinese become too afraid to buy dollar-denominated assets.

Bush, Bernanke, Paulson — we call them leaders.  The Chinese think of them as the customer service department.  I suspect the Chinese get straighter answers from them than we ever do.

Plans, plans, plans

There is the O’Neill plan:

His plan to deal with the crisis would start with a "discounted cash-flow analysis” of distressed instruments that are clogging the financial system. The government would guarantee the assets, paring back the support as principal and interest payments were made, he said. "That should take care of the liquidity problem because if they have a government guarantee at a specified level they should trade just like cash,” O’Neill said.

Or the Soros plan.  And here is a "SuperBond" plan to recapitalize the banking system. 

And then there is the Phelps plan for capital injection in return for warrants.  Not to mention the French plan.

Or how about the Wright plan:

…to let any American with a mortgage swap it out for a government one at 7% for up to 50 years (to get the monthly payment down to where the borrower can handle it). The Treasury will pay off the existing mortgage with bonds (which it can sell cheap right now). If a borrower wants to default instead s/he can do so, and then the lender can mortgage the property on the above terms.

So many plans!

Here are some solar greenhouse plans.  And here are Silly Billy’s World’s Elementary Lesson Plans.

The best parenthetical statement I read today

(The fictional 18th century heroine, Moll Flanders, recognized that a high self-regard can be dangerous, arguing that women who believe themselves beautiful are easier to seduce: “If a young woman once thinks herself handsome, she never doubts the truth of any man that tells her he is in love with her; for she believes herself charming enough to captivate him, ’tis natural to expect the effects of it.”)

Here is the link.

The Snowball

The subtitle is Warren Buffett and the Business of Life.  Is it massive?  Yes.  Does it contain numerous revelations about his childhood, his "slight obsession" with trains, his love of collecting, and his sex life?  Yes.  Is it well written and well researched?  Yes.  Does it cover many financial episodes (most of all Salomon Brothers) and famous characters?  Yes.  Is it number one on Amazon?  Yes.  Does it contain analytic depth?  No.  Did I like it?  Yes, but for a return which is mostly biographical in nature, it’s a lot of detail to wade through.

My views on the crisis — a summary statement

A few inattentive malcontents are complaining that I haven’t stated my views.  I have, but if you want them, or some of them, in one neat place, devoid of subtlety or explanation, here they are:

1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced "minority lending."

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

3. The crisis represents a massive conjunction of both market and governmental failure.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

5. The modified Paulson plan was better than nothing — especially after the market had been scared — but far from my first choice.  In any case the plan would have been revised almost immediately.  The Paulson and Dodd plans were never that far apart.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

7. In the meantime the Fed should not worry much about inflation.

8. The critical deregulatory mistake was allowing excess leverage.  Many deregulations get blamed but in fact contributed little to the problem.

9. Everyone says that letting Lehman die was a big mistake but I’m not yet convinced.  Maybe a bracingly high TED spread is what we need.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious.  Also beware of anyone pretending to offer you simple answers.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don’t expect it to help much.

15. The crisis is complex and has many causes; there won’t be a simple or quick solution.

If you wish you can google to the details.  Also, I don’t believe I had offered #9 before on this blog.

From the Hill

“The House of Representatives is currently experiencing an
extraordinarily high amount of e-mail traffic. The Write Your
Representative function is therefore intermittently available. While we
realize communicating to your Members of Congress is critical, we
suggest attempting to do so at a later time, when demand is not so
high. System engineers are working to resolve this issue and we
appreciate your patience.”

Here is the story.  The associated explanation is this:

The House is limiting e-mails from the public to prevent its websites
from crashing due to the enormous amount of mail being submitted on the
financial bailout bill.

Gee, I wonder if all those people are for or against the bailout?

I thank Carrie Conko for the pointer.

Who is Greener?

There is a new InTrade.com contract, this one on whether oil futures and the Democratic President contract move in the same direction on Election Day.  Right now it’s running at about 50 percent, which means an Obama victory won’t on average bring a higher price of energy.  Mark Thoma directs us to this interesting article on the bursting of the Green bubble, most of all among the Democrats.