The US is embarking on the greatest public intervention into financial markets since the Great Depression. The ultimate success or failure of the intervention will depend, in part, on the fine details of the auction design.

The basic auction approach suggested here is neither new nor untested. It has been used successfully in many countries in recent years to auction tens of billions of dollars in electricity and natural gas contracts, as detailed in Section 8. Moreover, it is quite similar to the approach that has been used to auction more than $100 billion in mobile telephone spectrum worldwide. It is a dynamic version of the approach that financial markets use for share repurchases. If implemented correctly, each auction can be completed in less than one day. And the same software used for implementing electricity and gas auctions could be used to initiate these auctions in October.

Here is the whole paper, thanks go to Samson in the comments section.  So far this is the best paper I’ve seen on the topic.  Tim Harford offers other useful links.  Still, I am inclined to agree with Arnold Kling:

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that–a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later–probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan.

Fed announces commercial paper funding facility.  Here is my post from yesterday.  My best shot at a positive spin, just offered to Alex in my office, is this:

They wouldn’t do it unless they had to.  And if they had to do it, that they are doing it is very good news indeed.

I am not sure that Alex was persuaded.  There are some good comments at the first link.

With emphasis on that word "exactly," here is Gary Gorton’s superb paper The Panic of 2007.

Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed.  You are confused because it is confusing.  Then I got to p.45 (!) and I almost split a gut (and cried, simultaneously) when I read the sentence:

Now we come to the first information issue.

It then goes like this:

What is the loss of information?  The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone.  It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined.  But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages.

His examples show this in detail but I do not know a simple way to blog it.  Scroll to pp.23-30, and p.35 for a dose of how these securities were structured.

Gorton is also highly critical of "mark to market" (p.62) and he pinpoints the collapse of certain parts of the REPO market (p.66) as a critical development.  He ties it all in to Hayek and Grossman and Stiglitz and discusses how we ended up having assets with non-transparent, non-backwards-translatable prices and what that means for economic calculation.  He contrasts a private clearinghouse (and monitoring) vs. rules of accountancy and how we ended up relying too much on the latter.

Starting on p.67, there is a sustained and mostly convincing argument that securitization has not been much at fault.

If you are interested in the nuts and bolts of the current financial crisis, and its origin in 2007, this paper is essential reading. 

If the Fed ends up guaranteeing commercial paper and/or interbank loans.  Too many people are listening to Polonius.

Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong’s terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it’s unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

Forget about particular details for a moment, in conceptual terms what led so many financial institutions to take so much excess risk?  Bob Frank addresses that question and here is my list of major factors:

1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany.  They were just plain, flat out wrong.  I’ll also put "model error" under this heading.  The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

2. Writing the naked put: This is Bob Frank’s main explanation, noting that he uses different terminology and adds a relative status dash to the argument.  If you don’t know options theory, just imagine betting against the Washington Wizards to win the NBA title every year.  For a lot of years you’ll earn super-normal returns, but one year (not anytime soon, I can assure you) you’ll be wiped out.  That is essentially the strategy the banks were playing.  They were going "short on volatility," so to speak.  In the meantime they reaped high returns and some amazing perks for private life.  It’s hard to just call the party to an end, even if you have a relatively long time horizon.

3. The neutering of debtors. This is the sophisticated form of the moral hazard argument.  Bailouts mean that debtors and depositors don’t have enough incentive to keep safe the firms they give their money to.  Note that #3, as a corollary, suggests that equity holders do not on their provide adequate safeguards against a crash.

Evaluation: You can pin most of the blame on #3 provided you think that a) our government really could let these firms default on their debts ex post and b) society is willing to live with significantly less liquidity transformation up front and also lower returns for depositors.  I reject this mix for reasons of time inconsistency, namely that ex post the bailout is always on its way so this is simply something we have to live with. 

You’re left with #1 and #2 but it is hard to assign relative weights because they work together.  The people earning money under #2 won’t work terribly hard to disillusion the fools and frauds operating under #1.

At times I am tempted to add #4 to the mix:

4. The increasing value of human capital: Bankruptcy is no longer so painful for the wealthy.  You can always get another high-paying job plus you have $10 million squirreled away somewhere in Switzerland.  You could end up working for the guv’ment for $130K a year and your life still is pretty good once you get over the shock of adjustment.  So why not take lots of risk and try to get ahead of the other guy?

The full story then involves additional resources being put on the table — for possible risky investment — as a result of easy monetary policy, pro-housing government policies, the global savings glut, and simple bad luck.  I’ll cover those factors in more detail soon.  And I’ll also have more to say about some of the details of mortgage-backed securities and accounting practices and regulation; those were factors too, although not at the level of generality I am covering here.

Addendum: Here’s Mark Thoma and Barry Ritzholz.  In the comments Robert Feinman is square on, read him.

Second addendum: Megan McArdle adds quite a bit.

It turns out there won’t be one.  In fact we are seeing the opposite:

"We will work cooperatively and in a coordinated way within the
European Union and with our international partners," it [the statement] added. "In the
spirit of close cooperation within the European Union, we will ensure
that potential cross-border effects of national decisions are taken
into consideration."

This language was seen as a rebuke to Ireland, which last week
decided to offer guarantees to all Irish depositors. The decision,
taken unilaterally, irked Brown and his lieutenants in London, who
feared it might lead Britons to pull their money out of British banks
and put it in Irish banks instead to enjoy the guarantee.

British depositors were already crowding to get into the nationalized Northern Rock but they were turned away at the proverbial door.  Other news is that the German government-led bank consortium to rescue Hypo Bank has fallen apart, not a good sign.  The German government has today moved to guarantee all "private savings deposits" [private Sparanlagen], also not a good sign.  Which other countries will now follow suit?  All of them?  Europe as a whole lacks a safe asset as focal, liquid, and available as T-Bills and now that is becoming a problem.

Gartner’s keys to success as a supplier in reverse auctions are: (a)
Thorough preparation – it’s essential to know your costs, your
suppliers, and your market to the greatest extent possible – tiny
details can make the difference between winning and losing, and between
being profitable or not; (b) Reverse auctions should be largely kept to
the supply of commodity products rather than proprietary ones; and (c)
Having a strong, competent bidder leading your effort at the time of
the auction, with clear guidelines on when to bid and when to fold is
essential.

Anticipating Hank Paulson, Gartner adds:

"I know most people don’t look at reverse auctions positively, but we see them as a process that makes you better,"

Here is the link.  The article will soon be much longer.  Here is a website devoted to summarizing the research against reverse auctions; it appears unrelated to critiques of Paulson and the Paulson plan.  It seems to be fighting a personal war and so I doubt its objectivity:

The bottom line is BUYERS should not use reverse auctions because the amount of savings that can actually be achieved is greatly overstated. In addition, reverse auctions create numerous other problems for buyers.  SELLERS should not participate in reverse auctions because there is nothing in it for them; especially incumbent suppliers. In almost every case, neither buyers nor sellers benefit from this purchasing tool because it is an unhealthy continuation of zero sum power-based bargaining that degrades the competitiveness of both parties. Reverse auctions are undeniably a bad purchasing practice and a wrong approach to spend management.

I hope to soon consider other research on reverse auctions.

Greg Mankiw shows that real interest rates are rising on inflation-adjusted government bonds.  Paul Krugman shows that short-term Treasury yields are down.  The state of California cannot get short-term financing.  There is simply no one willing to lend.  Yet I would have no trouble buying a second home and getting another mortgage at a reasonable rate of interest and I am hardly a rich man.

Credit market segmentation is always there but it doesn’t usually matter this much.  The parts of the credit market that are paralyzed by fear are the major problem right now.  And until that problem is cleared up, we will witness a step-by-step disembowelment of the American economy. 

The clock is ticking.  We need very rapidly to get to the point where natural lenders are willing to lend and "cross-market arbitrage" is no longer a dirty word.