It is impossible for me to find any commentary anywhere by anyone on the topic covered by William Lucy. Except my commentary. This makes it difficult to analyze, because I cannot benefit from the insights of others. The most frustrating part about this is that one would at least expect some one to debunk it. If anyone has seen any article discussing this study, I would appreciate it. Several newspapers did put it on their front page. Several real estate associations have also posted articles. But no one has analyzed its implications to my knowledge.

Maybe he and his graduate assistant at the University of Virgina forgot to add something. It would be as if a physicist published an experiment demonstrating that the speed of light can be breached, and no one bothers to even comment on it in passing. Here we are, supposedly, in the midst of the greatest financial crisis since the great depression.  Some academic then discloses that our perception of the crisis has been massively distorted by not understanding the difference between the market value of mortgage securities and the market value of the housing collateral which backs it. Further, the academic declares the decline in the value of the collateral itself (housing) has also been massively exaggerated and extremely localized. And no one comments?

There must be a reason this study is ignored The William Lucy Study. Look at my links to the right under Commentary and Economics. I look at these frequently and another dozen or so. The economists in particular are academics who have tended to also be involved in policy. They all comment on the crisis.  Much is discussed. What is not discussed is "how much was/is the financial system really at risk due to the housing crisis"? The answer to this question impacts our judgment of the actions taken by the Bush and now Obama administrations.

My theory for the study's invisibility is its potential for massive embarrassment for the economics profession and to our regulators. It was released toward the end of February of 2009. If they could debunk it, I am sure they would have. William Lucy is not an economist. He is a 69 year old professor of architecture who has written many books on urban and ex-urban planning. How could an architect figure out something they did not? Because, as Hayek often commented, economists tend to obsess with aggregates, often missing and ignoring the local knowledge which is critical to time and place.

As someone who has studied the specifics of urban and suburban formation, Lucy may have been in a better position to see the obvious, as he was not blinded by "mark to market securities". Regardless, the information contained within the study is there for all to see. If Lucy is even approximately correct, it means the regulators, i.e., Treasury Secretary Paulson, New York Fed president (now Treasury Secretary) Geithner, and Federal Reserve chairman Bernanke were lost in a fog of "mark to market" and never bothered to question what it meant. This lead them to take action which accelerated a panic which could have been mitigated. This is unacceptable.

Since no one else wants to critique Lucy's study, let me put forth one possible criticism. While one can multiply Lucy's estimations of losses by a factor of 4 or 5 and have all my following points still hold, let me state one possible error in his analysis. It is theoretically possible he took averages to calculate losses, even at the local level, when it is the case there should be adverse selection bias as to which mortgages will default. That is, it should be the case that the highest leveraged creditors are the ones most likely to default, where he might have assumed that everyone is equally likely to default. I raise this because I could not determine how this may have effected his numbers. Lucy implicitly raises this very issue when he discusses his methodology and believes he has effectively accounted for this potential phenomenon. So he clearly understands the complexity of the issue. This is all the more reason to be frustrated that there has been no commentary by economists.

This could be why, when I did my analysis last Fall, my number of potential "true losses" was 4 times higher than his. I am not saying he made this error, I am only saying I could not determine it one way or the other. Having said that, this is irrelevant to my conclusions. People like NYU's Roubini created estimates of losses up to $3.5 trillion, which is clearly off the wall. The point is these numbers were knowable then by the regulators. Given that banks had already written off more than $500 billion by last September, they would have already accounted for the high end of the estimation. Mark Zandi of Moody's had come to a similar conclusion last Fall as well. It does not matter if the losses were/are/will be Lucy's $145 billion or mine of $500-$600 billion. These were already accounted for and written off before the bailouts occurred.

SOME KEY OBSERVATIONS BY LUCY

Here are some remarkable statements (highlights are mine):

"National housing price declines and foreclosures have not been as severe as some analyses have indicated, and they are not as important as financial manipulations in bringing on the global recession. Most foreclosures have been concentrated in California, Florida, Nevada, and Arizona, and a modest number of metropolitan counties in other states. In fact, 66 percent of potential housing losses in 2008 and subsequent years may be in California, with another 21 percent in Florida, Nevada, and Arizona, for a total of 87 percent of national declines in these four states"

"California was vulnerable to foreclosures, because the median value of owner-occupied housing in 2007 was 8.3 times median family income, while the 2007 national average was only  3.2, and in 2000 it was lower still at 2.4"

"Potential housing value losses from 2008 foreclosures in 50 states, if values decline to year 2000 levels, were less than one-third of the $350 billion that has been provided to banks and insurance companies to cope with losses in mortgage backed securities"

Lucy did not state this, but the latest OFHEO data shows home prices at just under 50% higher than 2000 levels, nationally. Think about that for a second.

"Housing price corrections in a few states and a modest number of counties and metropolitan areas contributed to a national and international financial crisis. The spatial pattern of these foreclosures has received little attention, even though manipulations by financial institutions broadened localized foreclosure problems into an international financial crisis which has begun a global recession".

"Foreclosure rates were low in most states in 2008. In three-fourths (38) of the 50 states, foreclosure rates were below 0.50 percent (1 in 200). In one-half of the states (25), foreclosure rates were below 0.25 percent (1 in 400). And in 11 states, foreclosure rates were below 0.10 percent (1 in 1,000).The extreme skewing of foreclosure rates has economic, political, business, and public policy implications. The economic implication is that the origins of the foreclosure crisis were geographically limited, even though the financial crisis has spread worldwide"

"Announcements of foreclosure increases during 2007 and 2008 tended to be exaggerated..... National and international financial systems are extremely fragile if they are stressed to the breaking point by a moderate foreclosure rate with foreclosures concentrated in a few states"

Lucy is also critical of the always quoted Case-Shiller index which contributes to the exaggeration. As an index, it is what it is, and is radically misunderstood. It decidedly is not the best measure of house value trends. Foreclosed houses have constituted half the houses in the Case-Shiller index for the "big four" states. It does not measure, apartments, new houses, or condominiums. Since 7 of 20 of its measured areas are in the high foreclosure states, they are overstating national housing declines. The Case-Shiller index is a "capital weighted repeat sales index". These kinds of indexes can be viewed as "trend biased". Other points by Lucy are:

"One benefit of foreclosures concentrated in a few states is that price declines are rapidly reducing the house value to income imbalances that fed the foreclosure crisis. Housing in these high price markets is becoming more affordable. The National Association of Realtors compiles an existing single family affordability index that includes median prices and median family income. It showed a 2007 affordability index value of 111.8 followed by an average January through September 2008 index value of 127.9, a considerable improvement.  If maintained, the 2008 affordability index would show housing affordable to more families than in any year since 2003".

Lucy's study is far more academically precise than what I wrote during September and October. But a large percent of these same points were made by me in these three essays; California Dreamin?; Where is Cool Hand Luke When You Need Him?; and And the Darkest Hour is Just Before Dawn. I raise this because it means anyone with an internet connection could have seen this last summer. It is remarkably irresponsible that these issues have not been stressed, as they are at the core of the failure of Paulson's and Geithner's policies.

SO, WHERE HAVE THESE LOSSES COME FROM?

So if housing prices drop to levels in 2000, which are currently 50% higher than in 2000, Lucy estimates actual realized losses will be about $145 billion. Since housing prices have not declined to these levels, why have the bank's stated losses been so high?  Lucy believes it comes from mispricing mortgage backed securities. Some more quotes from the Lucy study follow:

"The absence of a market blocked the federal government from establishing a value for many MBSs backed by delinquent and foreclosed mortgages. But an estimate of the cost of buying these mortgages, if they can be separated from MBSs, is possible. Data in this study for housing values relative to family income can be used. Or, as an alternative, housing values relative to household income could be used."

Lucy's insight is that the creation of large quantities of mortgage backed securities limited the ability of mortgage servicers to renegotiate mortgage terms. This, of course, was well known and commented on. Think of these securities as the equivalent of a mine field. 99% of the field is clear, but every once in a while someone steps on a mine and they are gone. No one in their right mind will, therefore, enter the mine field. Unless, of course, they are accompanied by a minesweeper. The government's role was to be that minesweeper. Lucy states that the data was there for all to see. So why didn't they see it? I have already said why in this and other essays. For a refresher the opening paragraph of Anatomy of a Bailout will suffice. Some more Lucy quotes follow:

"If all the listed foreclosures and preforeclosures became repossessions, then these value reductions would cost $95 billion in California, $10 billion in Florida, $5 billion in Nevada, and $4 billion in Arizona, a total of $114 billion....{even} this estimate overstates the crisis dimension of foreclosures."

"An extreme perspective on pricing mortgage-backed toxic assets can be acquired by projecting 2008 foreclosure losses if housing prices decline to year 2000 ratios of housing values to family income. In all 50 states, the decline to year 2000 house values would be about $145 billion, with 87 percent in four states—California $95 billion (66 percent), Florida $18 billion (13 percent), Nevada $6.5 billion (5 percent), and Arizona $5.5 billion (4 percent)."

"A problem faced by lenders has been the so-called “mark to market” accounting rule. This rule requires lenders to value assets at current market prices. While seemingly reasonable, this rule over-values property assets during the “bubble” period of inflated expectations during housing price increases. Mark to market undervalues properties if the market for them erodes or disappears when housing prices fall.  Banks then limit loans to retain enough capital to meet regulatory requirements for reserves relative to liabilities."

ECONOMICS PERCEPTION BIAS

One immediately can tell that Lucy is not an economist by reading the above paragraph. Mark to market is to most economists what the Pope's infallibility is to Catholics. It is both faithfully believed and misunderstood. Nothing creates more cognitive dissonance in an economist's mind than questioning the legitimacy or meaning of mark to market. To declare that mark to market accounting might actually give out wrong signals is just very difficult for them to accept. Yet anyone who thinks about it realizes it is just an approximation of value, no more intrinsically valid or "true" than other approximations. This does not lead down the road to nihilism. It leads down the road to recognition that judgment is always particular to time and place, regardless of valuation method. We all know calculating the value of a particular mortgage backed security is difficult in times of crisis. But this is exactly what regulators should have known.

Ironically, Lucy also has a simple solution which I did not and still do not support. Yet, his straight forward approach is refreshing. He does not get twisted up in "angels on a head of a pin" issues like "moral hazard". He says:

"If the U.S. Treasury purchased the MBSs at a discount, it might not lose any money on the MBSs in the short-run and might make some profit later. The discount would not need to be large for most MBSs, since most of them are performing above 90 percent of payments due. And the U.S. Treasury does not need to satisfy regulators that it is valuing the MBS assets by "marking them to market".”

"Banks and other lenders have claimed losses on their balance sheets far in excess of the actual reduction in value of the houses on which mortgages have been foreclosed. Moreover, the recorded losses are greater than the house value declines that would occur if the foreclosed properties declined in value to year 2000 levels. It is possible that price reductions to year 2000 levels will occur. But such large price declines can occur as a result of deep and prolonged recession, not because of an excess of supply occasioned by the foreclosures themselves which add to the backlog of houses for sale."

Alright, enough already. You get the point. He also says the bubble was caused by Government policies pushed by the Clinton and Bush administrations to increase home ownership in America from 65% to 70%. This was the ultimate cause in his opinion. This makes way more sense to me than money supply and interest rate policy gobbledygook critiques of Greenspan and Bernanke.

CONCLUSION

What does one conclude? Was this an excusable mistake by Paulson and Geithner back in September when they sought to bailout AIG (really Goldman)? Absolutely not. In fact, relative to the 7 previous crises that were faced by Greenspan, this was by far the easiest to understand. This was a travesty. This was easily explainable to the public and investors, but it was not. Why? We know why. Goldman Sachs faced "mark to market" extinction. As I have previously said, "{Paulson, Geithner, and Bernanke's} confusion in understanding the approximation which is mark to market accounting, their failure to understand a financial market "squeeze", their failure to not compare mortgage values to actual housing values in the real housing market, their crony identification with the very firms they were regulating, their failure to realize that derivatives are a "cash zero sum" transaction, and their inability to be calm under fire and rise above the cacophony of screaming Wall Streeters", is what turned a controllable crisis into an uncontrollable one. 

It also means when the dust settles, we all will realize we have been had. A fake crisis cannot last forever. We have not lasted as a species for a few hundred thousand years to have that happen to us. This crisis, at least in the financial sector, may already be over--although it was largely a mirage from the outset. Remember the photo shopped pictures of Obama as FDR on the cover of Time Magazine? Remember Rahm Emmanuel's brazen comment on Meet the Press about a crisis being an opportunity to pass legislation that otherwise could not be passed? They have manufactured a crisis of historic proportions. Who benefits from this crisis mongering? Not the people who have lost their jobs because of it. Not the shareholders of financial institutions who lost 75% of their investment. Who are the smiley faces around town? Obama/Pelosi/Reid seem pretty happy these days, don't they?

New forecasts for 2009 GDP Q1 decline are very concerning. The range is from 8-10% negative growth on an annualized basis. That is worse than any quarter in decades. It is clear this has been caused by the Federal Government. The primary culprits are Henry Paulson, Tim Geithner,  Barack Obama, Nancy Pelosi, Barney Frank, and Harry Reid. The most important person going forward will be Obama.

My point is not that these people caused the recession, but that they caused the "depth" of the recession, even as some of them had a hand in causing the recession as well. Politicians can do little affirmatively to help the economy. What they can do is forebear, or stay out of the way. The more they do not forebear, the more difficult it is to not cause some damage. During the course of the last 80 years, the federal and local governments have steadily increased their role in economic decision making. Some of these involve social policies which trade growth for some social good, real or imagined. Some expenditures are really just transfer payments where people are merely getting back their money. For example, some portion of Social Security and Medicare, not all of it, can be characterized this way. Some are expenditures which really only government can supply, the military being the most obvious. But an increasingly large percent of federal and state spending has been directed at redistribution--or choosing winners and losers--in the economic and political sector.

Paulson and Geithner created unnecessary panic in the Fall by not understanding the nature of the banking crisis and by having, in the case of Paulson at least, conflicts of interest.  My last essay, Anatomy of a Bailout, discussed these issues. This series will provide more details of what should have been known by Treasury and the New York Fed. On the fiscal, or spending, front Pelosi/Reid/Obama have proposed an accelerated path of governmental economic interventionism and even Fascism, Mussolini style, pursuing policies of political and economic cronyism, which in the end can only result in massive waste and spectacular inefficiencies. The spendthrift and ideological trio would have pursued these policies regardless of our economic conditions. But under our current conditions they can assert these are to help the economy. Yet their forward budget is anti-stimulative. It supports pursuing costly policies in the midst of a radical decline in economic activity. These proposals are partly the reason for the depth of the decline itself. This reveals a willfulness and willingness to create and use national hardship as a tactic to achieve their ideological goals and increased power.

Obama is an extremely dangerous politician and, economically at least, well outside the historical American norm. He named a new CEO for GM; which will soon be followed by a strategic direction chosen by the government. If this WSJ story has merit Obama Retains Bank Control By Refusing To Accept TARP Repayment., then he has upped the ante even higher and his Fascism is no longer implicit. To quote Newsweek's Evan Thomas, who was "embedded" in the Obama campaign, Obama is an "explicit follower of {the socialist} Saul Alinsky", "a deeply manipulative person", and engages in a "creepy cult of personality". Because many in the media, right and left, insist on discussing how "charming" and "engaging" he is, there seems to be a blind spot toward how dangerous his goals and purposes are. Various moderate Republican "Mr. Jones", in particular, have had trouble seeing this from the beginning. I hope they will eventually see the light.

Obama also does not instinctively understand, or believe perhaps, America's net contribution to good in the world. In a satirical but scathing attack on Obama's rhetorical skills at the G20, the UK newspaper, The Guardian, dissects a confused response by Obama to the question of whether the US caused this global crisis. I actually think it did. But Obama's response, seen at the link, was pathetic. The easiest answer would have been along the lines of putting the reporter back on the defensive and diffuse it with a counterpoint. Something like; "that may or may not be true, but if the US is to take the blame now, should the US also take the credit for the global prosperity Europe and the world has universally enjoyed since 1945? Engaging in this kind of questioning is not productive". Then let it drop, versus his rambling apologetic non-sequitur of a response. But that takes intuitive and instinctive knowledge and belief about the role the US has played in the world, something he does not have.

There is still some reason for optimism, albeit flickering. There is a growing bottoms up political movement, characterized by the enormous number (barely covered by the major media) of Tea Parties. Many individual Tea Parties were larger than the G20 protests--yet which gets the coverage? Also, most of the new Democrat programs have not yet been passed, let alone implemented. So there is still time for the Republicans in the House and Senate to make alliances with so-called blue dog Democrats to stop and/or reverse them.

The most damaging programs are the energy cap and trade proposals, the national health care proposals, the saber rattling toward and explicit takeovers of private businesses, the extraordinary financial system meddling, tax hike proposals, demonizing financial success, and interference in the natural creative destruction inherent in any efficient capitalist economic system. I am holding back on final judgment of Obama's foreign policy. Certainly, his interactions with foreign nations have ranged from the merely irritating to an almost denigration of our country. But his actions in Afghanistan and Iraq cannot yet be deeply criticized. His policies toward Israel, Iran and Russia have to be watched closely. At best, his approach with these nations seems more consistent with typical liberal Democrat policies, and not yet a radical departure from American norms. But this needs to be monitored with  diligence.

The other cause for optimism is the "run on the bank" crisis appears to be subsiding. How more absurd can it be when the Financial Times reports that the banks, who themselves are supposedly the beneficiaries of Geithner's TARP 1.001, are the very entities who want to use Treasury and TALF funds to buy each other's so called toxic assets!? This is supportive of my main point criticizing the actions taken in the Fall. That is, these assets were inherently undervalued and were further driven down in price by policy actions. However, fear of new investment by entrepreneurs, big business, individuals, and financial institutions--banks included--has not yet subsided as Q1 GDP growth indicates.

This series will explain why the government caused the depth of the recession.The primary causes as implied are 3: 1) Making the bank crisis worse than it needed to be;  2) proposing massive deficit spending to create greater government power under the guise of promoting growth; and, 3) most dangerous of all, an increasing casualness by Obama of eradicating the distinction between the public and private sector. In my next 2 essays I will discuss in detail William Lucy's housing study released around March 1, 2009, review some of the points I made last fall, discuss some of the more blatantly bad fiscal/social policies, and try to heighten our awareness of Obama's dangerous power grab.

Hannah Arendt famously observed, with a presumed chill up her spine, how ordinary and banal the evil Adolf Eichmann appeared at his trial in Jerusalem in 1963. He was "just" an obedient civil servant of the Reich, and a lawful one too. Well, Tim Geithner is not evil, but he is banal, and an unlawful banal tax cheat at that. I fear Jonah Goldberg's next book will be titled the Banality of American Liberal Fascism (see Liberal Fascism: The Secret History of the American Left). While many authors, left and right, harped on their favorite agenda item in response to the "Geithner Plan", many missed the forest for the trees. Paul Krugman, on his blog, almost had a panic attack at the thought someone in the private sector might make money. Conservative pundit Jed Babbitt referred to the plan as "layered and textured". Even on my blog, I gave it  Simon Cowell "damn with faint praise" treatment in saying that anything fixed in stone is better than a trial balloon a week.

Geithner had a busy week. He announced his plan on Monday. Tuesday, Obama discussed outsourcing new constitutional authorities on corporate takeovers to the Treasury Secretary. And on Wednesday Geithner revealed his openness to some global reserve currency in response to the Chinese moaning about how much we import from them (or as they like to say, how many Treasuries they buy from us). But our Liberal Fascist administration is not yet ready to make the Hegelian dialectical move into combining global Marxism with Liberal Fascism. That is next year's agenda.

Geithner's plan was revealing as a function of what is in the plan and what is not. The "Goldbergian" Liberal Fascist point, which was central to the Geithner proposal, is that it is a "public-private" partnership. This is the central feature of any Fascist economy. As Sheldon Richman stated in an article entitled "Fascism", "fascism {seeks economic} control indirectly, through domination of nominally private owners". We have already seen this with how the banks have been treated. We have witnessed the administration's willingness to abrogate contracts, propose de facto (soon de jure) nationalized health care, propose massive monetary and regulatory subsidies on behalf of ludicrously named "green energy" enterprises and are now trying to suck non bank financial entities into their web through the "Geithner Plan". Why would any asset manager in their right mind concede to this? While he assures us that the managers will be in total control, all transactions will ultimately be approved and monitored by some banal bureaucrat.

What incentives have been offered? This is TARP 1.001, with a Liberal Fascist add on. Like TARP 1.0, Treasury will purchase mortgages outright (just what is borrowing to invest in both "debt and equity" except an outright purchase?). The Liberal Fascist part is the government will lend money to investors to buy certain defined assets in exchange for them putting "equity" in dollar for dollar to match the government's "equity" contribution. Many moan about the implied guarantees or "non-recourse" loans the government is supplying. But the guarantee levels are set so far from the current "implied default rate", given how far prices have already fallen, that if they are hit, the economy will be so distraught, we will be growing vegetables in our back yard to survive. This is basically a lending program at low rates to entice buyers. It took Geithner how long to come up with this? It is an absurd and trivial adaptation to TARP 1.0, were it not for the "public-private" partnership principle. This will end up being an arm twisting exercise by the Treasury. They will push buyers and sellers together to establish the precedent of the effectiveness of "public-private" partnerships. Keep your eye on this---this will be pushed hard. Conservatives continue to not believe what they are seeing, and I include myself in that critique. What else does Obama have to do before we accept full stop what he is about?

There is no mention in Geithner's plan on how we got to where we are. Just what are those failed mortgages? UVA professor William Lucy has an extraordinary detailed work on how California, Nevada, Arizona, and Florida have 87% of the current foreclosures Study: Foreclosures in States and Metropolitan Areas: Patterns, Forecasts, and Pricing Toxic Assets. Isn't this important for policy reasons? The implications of this are profound. Dollars to donuts the "localized" nature of this crisis leads back to various Committee Chairs in Congress. What happened to the CDOs in Geithner's plan? Several hundred billion were issued with mortgages in 2004-2007---no mention. This plan was pathetic--worse, it will provide an opportunity for "the Laughing President" to continue his step by step Statist objectives.  Little if anything from this administration fits what America is about. From Saul Alinsky to Black Liberation Theology to the Woods Foundation to confiscatory tax rates to "public-private" partnerships, Barack Obama and all his banal men have one objective in mind, Liberal Fascism.

Monday's rally was presumably caused by the fact that we actually have a bank plan. Almost any plan is better than either no plan or a constantly shifting plan. Let's stipulate that anything which gets us out of this self-reinforcing negative feedback loop is great. If this involves us all chanting for a day at the Sun (or perhaps even being forced to watch the Leno and 60 Minutes Obama interviews again and again) then great. But I assume confidence, generally, is derived from some semblance of rationality, even if such rationality itself sits on top of a pool of the unknown and the unknowable. The Geithner plan seems reasonable enough, although it still leaves certain questions unanswered.

It is disconcerting how long this took. The most obvious thing to state is that this could have been done 6 months ago, or 3 months ago. There is nothing here of any great complexity. Lack of complexity is good. It is different from the original TARP proposal in that the private sector shares the first 16 2/3% of losses with the Government. That is basically it.  Not to be a wiseguy, but how is it possible it could have taken this long to come up with this? This is truly something that could have been devised in a month last Fall by Geithner and Paulson. These guys were so focused on the joke which has become the AIG/ Wall Street derivatives scandal, they had no time to think clearly.

The second most obvious thing about this announcement is it reinforces my belief about the relative triviality of this crisis from day 1. To be more precise and to repeat for the 25th time, we took a severe but localized recessionary real estate bubble and proceeded to declare loudly, by words and deeds, that this was the worst crisis since the Great Depression. This caused panic. This I blame on Obama, before and after the election, and the media who supported him; and Hank Paulson who had other objectives in mind besides solving the liquidity crisis, like saving Goldman Sachs. (Some call it a solvency crisis, which is different; at some point these two interpretations can merge. I do not want to get into that issue).   Obama played minister of propaganda since October while Hank Paulson was the minister of operations. The confusion created by Obama's FDR/Depression obsession and Paulson's disastrous TARP bill and AIG bail out were both acts of great irresponsibility.

THE MARKET CONTEXT OF THE PLAN

THE GEITHNER PLAN

I agree that the collapse of the housing bubble created a "negative economic cycle" beyond what was warranted. However, the persistent stubbornness on the part of Treasury to not name the areas of the country where these problems actually exist in extreme disproportion to the rest of the country is disturbing. Readers of this blog know these areas to be California, Vegas, Phoenix, and Florida (primarily the cities and surrounding areas of Miami, Tampa, and Orlando). The West dominates. I believe this lack of disclosure has contributed to the general panic. It also prevents us from finding a more precise set of reasons for what caused this bubble to begin with.

The premise behind the program is that owning mortgages and securities collateralized by mortgages has created uncertainty regarding banks' solvency/liquidity due to price "uncertainty" regarding these instruments. This has made it difficult for banks to raise capital and thus has limited their ability to make new loans. The Treasury says it would like these banks to sell many of their mortgages. They also say they want "price discovery". These 2 objectives are not the same and, in fact, the latter can preclude the desirability of the former.  Price discovery presumably eliminates "uncertainty" about the values of mortgages. This makes it safer to provide capital for banks. Investors will now presumably be more likely to believe the stated values at which the banks have these assets priced. This would help restore confidence in the financial system. That is the idea anyway. It is unclear this program will create enough price discovery, although I think it potentially can. Of course, the recent hissy fit thrown by the Obama Administration and the Democratic House of Representatives on "compensation" limits is damaging to the extreme. For this plan to even have the chance of working that lack of trust in the Feds has to be addressed.

There are 2 categories of loans discussed in the "Fact Sheet". Category 1 is what we all understand, mortgages made by banks and still owned by banks. They call these "legacy loans". Your local bank lends you money and they hold your mortgage. The second category is "legacy securities". Legacy securities were issued by banks. They created off balance sheet entities called special purpose vehicles ("SPVs"). These SPVs purchased regular mortgages. They borrowed money to buy these mortgages by selling bonds to other financial institutions, including other banks. These bonds are the "legacy securities" and are called "residential mortgage backed securities" or RMBS. These SPVs have securities  with different risk characteristics. They have subordinated securities which would lose money first if the underlying mortgages began to default. They also have senior securities which only lose money if more than 25-30% of the mortgages default. These securities were rated AAA. The only legacy securities eligible for bidding are these senior RMBS that were originally rated AAA (also commercial real estate and consumer credit securites, but these are relatively small compared to residential mortgages).

There is another whole class of securities explicitly not mentioned, at least I did not see them in the plan.  Implicitly excluded from Geithner's plan are CDOs or Collateralized Debt Obligations, of which a few hundred billion were issued. CDO's are another type of special purpose vehicle (or SPV) that purchased what Treasury is calling "legacy securities", or the bonds sold by the RMBS special purpose vehicles mentioned above. They then financed the purchase in the market by selling "CDO debt". No mention was made by Treasury as to why these were not explicitly included in the program. I don't know what to make of the CDO exclusion, other than it seems very peculiar. I have a hunch the largest percentage of these are owned by foreign institutions and non-banks.

WHAT DOES THIS ALL MEAN?

What does this all add up to? Not sure yet. Even the worst of the sub-prime and so called "Alt-A" mortgages issued in 2005-2007 (Alt -A are typically undocumented loans which are a step up in credit from sub-prime) have "only" defaulted at a 25-30% rate. These typically were the mortgages purchased by the RMBS vehicles. This means that the "legacy securities" eligible to be bought are close to being at some level of default. But not all of these formerly AAA legacy securities should be experiencing actual defaults, although some will, because default rates need to rise higher than 25-30% for this to happen. They are certainly no longer AAA rated securities, however. But these have presumable already been marked down by the banks. The "legacy loans", on the other hand, are just pools or groups of loans, so any potential buyer can subjectively determine their own implicit "credit rating".

One reason we have a financial crisis, I believe, is that these legacy securities and loans have been marketable only at a price that implies a much higher probability of default then is likely to occur, or at least that the current economic forecasts imply. We do not know what price these instruments are marked by the banks on average, but are likely marked well less than par. Since it is more likely than not that banks and RMBS holders believe 90% plus of these securities and loans are likely to pay fully, or close to fully, they will probably want to hold them, if they have not been marked down severely, rather than sell at a deep loss. Some smaller losses may be acceptable. If they have been marked down severely, they may want to sell if they can get a quick gain and be done with it.  Buyers are going to want a big payday. Their initial thoughts on this will likely be to want to bid too low. But the leverage provided by the government can make returns very high at higher prices, with arguably very acceptable risk.

For the "legacy loan" pools, investors are risking a maximum 16.6% loss if defaults rise to an extremely high level from what the current default levels are projected to be. Government shares the first 16.6% loss with investors---they also share gains---think of it as joint venture . Actually, investors risk 16.6% of the purchase price of the mortgages which could be 100% of the cash they put up. But the potential returns are also very high if defaults do not materially rise from current levels. The likelihood of total loss should be low. So while the Treasury is capping losses, they are capping them at presumed disaster levels. For "legacy securities", the potential percent losses are less but the amount of capital put up is greater. They risk in theory 33%- 50% of the purchase price  because the leverage provided is less and the cap on losses triggers at much lower prices than the loans. The odds of losses hitting those triggers should be remote, relative to a baseline of a 10% default rate.

In other words, while the investors are getting capped losses for both loans and securities, they appear to be at levels which could only occur if we truly have Armageddon default levels, much higher than 10% over all. Therefore, the greater benefit the Government is providing is the actual financing, not the guarantee.

If it is the case that price discovery has been prevented primarily because investors have been unable to get financing, then maybe this plan can get the secondary market moving again. Still, the language used by Geithner in his fact sheet implies the objective is to get "bad assets" off the books of banks. But, on the other hand, implicit in the plan's proposals is these assets have been undervalued by the market. This appears like a contradiction in their understanding of what needs to happen and why. It certainly is confusing communication.

The plan can be helpful in the following sense. The bidding process can make it more explicit to both buyers and sellers that we may have in fact discounted these securities and loans too low. It can also prove the opposite. But as potential buyers do their calculations, they may find that potential returns due to leverage is so high they can afford to bid prices up higher than has been the case since financing dried up.This could have the benefit of  prices moving closer to what banks and Treasury hope and believe is fair value. Banks may just want to put the whole thing behind them, at least to some degree by selling some percentage of assets even by taking more losses.

Of course, the devil is in the details. The government ultimately has final say on what leverage will be on any pool. We also do not know how much damage has been done by the latest anti-capitalist outburst by the administration. It is hard to imagine why anyone would blindly trust the government not to renege. We also do not know if the current wide spread between where banks want to sell and where buyers will buy is so great, the gap cannot be closed. There may be price discovery only on certain classes of securities and loans but not others. One can still argue that all we are doing is providing price supports for Zombie banks through subsidies for new buyers. This may be accurate, although I do see it as less price subsidy and more financing. If buyers do believe that foreclosure rates above 5% are not implicit in their economic forecasts, the cheap financing can be an incentive to buy. Still, the perceived risk reward may not be sufficient without just letting these prices drop further. If this happens, then the government should just get out of the way.

I believe the present actors caused this financial crisis to be more severe than it needed to be through panic and opportunism. Therefore, I also, ironically, share their view this is likely to be more a crisis of transparency and confidence rather than one caused by some global systemic set of deterministic causes. If the "systemic risk" proponents---Roubini, et. al---are right (or investors simply fear they may be right) and see something more ominous than what I see, this will not work. It still may not work, even if "the Roubinis" are wrong. If certain buyers are prohibited from bidding, that will be a problem. If bidders do not come in for whatever reason, that could be a  problem. It certainly will be a huge embarrassment. Ultimately, we may have to let the Zombie banks go if default levels rise from here. Let's see what happens. I hope it works. Then we can focus on the largest problem of all---the Pelosi/Frank/Reid/Obama Statist agenda.

GUEST WRITER ANDREW SHELDRICK WEIGHS IN ON MY "Toxic leadership Out on Highway 61" essay.

Andrew responded to my recent post with a slightly different perspective. I thought it would be great if he posted it as an essay on Law of the Bad Premise, as it was fact filled with insightful opinion. He kindly agreed. (If others wish to do so on this or other topics, please feel free to do so---I do reserve the right to "play editor"---but anyone who has enough interest to write such an essay will certainly have pretty free leeway!)

Here is Andrews's response complete and unabridged.

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Enjoyed your latest essays, and wanted to weigh in on the issue of "toxic leadership". 

I agree that it is toxic, though for different reasons.  I don't believe for a moment that Obama is a socialist and is using the AIG mess as a justification for curbing executive comp and bonuses.  In fact I don't believe Obama has any ideological predisposition one way or the other on that or any issue - he is simply a self-serving politician who above all needs to feel "popular" with the electorate.  He is currently wasting the taxpayer's money gallivanting around the county on his private 747 making what are essentially campaign speeches, posing for cable TV photo ops and weighing in on his selections for the NCAA  tournament.  Now, we are told, he will "make history" - to quote MSNBC - by being the first sitting President to appear in a late night TV talk show.  A kinder and gentler forum than "Meet the Press", no doubt.  Clearly, he doesn't feel any need to be at his desk working to resolve the economic crisis he claims to have inherited.

Ironically, in the case of the AIG bonus fiasco, Obama's late arrival on the popular "outrage" bandwagon may well prove his undoing or at least the undoing of the hapless Mr. Geithner.  Obama and the ill-informed demagogues on the House Financial Services Committee have so contributed to the general sense of "outrage",  that a scapegoat will have to be found and made to fall on his sword.  Obama's protestations of support notwithstanding, all roads seem to lead to the Treasury Secretary.  As head of the Federal Reserve Bank of NY (the entity that actually pumped the first load of cash into AIG) Geithner should have known about the bonus program.  It was disclosed in AIG's SEC filings, and according to yeserday's committee testimony was discussed with officials of the Fed.  So either (1) he knew about it a lot earlier than last week, and has lied, or (2) was asleep at the switch while the original transaction was negotiated (under his watch at the Fed) and subsequent payments authorized (under his watch at Treasury).  Either way, Geithner has lost all credibility.

And then consider yesterday's interesting twist regarding the statutory provisions to cap exec comp payable by companies receiving Federal bail-out money.  As drafted, the Senate bill would have applied to all comp and bonuses paid after after the bill became law, including amounts payable under pre-existing agreements.  This would have barred the AIG bonuses that Obama and Geithner now profess to be so incensed about.   During the Committee stage of the bill, the provision was amended to permit the payment of bonuses due under pre-existing agreements.  The Conference Committee Chairman initially stated categorically that he did not know who had amended the provision or why - a remarkable assertion he later "clarified" by explaining that the provision was changed at the behest of none other than Larry Summers and - yes - Timothy Geithner.   Just coincidental, of course, and nobody concerned knew it would affect the AIG bonuses.

Obama apparently hasn't figured out yet that when you lead the charge from behind, you can't always see who is in the line of fire.  I hope he is now looking for a suitable replacement for Geithner, preferably one who actually pays his taxes on time and inspires at least minimal confidence that he is up to the job.

This is really by way of a preface to my response to the question in the first sentence of your essay.  When I initially read about the AIG bonuses,  I was pretty angry.  But yesterday's testimony by Liddy was illuminating.  Clearly most of the Committee members had spent more time preparing their opening comments (stressing how "outraged" they and their constituents are by the whole thing) than in attempting to understand what the whole thing is really about.  Liddy was treated with a appalling lack of courtesy and respect, especially given the fact that he agreed to take the AIG job without compensation, and barely given the opportunity to answer the questions.  However, the one fact I learned, which most of the Committee apparently ignored, is that although the people who received bonuses were from the Financial Products unit, which was the cause of AIG's demise, they were not involved with the credit default swap business, which was where the principal losses were incurred.  Those folks, according to Liddy, have left and got nothing.  The recipients of the bonuses were the other derivatives traders, who were offered retention packages to wind down their books of business in an orderly manner after AIG decided to close the financial products unit.  Given the complexity of the derivatives business, I accept Liddy's business judgment that it was in the best interests of the taxpayers to pay these people appropriate retention bonuses to avoid the exponentially greater losses that would have arisen had the business been liquidated in a disorderly manner.  The media and politicians have made much of the fact that certain people had left AIG before they received their bonuses and therefore didn't warrant "retention" payments - but apparently the truth of the matter is that they had already done what they had agreed to do under the agreements (wind down their portfolios) and thereafter had left the company having fulfilled their part of the bargain. 

Personally I think that Wall Street comp has become excessive by almost any standard, and bonuses frequently do not reflect the creation of genuine value added.  But that is not specifically an AIG problem.  What angers me more than the payment of the bonuses is the fact that the bail-out occurred at all.  It was made in haste, with little thought and even less oversight and, as we have now discovered, represented an indirect and concealed bailout to other financial institutions that equally did not deserve or warrant taxpayer intervention.  Bankruptcy would have been a better resolution, and it is probable that a bankruptcy court would have approved some form of performance bonus plan - albeit of a lesser amount.

Now our elected officials will spend several more weeks grandstanding about how we can recoup the money, and the race is on to see who can come up with the most punitive solution.   The proposal to make AIG pay it back (another Geithner brainchild) is laughable - the taxpayer owns 86% of AIG.  If it can go without the $164 million Geithner wants them to repay then they shouldn't be getting it in the first place.  As to Barney Frank's proposal that the Congress bring some form of shareholder derivative action against the bonus recipients, someone needs to point out to him that the Federal Reserve Bank of NY is the entity that provided the funds and is therefore the "shareholder", and that we still have a concept of separation of powers.  Given the bank's prior knowledge of the bonus program, there is zero likelihood of these amounts being recouped.  (Frank also claims that AIG failed to disclose to the Committee that the information to which the Committee was entitled to as a "shareholder"; again, someone needs to explain to him that the principal manner in which public companies make disclosure to their shareholders under U.S. law is through SEC filings, which AIG made but nobody on the Committee apparently read.)

However, what angers me most of all is that neither Obama, Geithner, Gibbs or anyone else in the Administration or Congress has the guts to try to explain to the electorate what actually happened and to accept responsibility accordingly.  The day Obama does that, he really will be "making history", but for now we will have to settle for his 15 minutes with Jay Leno.   I can't wait.

God said to Abraham, "kill me a son", Abe said "man, you must be puttin' me on", God said "no", Abe said "what?", God said "you can do what you want Abe, but the next time you see me comin' you better run". Abe said "where you want this killin' done?", God said "out on Highway 61" (Bob Dylan--1965)

In this deranged metaphor, Government is God, Financial institutions are Abe,  "Issac" (the "son") is our mortgage market, and our economy is Highway 61. Whatever. Except next time they need to run. As Reagan said, "Government is the problem". Does the AIG situation not spell this out in the blackest and darkest of stark relief?

I am now officially the only person in America not angered over the AIG bonuses. After watching all the Fox news shows last night (on DVR, of course, one gets to see 60 minutes in 15) I am now certain we have gone absolutely mad as a nation. When "my guys" (e.g., Charles Krauhammer, Stephen Moore) actually feel anger at the AIG bonuses, it means we are completely missing in the forest. I have no idea who gets the $163 million for what, or whatever the number is, (which Bill O'Reilly said for some odd reason was $1.2 billion) but I am willing to bet most of it is good for the taxpayers. AIG has 116,000 employees, but only 500 or so are in the so-called "AIG Financial Products" division, where all the $175 billion of collateral calls the Feds have made existed. AIG sells life, auto, workman's comp, property and casualty, liability insurance and a host of other things. I assume, we as shareholders (the US taxpayer owns 80%--a problem but it does), want these guys to make money. The insurance people have nothing, I repeat nothing, to do with the guys who got them involved in the credit derivative mortgage business. Should we stop paying Car Dealers commissions and incentives for selling Detroit's products because we lent money to the US auto companies who themselves could not keep costs down?

OPPORTUNISTIC OBAMA

But I digress.  Why is Obama stoking the flames on this one in the first place? Today he gave us a hint. He is looking into how we can, through regulation, limit such "greed" in the future. Doesn't anyone see where this is going? Once again, like "Mr. Jones" , we are getting sucked into his Socialist nightmare by trickery and diversion.

Ironically, the one bright shining light at the end of this tunnel will be that the AIG fiasco will cause banks to pay back that preferred stock as soon as humanly possible to get out of the snare of Barney Frank and Barack Obama. This is good. Fear of Socialism might actually make these guys do something on their own. But it may already be too late. Obama is taking advantage and encouraging this  ludicrous universal "outrage" over AIG "bonuses", creating our 19th nervous breakdown on "greed" and staging the 5th rerun of the Nuremburg trials. Why? So it can write pay limits into bank regulation.

Does anyone but me have any cognitive dissonance over (for one example among 10 million) the fact that Senate Majority Leader Harry Reid can direct for himself a $8 billion dollar Levitation train from Disney to Vegas and we have no similar outrage as the AIG "bonuses"? Does anyone think $8 billion is the real number (ask Boston about its Tunnel project)? And how much more will it lose than Amtrak on an annual basis? Can anyone spell the words "diversionary tactics" regarding AIG bonuses? I believe it was the Nazi Goebbels who said  “If you tell a lie big enough and keep repeating it, people will eventually come to believe it". Well, the big lie here is Obama is screaming outrage at AIG "bonuses" while shoving Socialism right in our face.

All so called insiders who followed markets knew in September that Goldman Sachs and others were on the hook for double digit billions owed them due to collateral calls on unsecured, 100% self financed, maximum leverage loans---otherwise known as Credit Default Swaps---effectively made to AIG (the technicalities are complex, the reality is simple) by these firms. But Hank Paulson and his junior side kick in waiting, Tim Geithner, never revealed that to the public. All the money that is being "paid to AIG" by the Feds is just pass through dollars to Goldman and others.

In a PR move Tuesday,AIG named counterparties to whom it owes collateral and, lo and behold, Goldman Sachs is high on the list. Think about this. Banks like GS "lend" to AIG, use poor risk management, lose a ton, AIG cannot pay, the banks petition to the high lords for help, so the Government provides the collateral that AIG could not. All the AIG money is just being passed through to the "Street". The same "Street" who stupidly exposed themselves to enormous credit exposure to AIG. It is they who are also being bailed out, not just AIG.

But Goldman and Morgan still pay their people "bonuses". Why is there not equal outrage? Because this is not about bonuses. Its about Statism and using this issue as a wedge to help make it happen. Goebbels' social policy was Satanic, but his political tactics were quite modern. We are witnessing them in full rebirth today.

The so called moderate wing of the Republican Party is only slightly coming to its senses. Christopher Buckley, son of conservative icon William Buckley and late supporter of Barack Obama, seems flabbergasted that the new administration is "spreading the wealth around". Sorry, Dad, I'm Voting for Obama. He also seems flabbergasted that it seeks such big government programs, class warfare and centralized control. What did he think the left liberal wing of the Democrat party was going to do, denounce its own policies? As reported by Hot Air "A few trillion dollars in spending later, comes the reckoning".

David Brooks still struggles with the aesthetics of the "Rush Limbaugh" wing of the Republican party. They seem so loud and boisterous. But he informs us that Barack Obama is not who we thought he was. It is remarkable to me that these polite, "open minded", and reasonable people cannot see what is right in front of their face. Of course, I believe that They Are Who We Thought They Were . I really do not know what these "moderate" Republicans are going to do. Brooks is experiencing an existential breakdown. On the one hand, he cannot stomach the Sara Palins of this world because they do not fit his high intellectual standards. On the other hand, he realizes he and others like him have been played, or really, let themselves be played, by a Harvard "intellectual" follower of Saul Alinsky. Talk about street naivety. As he pines for the return of Alexander Hamilton to lead the moderates out of the wilderness,Tea Parties get viral. Obama seems so smart, articulate and reasonable, how could he be doing this?

Of course, there is the small matter of the Pelosi-Reid crowd too, but who notices? And who are these Santelli and Limbaugh people anyway? They are people who cannot bear the thought of hard work and success being demonized and materially punished. People like Buckley and Brooks write for a living. They need to take a walk outside once in a while. Brooks once wrote a book called Bobos in Paradise , his self projection of the new effete upper middle class in which he so comfortably fits. I never really got what the heck he was talking about, but I suggest he and Buckley take another look around. Rather than hoping Hamilton rises from the dead off the cliffs of New Jersey, he should realize that this is the most significant culture war in our nation's history, with the exception of the Civil War.

As Bob Dylan famously wrote,"Something is happening here and you don't know what it is, do you, Mr Jones"? It really isn't all that difficult guys.

(posted by Mike Rulle on Marginal Revolution, February 25, 2009)

I do not understand Health Care/Medicare/Medicaid one iota; so I will limit my comments to Social Security. The problem with Social Security is not what it is supposed to be, a Government managed deferred retirement account. It is "what it is", or has become, thats the problem. It is a Ponzi Structure. It did not need to become one, but it has. We have literally borrowed from our savings and spent it on things like "Levitation Trains". This is no different than if we borrowed from our 401ks to go on vacation, then got angry because there is no money left for retirement. I am fairly sure that the large majority of the public does not understand this. It would not surprise me if politicians did not understand this. Whether they do or not, one need only recall the "lock box" debates of 2000. While Gore was mocked by comedians, he was mocked because of his "affect", not because any one understood why a "lock box" was absurd.

The bottom line is there is no savings. Since we have no savings, but the Government has taken money from the public which would have paid for their retirement, we have a true societal loss (perhaps one could argue our incomes are higher for having "arbitraged" the future--but someone else can make that case). So what to do? There has never been a problem so conceptually easy to fix, yet so politically impossible to address. To address it is to openly admit the fraud, and no politician is moral enough to do this. I believe 3 things need to be done. First, "stop the madness". That is, we must begin the phase out of Social Security taxes. Secondly, we need to reduce the payments. Third, we need to freeze everyone's accrual at today's level. So a 62 year old will have a higher payout come age 65 then a 25 year old (who will effectively have none).

By freezing everyone's accrual at today's level, we have a known set of future payments. Just knowing we have done this should have a positive effect on markets. This may permit the market to absorb some of the initial incremental borrowing required more easily. How do these obligations get funded? As far as I know, there are only 3 ways to pay back money you owe, which is our current situation. Spend less, take from savings, and grow your income. Spend less means other program's growth rates will have to decline. Take from savings means the indexing of Social Security will have to create a lower internal rate of growth. We currently index to wages. There will need to be an index to inflation rather than wages. Finally, since the number of people receiving SS will no longer increase, revenues from economic growth (i.e., population growth combined with producitvity growth) will begin to dominate what is owed.

There may be some requirement for individuals to still pay a "SS" tax for a period of time, phasing out over 5-10 years so the Government need not borrow so much so quickly. In return, individuals who were required to do this, will be permitted to defer more into tax deferred savings later on, which becomes the ultimate replacement for SS. Is this the best idea? I doubt it. But the reality is we do not have the money. It has been spent. We have a Ponzi in its place. Government Ponzis can work in principle, but they are highly unstable and unpredictable. Solving the problem is all about present value, compounding and intergenerational subsidies. But first, recognize the money is owed and does not exist---hence it must come out of future income.

But this, or any other reform, will never happen in the near future. So far we see a President who is increasing, or proposing to increase, taxes, spending, and borrowing. He wants to provide price supports for houses and price supports for Bank stocks. Things don't look so hot.