American Unemployment Rate Approaches 10%

[DGuller]

It is hard to race to the bottom when discussing what CC is talking about, because everyone is sitting on the bottom.

To be honest, I'm having a difficulty grasping what CC is talking about.  I'm talking more generally about the regulation aimed at reducing the systemic risk.  If, as you say, companies can escape it just by shopping for a more lenient regulator, then it's not a good thing.

[Berkut]

I hope what you're talking about is not completely true.  We don't need a world-wide regulatory race to the bottom.  I do think that the boom and bust cycles we've been stuck in for the last 30 years are destructive, and they're not a necessary evil that we just have to live with.

I think you are very much exaggerating the "bust" in that cycle.

Right now, in one of the worst down cycles we've seen in a long time, it still isn't that terribly bad.

Perhaps the business cycle can be eliminated, and we could replace "boom and bust" with just a constant level of poor growth - but would that in the long run result in a better outcome? I suspect not, nor do I think it is really possible to eliminate the cycle anyway - certainly history has shown that it seems somewhat ubiquitous.

[alfred russel]

It is hard to race to the bottom when discussing what CC is talking about, because everyone is sitting on the bottom.

To be honest, I'm having a difficulty grasping what CC is talking about.  I'm talking more generally about the regulation aimed at reducing the systemic risk.  If, as you say, companies can escape it just by shopping for a more lenient regulator, then it's not a good thing.

I'm not sure what he is talking about either, but in general having separate rules based on companies being public doesn't seem wise, as we have some very large private institutions, and in many cases those are loaded with more debt than public ones. It doesn't seem especially just to me to make the opportunity to invest in high growth companies limited to high net worth individuals who have access to private markets.

[DontSayBanana]

I don't think that is as attrative as it might seem. If people want to invest their money in traditional equity investments, it is going to be hard to stop. Sure you can regulate public markets in the US, but people can just move their money to international public companies and to private companies in the US. From the perspective of a company wanting to raise funds, why not then go public overseas, rely on private money in the US, or sell yourself to a large public company here (that in your example would be exempt from regulation).

In fact, after the Enron/Worldcom debacles, we ramped up our regulation of publicly traded companies to a level arguably higher than the rest of the developed world, and all these trends have played out since then. In a globalized economy where it doesn't really matter whether a company is nominally American or foreign--we all share the same systematic risk--what could end up happening is the next wave of growth occurs overseas, without the oversight of the American government, and whose American investors don't have the benefit of SEC oversight (and are exposed to foreign currency risk).

I'm not so sure. Simply pointing out that the problems occurred post-regulation doesn't tell me anything. In fact, a lot of the problems were attempts to circumvent regulation- CDS being treated as insurance, companies posting overly-rosy projections to spike value; even when we bandy about the term "value," there's very little objective definition of what we're talking about.

As for these companies being seen as representatives of the US economy, everytime someone starts talking about that mythical beast, the first indicator of progress mentioned is usually the NYSE. Since AIG, Madoff, and several other significant rogue elements have surfaced, I've been having a harder and harder time believing that it truly is the be-all and end-all accurate representation of performance in the markets.

[Berkut]

I'm not so sure. Simply pointing out that the problems occurred post-regulation doesn't tell me anything. In fact, a lot of the problems were attempts to circumvent regulation-

This is an excellent point.

[alfred russel]

I'm not so sure. Simply pointing out that the problems occurred post-regulation doesn't tell me anything. In fact, a lot of the problems were attempts to circumvent regulation- CDS being treated as insurance, companies posting overly-rosy projections to spike value; even when we bandy about the term "value," there's very little objective definition of what we're talking about.

As for these companies being seen as representatives of the US economy, everytime someone starts talking about that mythical beast, the first indicator of progress mentioned is usually the NYSE. Since AIG, Madoff, and several other significant rogue elements have surfaced, I've been having a harder and harder time believing that it truly is the be-all and end-all accurate representation of performance in the markets.

CDS weren't and have never been treated as insurance. No one was circumventing regulation--it just wasn't there. This wasn't a secret--everyone including regulators was aware of it for years.

I don't know if AIG was a rogue company--it just went bust. Madoff ran a hedge fund, which has been exempted from most regulations since FDR and was certainly not on the NYSE (he almost certainly couldn't have run his gig if he was).

[DGuller]

In fact, a lot of the problems were attempts to circumvent regulation- CDS being treated as insurance,

Was that really the case?  I know that CDS is often confused with insurance, either out of ignorance or due to deliberate misdirection, but I wasn't aware it was actually treated as insurance.  It was treated as a financial product by AIG, for example. 

In any way, I don't know why you would ever want to treat anything as insurance to escape regulation; insurance is by far the most regulated part of the financial industry.  It's also, not coincidentally, the part that took on the least damage in the meltdown.

[Berkut]

I'm not so sure. Simply pointing out that the problems occurred post-regulation doesn't tell me anything. In fact, a lot of the problems were attempts to circumvent regulation- CDS being treated as insurance, companies posting overly-rosy projections to spike value; even when we bandy about the term "value," there's very little objective definition of what we're talking about.

As for these companies being seen as representatives of the US economy, everytime someone starts talking about that mythical beast, the first indicator of progress mentioned is usually the NYSE. Since AIG, Madoff, and several other significant rogue elements have surfaced, I've been having a harder and harder time believing that it truly is the be-all and end-all accurate representation of performance in the markets.

CDS weren't and have never been treated as insurance. No one was circumventing regulation--it just wasn't there.

I think that is the point - one of its attractions was that it was not regulated, and hence could take on a huge amount of risk.

We can (and should) close that hole, but will the financial whizzes just find another one?

[alfred russel]

I think that is the point - one of its attractions was that it was not regulated, and hence could take on a huge amount of risk.

We can (and should) close that hole, but will the financial whizzes just find another one?

Of course. Any time you have something you want to sell (in this case risk) and I'm willing to buy, it is going to be almost impossible to prevent the transaction. Especially for global institutions that have extensive operations in virtually no regulation jurisdictions.

I do agree there should be regulations of CDS and other products, I just don't delude myself of how effective they will be.

[The Minsky Moment]

2) Government subsidization of the mortgage market via Fannie/Freddie and the interest deduction combined with light regulation of the secondary and derivative markets.  Privitization of gains and socialization of losses.

I'm curious why this was such a major factor; the government has subsidized the mortgage market since the National Housing Act in 1934 and interest deductions on loans has existed since the beginning of the income tax.  Why did those factors cause a bubble now?

The extraordinary growth in securitization markets.

[DGuller]

The extraordinary growth in securitization markets.

Which was brought about by deregulation.  By itself such growth wasn't a bad thing, but it brought about issues that should've been addressed (mainly underwriting incentives and excessive leverage).

[Savonarola]

The extraordinary growth in securitization markets.

I still don't understand.  Wouldn't the growth in the securitization market be the underlying cause rather than federal subsidization of the mortgage market?

[Hansmeister]

I'm not so sure. Simply pointing out that the problems occurred post-regulation doesn't tell me anything. In fact, a lot of the problems were attempts to circumvent regulation- CDS being treated as insurance, companies posting overly-rosy projections to spike value; even when we bandy about the term "value," there's very little objective definition of what we're talking about.

As for these companies being seen as representatives of the US economy, everytime someone starts talking about that mythical beast, the first indicator of progress mentioned is usually the NYSE. Since AIG, Madoff, and several other significant rogue elements have surfaced, I've been having a harder and harder time believing that it truly is the be-all and end-all accurate representation of performance in the markets.

CDS weren't and have never been treated as insurance. No one was circumventing regulation--it just wasn't there.

I think that is the point - one of its attractions was that it was not regulated, and hence could take on a huge amount of risk.

We can (and should) close that hole, but will the financial whizzes just find another one?

This is the fallacy of the regulators:  to believe if we just empower the right people they can create regulations that can account for the near limitless permuntations of economic possibility.  It is a fool's errant and will always end up in failure.  No person, or collections of persons, are smart enough to regulate the activities of billions of human beings.  Regulations don't prevent economic crisis from reoccuring, the crisis in itself does that.  regulators like to like to claim credit for their new regulations preventing people from making the same mistake twice, when in reality it is the learning process from that mistake which accounts for the change of behaviour.  Regulations serve simply as dead-weight.

In a free market there is constant experimentation, which leads to huge successes and to large failures.  Things get tried out until they don't work and this constant creative destruction creates growth.  Regulators attempt to control the economy are more likely to do harm than good.

[The Minsky Moment]

I still don't understand.  Wouldn't the growth in the securitization market be the underlying cause rather than federal subsidization of the mortgage market?

The two are intertwined. 

Freddie and Fannie created the mortgage backed securities market, and they and the private market grew together hand-and-hand.  Recall, that although Fannie was founded in the 30s, it did not begin issuing mortgage-backed securities until 1968.   During the 60s 70s, and much of the 80s, the level of MBS issuance was fairly modest, in part because the institutional demand for such securities was limited (for example during this period you could buy very high yielding treasury bills and bonds) and in part because the interest in securitization by banks was limited - banking in this period was heavily regulated and a typical bank could do very well making money from the spread between the interest rate obtained from borrowers and the interest rate paid to savers.

When the banking business was deregulated starting in the late 1970s to allow competition for savers from money market funds and the like, making money off the spread became more difficult - the cost of funding increased.  At the same time, the removal of restrictions to interstate banking and lines of business opened up the market for corporate control and encouraged consolidation - this put pressure on bank mangagement to maximize their own profitability and in particular their return on equity capital.  Finally, the Fed finally beat back inflation in the 80s and by the early-to-mid 90s interest rates fell to a low and stable level.  This had the following implications:

+ Tightening of the "spread" --> lower profitability from traditional lending and servicing
+ Drive to maximize return on equity --> emphasis on minimizing use of equity capital in the business
+ Low and stable interest rates --> bond investors look to chase yield to squeeze out extra returns.

Factors 1 and 2 generated significant pressure of the banks to abandon traditional loan servicing and favor of an originate and distribute securitization model.  Securitization conserves captial because the loan gets off the balance sheet, while earning the bank a steady new earnings stream in origination fees to supplement the dwindling profits to be earned from the interest spread.  But this would be irrelevant unless there was a strong market to purchase the securitized loans.  The key factor here was Fannie and Freddie's willingness to assume the credit risk without limit on conforming loans.  That meant that bond buyers could get a government-backed AAA credit with a nice interest premium over Treasuries, thus playing right into Factor 3.

Once institutional bond purchasers became habituated to looking for AAA bonds with spread premiums, that opened the door to Alt-A and subprime securitizations using "credit enhancements" and a CDO tranche structure.  This started out as a private securitization market, but one essentially parasitic on the vast MBS market that Freddie and Fannie had created and enabled to grow.  And once this new market took off, Fannie and Freddie stepped in to compete in that segment as well, thus implicitly throwing the weight of the US Treasury behind the entire housing securitization market and all the related derivative instruments.  what we had was a malign symbiotic relationship between private financial institutions riding a bubble and vast government-backed parastatal finance corporation gleefully working the bellows.

[Hansmeister]

I completely agree with this analysis.