Re: Can the Banks be saved? If not.......

[David Farber <dave () farber net>]

Begin forwarded message:

From: dewayne () warpspeed com (Dewayne Hendricks)
Date: January 24, 2009 4:16:43 PM EST
To: Dewayne-Net Technology List <xyzzy () warpspeed com>
Subject: [Dewayne-Net] Re: Can the Banks be saved? If not.......

[Note:  This comment comes from friend Charlie Brown.  DLH]

From: Charles Brown <cbrown () flyingcircuit com>
Date: January 24, 2009 12:57:07 PM PST
To: Dewayne Hendricks <dewayne () warpspeed com>
Cc: Charles Brown <cbrown () flyingcircuit com>
Subject: Re: [Dewayne-Net] Re: Can the Banks be saved? If not.......

Andrew,

I have no doubt we will get out of this, even if we have to sell bonds  
and print to the extent of 300% of GNP, assuming the dollar doesn't  
collapse in the process.  What is important now is HOW we do it.

People who read this list know that my "numero uno" scenario dating  
back to mid-2007 when this mess started was the creation of Bubble #3,  
currently referred to as "reflation of the credit bubble."  Wall  
Street loves a bubble because they can make lots of money throughout  
the cycle, as they have done, and are doing, with this last one.  We  
need to remember that the original rationale for the existence of the  
financial industry was the efficient allocation of capital.  New  
fortunes will be made buying and selling junk debt owned by the  
taxpayers.  So it goes.

The derivatives markets are opaque and the direct cause of the bailout  
of AIG and the restructuring of the monoline insurers.  Consider that  
the "shadow banking system" is larger than the erstwhile, regulated  
banking industry.

Steve's background piece on the early Hamiltonian/Federalist debates  
on the origin and evolution of the financial system were  
instructive.   And it's good to finally see a discussion of what  
happened in Japan.  But I think this is different than Japan in that  
there is much more here than just an asset and credit bubble.  For one  
thing, the credit bubble was exported as the US financial system  
soaked-up the savings of the rest of the world.   What is not  
instructive is another book from a former Wall Street plutocrat (there  
will be many more of these - don't waste your money) who has had an  
epiphany after having discovered classical history, literature and to  
some extent, philosophy.  I am speaking of the author of the Black  
Swan - Mr. Taleb and his ilk.   These "ex-finance" people who have  
discovered there is something of value in the world besides making  
money is just sad and uninteresting commentary.  Watch out for the new  
"quant" mathematical models to explain the recent phenomenon, with a  
bit of "new" classical knowledge thrown in.  That might sell.

I should preface my remarks with a brief story that might infer a  
slight bias to the reader.  I have an educational background in  
finance and the classics.  Early in my career I worked in some very  
lucrative financial positions and "had it made", as many acquaintances  
would say.  However, I suffered from severe nausea, not least because  
everyone I met would comment on the fact that they never known anyone  
with training in accounting and finance, and the classics.  I would  
hear all sorts of credulous remarks of bafflement in this regard and  
quickly realized that practically everyone I met in that world were  
cultural neanderthals.  And that was in the 70's, and nothing has  
happened since to change that view.  Yes, and I say that despite their  
generous benefactions to cultural institutions far and wide, etc.   
Needless to say, I departed that world early on to pursue a career as  
an entrepreneur and try to create something of value as my new goal.   
So, I am just an entrepreneur that has managed to survive in a tough  
industry (wireless) sitting out here watching all of this, and who  
felt compelled to engage in the various discussions on Dewayne's list  
by saying emphatically, "WTF?"

I enjoyed your story.  Mine is below, abridged from a post to the IP  
list last year.  As background, please keep in mind Long Term Capital  
Management and Enron.  I think what we have now is a rolled-up version  
of both, courtesy of Wall Street, their lawyers and the natural  
inclination of the American people to be easily manipulated by the  
pursuit of material wealth.  It is heartening to begin to see  
scientists, engineers and people like President Obama engaged in the  
political process.   As Steven Chu (Secty. of Energy) said recently,  
paraphrasing, "Get the lawyers and the regulators out of the way and  
hand the problem to the engineers and stuff will start happening."   
However, as he signed his first documents as President we see Sen.  
Feinstein hovering over him with Chuck Schumer buzzing around in the  
background.  We all understand the system well enough to want to  
change it in spite of its many failures of institutions and people.    
But we need to recognize who we are, where we live and what we have  
become.  I hear that rhetoric clearly from the new President but it is  
lost on academics like Krugman.  We are all responsible for what  
happens next.

I would also point out that Roubini's $4 trillion is a pure  
guesstimate.  The professional observers can't know the size of the  
crater  due to the opaqueness of some of the derivatives markets and  
the shadow banking system - private equity, hedge funds, money-market  
funds, CDOs, CDSs, non-bank financial institutions, and list goes on.   
I tend to agree with Steve in that it is useful to examine where this  
system came from to evaluate how to fix it properly, in the the socio- 
economic-political context out of which it was born, not thinking of  
it in terms of a silo.   It is perhaps simplistic to parse the  
financial dynamic from other influential factors, most of which passes  
for what I call "Wall Street spin."  "Hey, we were just doing our  
jobs."  Sounds like former members of the SS death camp brigade.   The  
nexus is clearly there for anyone who cares to look.  This must lead  
to a consideration of Constitutional and other systemic issues, which  
currently serve as enablers.

Andrew, they are going to do it again unless the Obama Admin stops  
them.  I'm not particularly sanguine about that prospect given who the  
President has chosen to put on his economic team, who seems to be  
applying the old baseball adage, "We are going with the people who got  
us here."  An optimist might observe that Obama is gearing up for  
"realpolitik" and marshalling his forces to take on Wall Street.   
Perhaps Summers, Geithner, et al, have had an "epiphany" too.   I hope  
so, because if you think the pain and aftermath is bad now it is  
determined mass destruction post a Bubble #3.  This isn't a "systemic  
financial issue" that needs to be tweaked and solved with the right  
touch of regulation.  The post-bubble #3 scenario is only possible if  
we let it happen - it is a socio-economic-political choice, and we  
have a chance to get it right.  We'll see what they do.

No one should have any doubt that Wall Street will drive all of us  
into a pauper's grave if they can line their pockets in the process.  
They don't think;  they are acquiring animals.  We need to focus on  
the elimination of the nexus of political and economic corruption.  If  
the President takes them on we should all be prepared to step-up and  
help him.  I think that is the challenge he has called on each one of  
us to take seriously, at least I hope I am reading that right.

Anyway, here it is from Oct. of last year.

Charlie

___________________________________________

Wally (Wall Street) goes to Smallville (Reagan/Bush/Clinton/Bush  
Administrations) and talks to the mayor about opening a casino in  
town.  The mayor thinks it is a fantastic idea.  Wally says there are  
a couple of preconditions though, he wants the casino to have special  
tax breaks for the players and no regulation or interference  
whatsoever in what goes on inside the casino. Fair enough, the mayor  
and the city council are glad to oblige.  In fact, he and a lot of  
local people want to play too through player-representatives (hedge  
funds).  The mayor and his friends are going to make a killing on the  
casino coming to town.  They want him to run for Governor next term.

The casino Wally is setting up is very different from the traditional  
casino in that there is no "House" to cover the bets.  The role of the  
traditional casino "House" is taken up by the other party to each bet  
made at any table (transaction) in the casino.  The "House" (Wall  
Street) is providing the facility and the playing field for the  
players, who are mostly known to each other and the House anyway.  A  
critical feature of the casino is that bad or good bets at the crap  
table are covered by another player at the crap table, not the House.   
Those are the rules.  The volume of action in the casino is only  
limited by the number of IOUs other players are willing to accept.   
The IOUs are payable in US dollars.

The players adore this game.  They walk in with $100 and can buy  
$5,000 worth of IOUs (chips), "nominally" issued by the House, but  
only as a custodian for the players;  like a private clearing house.   
The chips are the IOUs (derivatives, CDS contracts, MBSs, etc.) while  
a player is involved in the game.  Winners and losers are made every  
minute by the action at the various tables, which differ only in the  
type of game (cards, dice, roulette, slot machine, etc.), not in the  
substance of an IOU exchanging hands for the right to play.

One day, one of the "high-rollers" at the casino has a few of his  
IOU's called-in by other players and whoa!  He doesn't have the money  
to cover his IOUs!  In fact, it turns out he has big losses already in  
the game.  He starts trying to collect on some IOUs he holds and finds  
that some of them aren't any good.  He was having so much fun playing  
the game and making so much money for himself and his staff on a  
current basis, in terms of fees and reporting profits to his friends  
and shareholders, that that there was no need to think about these  
details.  The casino had everything going for it, political cover,  
it's own bank creating money, albeit phantom money, private exchange,  
and a host of "brilliant", credible players with deep pockets.

Now Wally has a problem.  Other players are lined-up outside his  
office wanting to collect on some of their IOUs.  Wally doesn't have  
the money, he's just the casino facilities operator he tells them.   
"I"m just the clearing house taking a cut. You knew what you were  
doing when you gave and took those IOUs", he tells them.  But they  
shout, "You have the power and wherewithal to cover us!"  Some of us  
have more IOUs going the wrong way and didn't balance our IOU  
portfolios, and unpaid IOUs will only make the problem worse!  Your  
reputation is on the line and you are in this too Wally", they plead.   
So, Wally goes to the mayor of Smallville and suggests that  
Smallville's citizens need to cover the bets made by the players at  
the casino.  After all, they benefited too, Wally argues.  Wally  
brought in lots of money to Smallville's town council and other  
politicians.  Funds flowed to Smallville and its environs and they  
also  put a lot of money into the mayor's upcoming run for Governor.

The mayor doesn't like it because he knows it is going to be hard to  
spin to the citizens of Smallville, but the alternatives as explained  
to him, are bleak indeed.  "What else can I do?" he mumbles to himself  
constantly.  The town's economy has become dependent on Wally's  
business.  The local economy will collapse since some of the local  
commercial banks are carrying some of the high-rollers IOUs.  The  
political pressure is enormous from Wally and his influential  
friends.  The mayor goes along again.  "What else can I do?  File a  
law suit?  Against whom? For what?", he tells his staff and neighbors.

Finally, an aide in the mayor's office exclaims, "Wait a minute!  Why  
can't the casino patrons get together and cross-eliminate all these  
bets?  Net them out, gains against losses?  It's all IOUs anyway.  It  
doesn't matter how many times removed any particular IOU is from one  
another.  They are all holding IOUs transacted at the casino!  They  
put them all together in a big pot and compress them down to the nub,  
eliminating all of the debits and credits.  The last players holding  
the IOU in excess of someone's else ability to pay take the netted-out  
loss.  That way, the largest players in the game that are still around  
take their losses.  How do we know they don't also have astronomical  
profits from the casino?  And even if they don't, what can they do,  
sue us to cover their losses?  We didn't know anything about their  
gains and losses.  If anyone is going to be sued they will sue each  
other over not paying their respective IOUs after compressing them to  
the nub.  Why should we and our citizens vouch for the action at the  
casino?"

Another said, "Even Wally had friends who weren't patrons of the  
casino, but most of his friends were regulars."

Then, another of the mayors aides said, "I get it.  They created a  
type of currency with these casino chips that were convertible into  
Smallville dollars."  Another said, "Now if only the City Council  
could understand, but they are only listening to Wally and his friends."

The citizens of this Republic need to understand this.  In fact, it is  
the duty of those of us who do understand it to explain it to them.   
The substance of the above metaphor accurately reflects the details,  
regardless of Wall Street lawyers holding up 500-page CDS contracts.   
That is Wall Street spin.  You see, Wall Street lawyers made a fortune  
in this market as well.  And in case you weren't informed, we are too  
stupid to understand what these "brilliant people" have "created" for  
our benefit.  The "brilliant" people on Wall Street, the likes of  
Secty. Paulson, the progeny of numerous university business school  
professors, the main-stream press, et al, is just drivel.  Wall-street  
spin, or as David Reed would say, "failed physicists."

The remaining investment banks and other players want you and I to  
cover their IOUs and keep the casino in business.  If that isn't  
brazen enough, we don't even get a tax subsidy like they did on their  
profits, and still are getting!

The correct response of the mayor of Smallville is simple, if someone  
could inform him and he had any integrity.  Let the casino players  
unsort ("net out", or "compress") the pool of IOUs and sue each other  
over non-payment of their 500-page CDS contracts.  Their shareholders,  
hedge fund participants and other investors would take the compressed  
losses, however much it might turn out to be.  $1 trillion?  $2  
trillion? $5 trillion?  The shareholders and investors of the  
regulated and non-regulated financial institutions around the world  
can absorb those numbers without burdening the already harassed  
citizens of Smallville.  Just Alan Greenspan.  If the citizens of  
Smallville understood that, maybe the mayor would change his mind  
since he is running for Governnor next year.  Maybe he would find the  
strength to do the right thing, to do his duty by his fellows.   The  
Smallville banks that participated at the casino have to be compressed  
as well, and some will fail.  That's unpopular in some circles of  
Smallville.  Perhaps many will fail, so what?  Won't they likely fail  
anyway?  Wasn't the value proposition that Wally came to Smallville  
with in the first place exactly that, i.e., the IOUs were an elegant,  
fool-proof way of "spreading the risk" on losses and of collecting on  
the IOUs?  Yes, that's exactly what the physicists, mathematicians and  
high-rollers that came with Wally to pitch the mayor had said.  They  
said it over and over again as the casino was operating 24x7.

On the contrary, Wally, the mayor and all of their friends in the  
media frightened the citizens of Smallville into believing that they  
had  to incur further indebtedness and pledge what remains of their  
vanishing wealth to cover the outstanding IOUs at the casino.  No  
compression is necessary as long as a few of the high-rollers avoid  
scrutiny and prop-up the IOU market (Goldman Sachs, Morgan Stanley,  
certain purchased entities of other bankrupt high-rollers), because  
Wally and the mayor now have everyone convinced that the high-rollers  
bets need to be made whole, or they will suffer too, even worse.  They  
have been heard to say, "We are all in this together."  Yes, but only  
those who played at the casino, not those who did not.

_______________________________________


On Jan 23, 2009, at 10:26 PM, Dewayne Hendricks wrote:

> [Note:  This comment comes from friend Andrew Odlyzko.  DLH]
>
> From: odlyzko () dtc umn edu (Andrew M. Odlyzko)
> Date: January 23, 2009 9:58:03 PM PST
> To: dewayne () warpspeed com
> Cc: schear.steve () googlemail com
> Subject: Re: [Dewayne-Net] Re: Can the Banks be saved? If not.......
>
> Steve,
>
> I do not deny the possibility of a global crash.  The two historical
> analogies that seem closest to our current situation are those of
> the world in the late 1920s and of Japan in the late 1980s.  The first
> one led to a global crash, the second to a long muddle, but one that
> was bearable, largely because the Japanese did what governments in
> the 1930s did not dare do, namely shovel money into the system
> (which has its own costs, of course).  And there were some pretty
> obvious mistakes in what the Japanese government did, so perhaps
> we'll get out of this mess at lower cost, something like the
> $4 trillion that Roubini is talking about, or even lower.  If I had
> to bet, I would wager on something like $8 trillion, and would
> regard anything over $15 trillion, or less than $2 trillion, as
> possible but unlikely, with a collapse even less likely (though
> not to be excluded).
>
> The stock valuations of banks are basically irrelevant.  In a likely
> scenario in which asset values go down to their long-term trend
> numbers, essentially all those banks are insolvent, and what keeps  
> their
> valuations above zero is the hope that taxpayers (or their  
> representatives,
> to be precise) will be generous to the shareholders.
>
> But the entire problem seems fixable.  If we do what Japan did in the
> 1990s and this decade, we'll increase the federal debt by $15  
> trillion,
> which would make it comparable (in relation to GDP) to that of Japan  
> today,
> and only somewhat higher than US federal debt at the end of World  
> War II
> (1.7x instead of something like 1.3x, this ignores Social Security,
> Medicare, and other obligations, of course).  Now at their peak a bit
> over two years ago, US residential real estate was valued at something
> like $20 trillion.  The traditional measure of real estate values to
> household incomes would have valued all those homes at something
> like $12 trillion.  (I don't recall the exact numbers, but the
> overvaluation, as computed by Robert Shiller and others, was a factor
> of something like 1.7x.)  If we go down to that traditional measure  
> (and
> we could undershoot it, or else we could stop at a somewhat higher
> level, nobody knows), there is $8 trillion that various entities
> (individuals, banks, corporations, charities, ...) had been counting
> on that has to be squeezed out of their expectations.  The worst case
> scenario has the entire risk lying in the banking system.  A while
> ago I proposed an explanation of our crisis that uses the Aunt Millie
> and Cousin Jim analogy.  Let me use those names again, but simplify
> some more.  Suppose Aunt Millie owned all the (residential) real  
> estate
> two years ago, and owned it outright.  But right at the peak of the
> real estate market, she sold it off, for $20 trillion, and put that
> whole amount into the Bank Too Big to Fail (BTBTF).  (And let's assume
> she did not have to pay capital gains taxes, nor realtor commissions.)
> And suppose that Cousin Jim bought all that property for $20 trillion,
> getting the full $20 trillion purchase price in a low documentation,
> deferred interest, ...., loan from BTBTF.  And suppose that BTBTF had
> $1 trillion of its own capital, and all its deposits consisted of
> that single $20 trillion CD of Aunt Millie's.
>
> Note that there is nothing in this story so far about CDOs,  
> conduits, ...,
> that are often blamed for our crisis.  Those things are fluff.  They
> definitely contributed to the problem, by concealing what was  
> happening,
> and thus leading to the bubble inflating far more than it would have
> otherwise.  And they did help the financial sector rake off oodles  
> of money.
> But they were not essential.  There have been bubbles for centuries  
> even
> before such financial instruments were invented.  (And the bubble of  
> the
> 1920s, as well as the more recent Japanese bubble, both grew to  
> proportions
> comparable to ours, without assistance of such instruments.)  The real
> fundamental problem is that asset valuations got out of line with  
> incomes.
> There had been plenty of people producing justifications for this  
> (in particular,
> through reference to the Great Moderation, the taming of the  
> business cycle
> that supposedly made risks lower, and higher asset values  
> appropriate), and
> it was not obvious until recently that they had been wrong.
>
> But back to the story.  If all that real estate that is owned by  
> Cousin Jim
> is worth just $12 trillion, then the Bank Too Big to Fail (BTBTF) is  
> bust,
> it owes Aunt Millie $20 trillion, but it has only its capital of $1  
> trillion,
> and can foreclose on Cousin Jim and get $12 trillion from that  
> source.  What
> the feds have been doing over the last few months, as the estimates  
> of what
> Cousin Jim's real estate is worth have been moving from $20 trillion  
> down
> towards $12 trillion, has been shoveling money into BTBTF to cover  
> the gap
> between what it owes Aunt Millie and what it is really worth.  (Note  
> that
> the feds have guaranteed all bank deposits, so Aunt Millie is OK for  
> the
> time being.)  But no wonder that BTBTF is not making new loans.   
> Even as
> federal money comes in, the estimates of the value of Cousin Jim's  
> property
> keep dropping.  But, barring a major catastrophe that might drive real
> estate valuations even lower than $12 trillion, the most that it would
> take to fix the problem is $7 trillion (or possibly $8 trillion, if  
> you
> want not just to cover all obligations, but also to recapitalize  
> BTBTF so
> it can start lending again).
>
> Now it should not take more than half of the $7 trillion to fix the  
> real
> estate part of the banking portfolio.  Most people did have  
> substantial
> equity in their houses, and they can be told to eat their losses.   
> On the
> other hand (and this is what makes this crisis so dangerous) it was  
> not
> just residential real estate that got overvalued.  Commercial real  
> estate,
> corporations, everything got on the bandwagon of higher valuations,  
> and
> much of that stuff is securitized.  So multiply that 1/2 of $7  
> trillion
> by some number, like 2 or 3, or even 4.  But even that does not  
> exceed the
> $15 trillion that experience shows is feasible for the federal  
> government
> to take on.  So I feel we should be able to muddle through, although  
> at a
> high cost.
>
> As a final note, Aunt Millie is the big winner in the scenario I  
> outlined.
> (All those investment bankers, realtors, etc., are also winners, but  
> on a
> considerably smaller scale.)  But she does not escape completely.   
> After
> all, those bonds that the feds will be issuing will pay interest,  
> and that
> will come from everybody, including Aunt Millie and the interest on  
> her
> CD from BTBTF.
>
> Andrew
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