Basic Info - "Toxic Assets"

[johnkarls]

.
---------------------------- Original Message ----------------------------
Subject: Joe Stiglitz and Chris Dodd/Barney Frank
From: John Karls
Date: Sun, April 12, 2009 5:28 am
To: Utah Owl
--------------------------------------------------------------------------

Dear June,

Thank you very much for your e-mail.

First, I have been confusing Joe Stiglitz with someone else for the last
25 years or so. There was an eminent economist in the 1960’s when
Stiglitz was just a student. The older economist must have had a similar
name because whenever I have seen anything about Stiglitz, I have just
added it to my mental file about the older eminent economist.

Second, Joe Stiglitz says very little about the origin of the sub-prime
mess. Indeed, after saying at the beginning of his third paragraph that
he wanted to focus on it, he spent only two paragraphs doing so. And
obviously blurred Fannie Mae and Freddie Mac into the term “bank” – which
is legitimate since they obviously are banks, but illegitimate because he
knows his readers are going to interpret his use of the term “bank” to
mean private banks!!!

He is also disingenuous in these two paragraphs because he raises the
issue of “high leverage” as if this is NOT what banks have always been
expected to do since time immemorial!!! High leverage is what banks are
expected to do – normally investing in sound assets subject to high
regulation.

The problem, of course, is that Chris Dodd and Barney Frank pushed Fannie
Mae and Freddie Mac into making zero-down (vs. the old 20% down) loans in
order to stimulate home ownership in inner cities.

I have no quarrel with Dodd and Frank vis-à-vis whether home ownership in
inner cities is a laudable goal.

My quarrel with them is whether the resources that have been squandered
(including the current damage to the economy) on their altar of inner-city
home ownership was wise – since dedicating the same resources to education
of inner-city kids could have put all of them into our federal magnet
schools!!!

Such idiots!!! Unforgivable!!!

But back to Stiglitz.

He also mentions Credit Default Swaps.

Again he is disingenuous. As we have previously discussed, CDO’s were NOT
derivatives but ARE simple insurance. To save time I just spent 2-3
minutes searching the RL bulletin board trying to find a lengthy
discussion of this distinction that I posted – and came across our e-mail
correspondence of last December on Krugman vis-à-vis Dodd and Frank (you
were “AnonymousOne” in the third of five topics under “Participant
Comments” for the Dec 10th meeting).

The lengthy discussion of the distinction between traditional derivatives
(Las Vegas balanced books) and AIG’s simple insurance (masquerading as a
derivative) comprises the fourth of five topics under “Participant
Comments” for the Dec. 10th meeting).

The reason why Stiglitz is disingenuous???

Buying insurance from AIG for investments in pools of sub-prime mortgages
is precisely what one would expect of a commercial bank that is expected
to assume little risk with high leverage under strict regulation!!!
Obviously the regulators were fooled into thinking that AIG knew what it
was doing when it wrote the insurance!!!

The remainder of the Stiglitz article???

His basic points are sound!!!

But he continues to use sound points to be highly misleading!!!

Probably because, as an economist, he is a “disabled person”!!!

By this, I am harking back to our discussion of Wednesday evening during
which I pointed out that economists always assume everything away and
rarely deal with the real world!!!

Stiglitz’ disability in this instance is his inability to believe that a
market can NOT be imperfect!!!

That is, it cannot be irrational!!! Or subject to psychological fears
that produce silly results that ACTUALLY EXIST!!!

What actually happened with the Dodd/Frank sub-prime mortgage pools in
which financial institutions, among others, invested – some with insurance
from AIG???

As soon as they began experiencing losses and AIG began having to make
payments on the insurance policies, the market for sub-prime mortgage
pools dried up and disappeared!!!

Should it have done so???

Of course not!!!

And if the federal government (sans the FDIC) had stayed out of the way,
the holders of such investments that were not insured by AIG could
probably have found a way to sell them (IF THEY HAD WANTED) by disclosing
complete information regarding the contents of each pool (getting right
down, on a mortgage-by-mortgage basis to, for example, what the payment
history on each has been).

So why did the market for sub-prime mortgages disappear???

First, because they knew the supply of sub-prime mortgages was going to
swamp the market!!!

Not because there was anything particularly wrong with the assets
themselves, despite the media’s insistence on calling them “toxic”!!!

I have not been studying the situation closely since our RL meeting in
December because it doesn’t interest me particularly.

But from what I encounter in the media on an involuntary basis, my
impression is that the vast majority of sub-prime mortgages are NOT in
default!!!

The problem is with a simple accounting-rule change made about 20 years
ago and with the immutable law of supply & demand.

The accounting-rule change made about 20 years ago???

Applying “mark to market” to all financial assets held by financial
institutions!!!

“Mark to market” sounds fine to someone like Stiglitz who just can’t
conceive that the “market” would be imperfect!!!

But to illustrate my point, let me posit a numerical example that I hope
is fairly realistic but would illustrate the point even if it is wildly
inaccurate.

Suppose all commercial banks are holding sub-prime mortgages on Martian
real estate, that the annual default rate on the sub-prime Martian loans
is 1%, that the loss rate on the defaulted loans will be 20%, that the
sub-prime Martian mortgages bear interest at 10%, and that the market rate
of interest is 5%.

So let’s consider what the true asset value is for each $100 of sub-prime
Martian mortgages really is.

The interest on the 99% that does not default is $9.9999.

The 20% loss on the 1% that does default is $0.2000.

The overall return is $9.7999.

Accordingly, if the term of the mortgages were infinite, the true economic
value of the $100 of sub-prime Martian mortgages would be $195.9880.
(100*(9.7999/5.0000))

Obviously, if the term were only 30 years, the math would become a bit
more complicated and the true economic value would be somewhere between
$195.9880 and $100. BUT IT WOULD NOT BE LESS THAN $100!!!

But what happens in the real-world market, rather than Joe Stiglitz’
hypothetical perfect market???

Investors immediately flee to the sidelines!!!

Why???

First, because they don’t know the particulars of what each pool of
sub-prime Martian mortgages contains!!!

Second, because they know that the portion of the financial institutions
that are commercial banks will immediately have to write down their
investments in the pools of sub-prime Martian mortgages TO ZERO BECAUSE
THEY (THE INVESTORS) HAVE JUST FLED TO THE SIDELINES!!!

As a result of which the immutable law of supply and demand means that if
the FDIC is immediately forced to cash out the shareholders of a
commercial bank because its $195.9880 of sub-prime Martian mortgages can
only be sold AT THE MOMENT for ZERO, the investors are NOT going to return
to the market to pay much more than zero because there is such a glut
caused by the accounting rule!!!

In my view, the best solution would be to change the accounting rule!!!

Then the commercial bank regulators could look at each investment in
sub-prime Martian mortgages and evaluate whether each is worth $195.9880
or less than $100 – and only with regard to the latter would there by any
write-downs (not wholesale write-downs OF EVERYTHING to ZERO!!!).

But I don’t mind the Obama/Geitner approach either!!!

After all, they are simply trying to organize a sufficiently large group
of investors willing to bid on sub-prime Martian mortgages based on true
economic value (as illustrated above), rather than on the basis of the
price prevailing in the currently dysfunctional market.

Why is Stiglitz so upset???

How dare anyone impugn the reputation of a market by calling it
dysfunctional???

And how dare anyone question the wisdom of an accounting rule that is
predicated on the reputation of markets for not being dysfunctional???

I know (from my inability to avoid completely news about the Obama/Geitner
plan) that there has been criticism about the disparity between the profit
split and the amount of money each puts in. Indeed, this was one of
Stiglitz’ points.

But it is disingenuous because (and this is an assumption on my part) they
have the first layer of risk, rather than sharing risk proportionately.
In other words, it is the normal type of leveraged investment where you
put in a small amount and borrow the rest. The first dollars lost are
100% yours until you are completely wiped out.

Moreover, it is disingenuous because Obama/Geitner have to organize
sufficient investment funds to balance the outrageously-large temporary
supply caused by Stiglitz’ silly accounting rule. So I don’t begrudge
Obama/Geitner their use of leverage to enlist the help of private
investors to ascertain true economic value and restore sanity to Stiglitz’
dysfunctional market!!!

On a slightly different matter, I know there has also been criticism of
the Obama/Geitner plan because it limited potential investors, at least
initially, to investors that already had substantial investments in
sub-prime Martian mortgages.

I am guessing that the reason for limiting the pool of potential investors
was to reward (or bail out) the Dodd/Frank holders of sub-prime inner-city
mortgages (and to eliminate any holders of sub-prime suburban mortgages).

If my guess is correct, I can’t get very exercised over it!!! Which is
why I refuse to bother to ascertain what the squabble is about!!!

*****
With regard to your research on Dodd/Frank, I recognize the first graph in
the first article as something you sent me in connection with our e-mail
correspondence last December that is posted on the RL bulletin board.

I was willing to tolerate parsing through the Dodd/Frank mess last
December when it was our RL topic.

I am not willing to do so again. I am 100% certain that Dodd/Frank are
the culprits and the Democratic party was insane to permit them to
squander so much of the country’s wealth on inner-city housing rather than
the education of inner-city kids. I do not have the stomach to think any
more about what they did – indeed in my book, what they did is an argument
for capital punishment even though what they did was probably not criminal
despite their ethics being totally bankrupt!!!

Your friend,

John K.

PS – There are probably plenty of typos and grammatical errors because I
don’t even have the stomach to re-read the foregoing.


---------------------------- Original Message ----------------------------
Subject: Re: Fw: My "three musical notes walk into a bar" joke
From: Utah Owl
Date: Sat, April 11, 2009 8:00 pm
To: John Karls
--------------------------------------------------------------------------

Dear John,

You've found the right Mortenson - the 2nd book is a children's version.
I finally posted this suggestion, as well as the Greider book, to the
Reading Liberally website.

It took me several days to make sure my laptop & home computer were secure,
since the Conficker worm activated last Thurs-Fri, and absolutely brought
the Uni net to its knees. The U has multiple firewalls, and IT does its
best to make everyone keep auto-update active on their computers - but what
with everyone's personal laptops, etc, and students who log into anywhere &
download who knows what, it's inevitable that a monster Malware like
conficker causes havoc. Anyway, my laptop was on the University network
Friday, and conficker was activating there...so I spent hours just assuring
myself that my laptop & home computer are clean. So far, at least.

Below I've inserted the article I mentioned, which was indeed by Joseph
Stiglitz. Also, I attached my research on 'did Barnie Frank & Dodd make
Fannie & Freddie create the sub-prime mess', for your critique. Doubtless
there are lots of points that I swallow, because my background in eco is so
poor...but I tried to put together the argument a la Krugman & others. Have
at it !

Related: Times Topics: Credit Crisis - Bailout Plan | Joseph E. Stiglitz

Obama's Ersatz Capitalism Op-Ed Contributor

by JOSEPH E. STIGLITZ Published: March 31, 2009

THE Obama administration's $500 billion or more proposal to deal with
America's ailing banks has been described by some in the financial markets
as a win-win-win proposal. Actually, it is a win-win-lose proposal: the
banks win, investors win - and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed system
that the private sector used to bring the world crashing down, with a
proposal marked by overleveraging in the public sector, excessive
complexity, poor incentives and a lack of transparency.

Let's take a moment to remember what caused this mess in the first place.
Banks got themselves, and our economy, into trouble by overleveraging - that
is, using relatively little capital of their own, they borrowed heavily to
buy extremely risky real estate assets. In the process, they used overly
complex instruments like collateralized debt obligations.

The prospect of high compensation gave managers incentives to be
shortsighted and undertake excessive risk, rather than lend money prudently.
Banks made all these mistakes without anyone knowing, partly because so much
of what they were doing was "off balance sheet" financing.

In theory, the administration's plan is based on letting the market
determine the prices of the banks' "toxic assets" - including outstanding
house loans and securities based on those loans. The reality, though, is
that the market will not be pricing the toxic assets themselves, but options
on those assets.

The two have little to do with each other. The government plan in effect
involves insuring almost all losses. Since the private investors are spared
most losses, then they primarily "value" their potential gains. This is
exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200
in a year's time. The average "value" of the asset is $100. Ignoring
interest, this is what the asset would sell for in a competitive market. It
is what the asset is "worth." Under the plan by Treasury Secretary Timothy
Geithner, the government would provide about 92 percent of the money to buy
the asset but would stand to receive only 50 percent of any gains, and would
absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised
to create is willing to pay $150 for the asset. That's 50 percent more than
its true value, and the bank is more than happy to sell. So the private
partner puts up $12, and the government supplies the rest - $12 in "equity"
plus $126 in the form of a guaranteed loan.

If, in a year's time, it turns out that the true value of the asset is zero,
the private partner loses the $12, and the government loses $138. If the
true value is $200, the government and the private partner split the $74
that's left over after paying back the $126 loan. In that rosy scenario, the
private partner more than triples his $12 investment. But the taxpayer,
having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn't confuse the value of an asset
with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations suggest,
because of an effect called adverse selection. The banks get to choose the
loans and securities that they want to sell. They will want to sell the
worst assets, and especially the assets that they think the market
overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the price
that it is willing to pay. Only the government's picking up enough of the
losses overcomes this "adverse selection" effect. With the government
absorbing the losses, the market doesn't care if the banks are "cheating"
them by selling their lousiest assets, because the government bears the
cost. The main problem is not a lack of liquidity. If it were, then a far
simpler program would work: just provide the funds without loan guarantees.
The real issue is that the banks made bad loans in a bubble and were highly
leveraged. They have lost their capital, and this capital has to be
replaced.

Paying fair market values for the assets will not work. Only by overpaying
for the assets will the banks be adequately recapitalized. But overpaying
for the assets simply shifts the losses to the government. In other words,
the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily
"nationalize" the banks, but that option would be preferable to the
Geithner plan. After all, the F.D.I.C. has taken control of failing banks
before, and done it well. It has even nationalized large institutions like
Continental Illinois (taken over in 1984, back in private hands a few years
later), and Washington Mutual (seized last September, and immediately
resold).

What the Obama administration is doing is far worse than nationalization: it
is ersatz capitalism, the privatizing of gains and the socializing of
losses. It is a "partnership" in which one partner robs the other. And such
partnerships - with the private sector in control - have perverse
incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it's the kind of Rube
Goldberg device that Wall Street loves - clever, complex and nontransparent,
allowing huge transfers of wealth to the financial markets. It has allowed
the administration to avoid going back to Congress to ask for the money
needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high
costs of the administration's plan become apparent, confidence will be
eroded further. At that point the task of recreating a vibrant financial
sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of
the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel
prize in economics in 2001.


----- Original Message -----
From: John Karls
To: Utah Owl
Sent: Thursday, April 09, 2009 11:36 AM
Subject: Re: Fw: My "three musical notes walk into a bar" joke


Dear June,

As usual, I enjoyed your participation last evening at Reading Liberally
immensely!!!

*****
Re your suggestion of "Three Cups of Tea" I see that Amazon.com has two
offerings under this title =

Three Cups of Tea: One Man's Mission to Promote Peace . . . One School at
a Time by Greg Mortenson and David Oliver Relin (Paperback - Jan 30, 2007)
Buy new: $15.00 $8.55344 Used & new from $4.48

and

Three Cups of Tea: One Man's Journey to Change the World... One Child at a
Time by Sarah Thomson, Greg Mortenson, David Oliver Relin, and Jane Godall
(Paperback - Jan 22, 2009) Buy new: $8.9950 Used & new from $4.41

I am guessing that Greg Mortenson was the mountain climber who began
building schools -- since he is an author of both items, which should we
recommend???

*****
Also enjoyed immensely your joke about the open fifth!!!

Incidentally, the joke reminds me of a technique that we used to use in
the Greenwich Choral Society and that I still use in the Utah Symphony
Chorus.

When you are trying to make a significant jump or (what would be the term
for a reverse jump???), the easiest way to make the jump or reverse jump
accurately is to think of a Broadway tune you adore that contains
precisely that jump or reverse jump. I can guarantee that if you have
your Broadway tune firmly in mind, you will make the jump or reverse jump
accurately 100% of the time even if it is a major sixth, minor eighth,
augmented tenth, or whatever!!!

Your friend,

John K.


---------------------------- Original Message ----------------------------
Subject: Fw: My "three musical notes walk into a bar" joke
From: Utah Owl
Date: Tue, April 7, 2009 9:10 pm
To: John Karls
--------------------------------------------------------------------------

In case Linda hasn't forwarded this to you yet...

Several choir members have asked that I forward this joke to the entire
group. This was first heard on Prairie Home Companion, and has since been
told everywhere that advanced music theory jokes are told.

Three musical notes walk into a bar. They are a B flat, a D flat, and an
F. The bartender takes one look at the three of them and says "I'm sorry,
but we don't serve minors here." The D flat leaves, and the other two
stay at the bar and enjoy an open fifth.