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September 2008

The Mother of All Excuses

Noted economist Paul Krugman, 10:44 a.m. today:

But putting myself in Barney Frank or Nancy Pelosi’s shoes, I’d look at it this way: the Democrats could start over, with a bailout plan that is, say, centered on purchases of preferred stock and takeovers of failing firms — basically, a plan clearly focused on recapitalizing the financial sector, with nationalization where necessary. That’s what the plan should have looked like.

Maybe such a plan would have passed Congress; and maybe, just maybe Bush would have signed on; Paulson is certainly desperate for a deal.

But such a plan would have had next to no Republican votes — and the Republicans would have demagogued against it full tilt. And the Democratic leadership cannot, cannot, be seen to have sole ownership of this stuff.

So Republican demagoguery, in prospect, is sufficient for the majority Democrats to 1) to refuse to do something intelligent (at thought by Professor Krugman), and 2) to refuse to do something incredibly valuable for the country?

This beats the current record-holder, a student who had five grandmothers die in a ten day period, by a mile.

Remember Fantasy Island? "The plan, Boss, the plan!" (Sorry.)

By the time you read this, the Mother of All Bailouts may already be law. But I want to note my old boss Ed Leamer's questions, and also those of the Manhattan Institute's Nicole Gelinas. (These pertain to the original plan, but most if not all seem to apply to the revised plan.)

And see Arnold Kling's stern warning.

Finally, color me skeptical about the in-vogue "carry trade" argument:

Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries. . . .

By most accounts, current losses on U.S. mortgage paper -- the difference between face value and current fire-sale prices -- stand at about a trillion dollars. In a sign of the distortions from panic selling, eventual losses on the underlying morgtages figure should be no greater than $250 billion. The market, irrationally, is assuming losses of four times that amount.

An unusual opportunity?

As I noted last Friday, there's a reasonable chance that hedge funds will have to raise a lot of cash soon. Business Week writer Matthew Goldstein noted this, too:

With so many hedge funds—including some very large ones—posting negative returns this year, there’s a big fear that wealthy investors and pension funds are itching to take some money off the table. Many funds limit redemptions to four times a year in order to give managers breathing room to navigate choppy markets. But in order for an investor to qualify, managers generally require investors to submit a request 90 days before the end of the quarter.

Already, the redemption requests have been pouring into hedge funds well ahead of the Sept. 30 deadline. But it’s not uncommon for investors to wait until the last moment to submit a redemption demand. Sources say at some funds investors are seeking to recoup about 10% of their money, which is relatively high. The trouble is that most managers don’t keep too much cash on hand. To comply with their investors wishes, hedge fund managers may have to start selling lots of stocks—a move that could push equity prices even lower in the coming months.

If a lot of stock is dumped, with little or no relation to the intrinsic merits of the equities themselves, and if you have some cash and a medium-term or longer horizon, maybe an unusual opportunity to buy is coming up. (But economics predicts that if it does arise, it won't last long. Be ready.)

An account of why risk management failed

From Saul Hansell in the New York Times:

“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”

One way they did this, Mr. Berman said, was to make sure the computer models looked at several years of trading history instead of just the last few months. The most important models calculate a measure known as Value at Risk — the amount of money you might lose in the worst plausible situation. They try to figure out what that worst case is by looking at how volatile markets have been in the past.

But since the markets were placid for several years (as mortgage bankers busily lent money to anyone with a pulse), the computers were slow to say that risk had increased as defaults started to rise.

It was like a weather forecaster in Houston last weekend talking about the onset of Hurricane Ike by giving the average wind speed for the previous month. [Emphasis added.]

My late father used to say, "To err is human, but to really screw up, you need a computer."