These are people who make their living in the markets, generally as little fish to the titans like Bill Gross. Particularly for the small traders, who go through the regular experience of being wrong on their investments or trades and having to take the consequences, it is extremely galling to see the big guys walk away with their millions of dollars of bonuses while the taxpayers have to cover their mistakes. As a secondary consideration, the small, individual investor learns over time that they are always at a disadvantage to the big guys on Wall Street who play games with the markets, often squeezing the small guy out of their positions, or even misleading people as happened with these auction-rate securities. There is honest resentment here at a system that looks rigged a lot of time, and nothing can be more manipulative than pushing the government to bail out your losses. Only the investment banks and hedge funds get that benefit.

A lot of economists and people like Paulson would agree with you - there is no feasible alternative because a massive, quick cleansing of the system would guarantee a depression and all the social upheaval and pain that goes with it. During the last depression capitalism came under heavy criticism and fought a battle with socialism and communism in the 1930s. FDR was able to change capitalism and put a lot of government support and regulation behind it, and in Europe governments opted more for socialism. Paulson may be smart enough to see that those old conflicts could return if a systemic crisis were let loose that toppled banks like dominoes.

I approach the issue more with detachment. Of course there is no alternative - the government and big business will stick the bill to the taxpayers to save the system, and perhaps avoid worse damage. All this does, though, is defer the pain. Ultimately the cleansing comes, and people like Mish are in a sense vindicated over a longer period of time than they would like.

On your last question, deflation is more likely in store for us, not the hyperinflation like Zimbabwe experienced. I could be wrong, because unlike the 1930s, we are not on the gold standard. The government could try to inflate its way out of this mess, but already the social pressure to let people and businesses fail is building. The Fed and Treasury are under criticism for bailing out Bear Stearns, and so in this next bailout the shareholders of Fannie and Freddie are going to lose everything and management and the board are tossed overboard. All the efforts to ease the pain on homeowners going through foreclosure have been fruitless. What we are seeing so far is foreclosures and bankruptcies, and what inflation we have seen is in the 5-10% range, with key commodity prices now falling. This picture suggests inflation will start to ease while the deflationary pain will spread.

I also think that, in a crisis like this, people like Bill Gross and others who gamed the system should be allowed to profit from their game playing. We might want to protect some of them on the downside because there is a legitimate argument that Gross helped provide a floor, but they should not be allowed to profit. Breaking even is not a terrible result in this universe and is the very most they should be entitled to. In fact, a small loss (haircut) isn't a terrible result in this universe and would be a far more equitable result.

Bill Gross made a lot of bets just because he knew he was big enough to demand a government bailout if they went wrong, and that other big players were there with him.

Who do you think Bernanke and Paulson are talking to right now? It's the really big players holding agency debt, assuring them that they won't get stiffed by the US, meaning the taxpayers will pay for the moral hazard that the monetary and fiscal authorities created that led to this debacle.

This is "free market captialism" with a socialistic foundation. That's called "corporate socialism" AKA "fascism."

Paulson may be smart enough to see that those old conflicts could return if a systemic crisis were let loose that toppled banks like dominoes.

"If" or "when."

Ultimately insolvency has to be dealt with either by Schumpeterian "creative destruction" or a socialistic intervention on the government's part to recapitalize with the people's money. Given the scale, the former could lead to spiraling deflation and a long recession or even a global depression. The later leads to a dilution of the currency (monetary inflation) that ultimately reduces purchasing power, although this may be masked to a degree in an overall deflationary environment. There's little doubt on which of these alternatives the political, monetary and fiscal authorities will settle on, and so a deal for the government to bailout Fannie and Freddie is on this weekend. We'll see how the markets react on Monday.

The US is in the process of experiencing a massive and extended asset depreciation which occurred first in equities (dot.com bust), and then the housing bust, which has a long way to go. What we are seeing is a contraction of credit that is affecting both consumers and business, leading to a pull back in production as well as finance. This is also provoking a bust in commercial RE, and putting consumers under the gun as job losses increase and their credit dries up.

This "contagion" has spread to Europe and Asia, and the global economy is decelerating. Recently, exports have been the bright spot in the US economy, but with the world pulling back, that cannot be counted on to continue for for very long. Moreover, the dollar has been rising against the euro and pound as Europe and the UK catch the same virus that the US has. That makes US goods more expensive abroad and reduces exports, which were growing because of the dollar drop.

Given that much agency debt is held by foreign governments and other big players, the US is in a real bind here. If it doesn't support the GSE's, it's credit reputation will in effect be downgraded. On the other hand, if it is perceived as inflating the dollar (effectively devaluing) to pay it debts, then it threatens the standing of the dollar as the world's reserve currency.

So this is a big deal. And it's just the beginning. Glad to see it unwinding under Bush. They did all they could to dump in on the next guy (IBGYBG), but that hasn't worked out for them. This may not become "the Big One," but it's going to be very significant. And there will be repercussions.

People in the market are talking with a lot more respect about Hyman Minsky and his Financial Instability Hypothesis. He postulated that financial excesses are often part of the business cycle and can drive an economy just as much as over-investment in manufacturing resources. Because he also felt that government intervention and regulation were necessary to control these excesses, he stands opposite to Alan Greenspan's "the market knows best" philosophy. In fact, Bernanke seems to be following Minsky in trying to use government tools to mitigate the debt deflation.

It is well known that Alan Greenspan was in Ayn Rand's inner circle, although many Randians claim that Greenspan was excommunicated when he accepted the chairmanship of the Fed. Be that as it may, Greenspan's Randism (laissez-faire, rugged individualism, Objectivism) is now discredited as government policy.

of the idiocy of humans. Rand was ridiculous in the first place, I smelled that the first time I read her as a youth. You'd think the appallingly turgid and stilted dialogue she put in the mouths of her characters (who on Earth actually talks like that??) might have been a giveaway that she didn't have a clue about the real world.

Is no hypothesis really (its proven).

Minsky's Hypothesis is an application of Chaos Theory (Strange Attractors - abrupt change to a new equilibrium) to the Financial system.

The basis of any system that's chaotic (subject to chaos theory), is a system with non-linear feedback -- which turns out to be any system with humans in it. Non linear feedback (an engineering term) in human terms is called indifference on one end of the scale or over-reacting on the other.

The fallacy of the 'Regulated Market', or Fed Control, is the belief that a system is linear over its complete operating range, or "can be managed". Many systems are linear over a small range of input. When the range is extended the system then exhibits its chaotic behavior, called "No one could have predicted this."

The credit system was pushed to extremes - and now comes the reset to a new equilibrium.

Sorry for the engineering/math jargon, but that's how I think of things.

The problem with explanation of such types as occurs in the so-called social sciences, especially economics, is that one of the principal presumptions is that actors are rational, and, therefore, that their behavior can be modeled linearly in that it follows causal laws (invariant patterns) that can be discovered and articulated.

However, experience shows that human behavior is not completely rational, especially at the margins, e.g., in extremis. Human behavior is strongly influenced by subjective non-rational factors such as emotions and preferences, as well as biases, both personal and cultural.

There may be a physical basis for subjective "tendencies," e.g., genetic structure giving rise to "natural tendencies" and imprinting that opens some neural pathways and shuts down others, resulting in acquired tendencies, but so far, we are quite a way from being able to use these predictively to take into account non-rational behavior that results in non-linear events.

I don't think people are trying to get to predictive capability in this type of economics, as much as first describing with better accuracy what is happening rather than relying on the rational man hypothesis all the time.

You could say, though, that Robert Prechter's Socionomics does try to merge all this together. His use of Elliott Wave theory is his predictive tool, with reasonable results, while his studies of social mood are in advance of what the economists are looking at. For example, his research on automobile colors shows that red, silver, and gold, which imply daring or wealth, peak just as an economy peaks, and are then replaced by browns, taupes, etc in recessions. He finds similar patterns in whether movies lean more to horror or failure, as opposed to space exploration and success themes (Wall Street came out at the peak of the market two decades ago). Another infallible indicator he has seen in the last 25 years helps time peaks in the housing market, and that is the frequency with which Donald Trump is featured on TV or magazine covers, or has a new book out. As you may recall, Trump was everywhere in 2006, and since then his visibility is curtailed.

Yes, every trader knows that psychology trumps fundamentals, i.e., endogenous factors are more significant in the chain of causality than exogenous. This is what set Prechter on the course he followed, as he states.

There has also been extensive work done in the past in sociology, history, literary theory and film criticism on correlating such things as artistic, literary and cinematic trends with economic trends and other such factors in order to show behavioral correlation indicative of psychological states.

Thank you for the better descriptions.

The current state of the art (and I don't want to argue if math is an art or science) in Chaos Theory is the eventual equlibrium after the abrupt change cannot be predicted.

So: "predictively to take into account non-rational behavior that results in non-linear events" is currently not believed possible.

Plese note the word "currently".

I don't want to argue if math is an art or science

Math is neither an art nor a science; it is a branch of logic, specifically, syntactics. Mathematics is purely formal.

Science employs mathematical (syntactical) models in theory construction by interpreting them semantically using pragmatics (e.g., with technical tools such as operational definitions and protocols).

So: "predictively to take into account non-rational behavior that results in non-linear events" is currently not believed possible.

I am not asserting that it is. However, there are some who expect to be able to account for psychology/behavior on the basis of genetics, neurology and biochemistry, i.e., to reduce the psychological/behavioral to the physiological.

A few even claim that this is possible in principle if not yet it practice. See, for instance, Paul and Patricia Churchland, and eliminative materialism.

BTW, in science a major criterion for a theory's being an adequate description is that its model is predictive, i.e., it permits the framing of hypotheses that are empirically testable, and that it passes such tests successfully in controlled experiments that are replicable.

Not very predictive, but an accepted theory...

"Noise" or "Turbulance" is sometimes an indication of approaching a strange attractor. Somtimes a failure is so fast the noise is not apparent (3 dimension cracking -- the Twin Towers fell down, or the floor gave way).

In human terms: indecision, or panic: sell - buy, sell buy..the strange attractor is driven by the human herd instinct or group think.

it wasn't controlled demolition.

Where was the construction to place the CD charges?

but experts say that the official line doesn't add up, especially regarding Building 7, which wasn't hit by an aircraft — any more than on the anthrax case. BTW, there's a new book out on JFK's murder, written by James Douglass, called JFK and the Unspeakable

“Douglass presents, brilliantly, an unfamiliar yet thoroughly convincing account of a series of creditable decisions of John F. Kennedy—at odds with his initial Cold War stance—that earned him the secret distrust and hatred of hard-liners among the Joint Chiefs of Staff and the CIA. Did this suspicion and rage lead directly to his murder by agents of these institutions, as Douglass concludes? Many readers who are not yet convinced of this ‘beyond reasonable doubt’ by Douglass’s prosecutorial indictment will find themselves, perhaps—like myself—for the first time, compelled to call for an authoritative criminal investigation. Recent events give all the more urgency to learning what such an inquiry can teach us about how, by whom, and in whose interests this country is run.” --Daniel Ellsberg, author, Secrets: A Memoir of Vietnam and the Pentagon Papers

If powers that were could off JFK, their successors could probably have handled the demo too.

What I and lots of experts are saying is that there are lots of unanswered questions and the official line is suspiciously incomplete or twisted.

It has nothing to do with the main topic. Thanks!

_{"What we have here is, failure to communicate"}

that Minsky stuff is really interesting, BTW.

I'm sorry to have to ask this, but I'm probably not the only one wondering. How did this happen?
I was under the impression that the worst stuff wasn't on the books of the GSE's, that they had some level of standards prior to the MBS market freezing last year. Maybe I should just go dig thru some of Tanta's UberNerd posts, eh?
why do I have this feeling that once they're nationalized they'll be set up like the TAF or something, and take on everybody else's bad mortgage pools so the Fed doesn't have to keep rolling them over.
Crap, is that the point I've been missing?

By 2004, both of the GSEs were under heavy restrictions by their regulator OFHEO to clean up their accounting messes caused by inefficient derivative hedges. Until that point, they had relatively safe assets consisting of prime mortgages, fixed and floating, with reasonable standards for down payments, verification of income, assets and employment, and a limit of $417,000 per mortgage. They bought mortgages that qualified under these standards, and they reissued them in mortgage backed securities that were rated Aaa because of the presumed backing of the US government.

With the restrictions, though, they couldn't grow their balance sheet, and as a public company with stockholders, their share price was suffering in comparison to the boom in any equities related to housing. They got "bored", in other words, with their pedestrian returns, so Mudd and Syron rolled the dice and starting filling their investment portfolios with the non-conforming option-only ARM, NINJA and other dubious mortgage securities peddled by Wall Street. This gave them higher returns than on their normal portfolio, but much higher risk.

Because they always had only 2% capital/asset ratios, they ran through their capital pretty quickly with the losses on this Wall Street paper. They are now effectively bankrupt. The takeover, or quasi bankruptcy mandated by the federal government, is designed to protect investors who have bought the hundreds of billions of securities they issued over the years.

I don't think the nationalization is intended to use them as a dumping ground for all of Wall Street's bad assets. It is instead intended to prevent a global run on their bonds, which would damage the credit worthiness of US Treasuries in general.

By the way, it is still an open question whether the pre-2004 mortgages held or securitized by the GSEs are entirely safe. With a 9% delinquency rate on all mortgages, the rot is spreading to the better quality mortgages. It could get really bad if unemployment continues to ratchet up, because that is what would make even the best mortgage portfolio take some losses.

"I don't think the nationalization is intended to use them as a dumping ground for all of Wall Street's bad assets. "

The $64,000 question is this: Whether intended or not, will they be exploited that way? In the current financial climate, whatever abuses are permitted to occur, will occur-- to the degree that they present any potential for profit.

I'm seeing a bottom (maybe, or a dead cat bounce), in my local Sub Prime market. the Alt A market is still declining. I'd post the charts but I don't know how.

Help on posting these charts? (they are very local).

That is, a private message to Sean-Paul or Tina often helps; they will load up charts for you.

I agree with your thesis, I'd just substitute the word Greedy for Bored. They wanted transaction fees, lower standards = more transactions = more fees = bubble.

There is a class action lawsuit in here somewher. The Tort is clear.

And, I believe, legally (there is case law) the Fed is a private Institution, not protected by any Government Privilage.

And, I believe, legally (there is case law) the Fed is a private Institution, not protected by any Government Privilage.

I'm not a lawyer, but that I doubt. The Fed is run by a Board of Governors, appointed by the president and confirmed by the senate.

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.

Federal Reserve System-Board of Governors

Allowing civil suits against Fed for actions of the board of governors would cripple the central bank. Not going to happen.

Anyway, who would pay in case the complaint was successful. Proceeds resulting from Fed operations go to the government, not private equity. Federal Reserve banks simply carry out Fed policy.

http://www.save-a-patriot.org/files/view/frcourt.html

Below are excerpts from a court case proving the Federal Reserve system's status. As you will see, the court ruled that the Federal Reserve Banks are "independent, privately owned and locally controlled corporations", and there is not sufficient "federal government control over 'detailed physical performance' and 'day to day operation'" of the Federal Reserve Bank for it to be considered a federal agency.

Each Federal Reserve Bank is a separate corporation owned by commercial banks in its region.

Finally, the Banks are empowered to sue and be sued in their own name. 12 U.S.C. Sect. 341. They carry their own liability insurance and typically process and handle their own claims. In the past, the Banks have defended against tort claims directly, through private counsel, not government attorneys . . ., and they have never been required to settle tort claims under the administrative procedure of 28 U.S.C. Sect. 2672. The waiver of sovereign immunity contained in the Act would therefore appear to be inapposite to the Banks who have not historically claimed or received general immunity from judicial process.

The Board of Governors, which controls the relevant operations in the case at hand, is appointed by the government and therefore is protected. One would have to show negligence on the part of the various Federal Reserve Banks to make a claim. They would obviously claim that they were just executing policy. Then one would have to prove that they weren't.

I suspect that they do have specific immunity regarding their carrying out policy set by the Fed's Board of Governors, regardless of their not having general immunity.

Aka "Liars Loans". Allowing these underwriting standards was negligence. Not much proof needed there.

One would sue the then board of Governors Jointly & Severally. The case law stated supports no claim of immunity. The Fed may have idemnified it's Governors and the Governors may carry insurance.

But they don't enjoy immunity as do Federal Officials carrying out policy of the US Government becuase of the peculiar status of the Federal Reserve.

I think it would be difficult to prove in court that the Fed's Board of Governors "allowed" liar's loans as a policy. Perhaps it could be argued that those charged with oversight were negligent in their responsibilities. This would extend from the SEC, to the Fed board, to the Fed banks, to the rating agencies, to the IB's and to the various banks involved in the loans, in addition to the mortgage brokers and loan officers.

But the lawyers are going to get rich on this one if the case has legs and gets through appeals. I imagine that some of it would go to SCOTUS, which is very business friendly thanks to the aggressive GOP and spineless Dems. There is no doubt that there will be successful suits down line however. The question is how high the responsibility/accountability will rise. If history is any judge, not far.

One has to prove they did nothing to stop or control the "lairs loans". That would not be hard,

The Feds charter is clear.

It's breach of fiducary responsibility by failing to act,
and the proving the tort (loss).

This would be a godd topic for the expertise on emptywheel.com

but I'm not holding my breath. On the other hand, I think a lot of suits down the line, right up to and including the IB's, will be sustained.

I would be very surprised if the courts would implicate the Fed, though. After all, it is the CB of the USA. They'd find someway out, even if it were an iron-clad case.

The IB's are different. They stiffed some of the Big Guys, and if they don't take that toxic stuff back, they are going to get sued. So far, they seem to be taking a lot of it back and trying to bury it deep through accounting folderol.

I agree re: intent of conservatorship. but, well, a twofer would be awesome.
I'd read that at the end of 2006 subprime constituted 2% of their book, and alt-A being 10% most recently, and it just didn't seem that much compared to commercial banks. I guess we'll see more details tomorrow.
thanks again for taking the time.

edit to add:
some thoughts from Mish on capital/ asset ratios

Fannie Mae was founded in 1938 as a government agency under FDR to provide liquidity to a mortgage market still struggling to overcome the Great Depression. It was made private in 1968, removing its obligations from the federal balance sheet, but kept an implicit guarantee.

Freddi Mac was founded in 1970 by the government as a private corporation to provide competition in the secondary market pooling mortgages into securities.

The purpose of Fannie was originally to make home ownership more available at the low end of the scale by providing liquidity for and guaranteeing mortgages that would otherwise not have been written by banks, who, in those days, held them to maturity. Same with VA loans for returning vets after WWII. Securitization was later added to spread risk as well as to lighten balance sheets, freeing up reserves for more lending, thereby providing more liquidity.

However, as time passed, Fannie and Freddie took on new roles, initially unintended, that eventually put them in the position of being compared with hedge funds.

Critics charge that while they are technically private companies, they are represented as carrying at least an implicit government guarantee, thereby muddying the waters and creating moral hazard.

The current crisis was predictable on this basis. The market took up the challenge of moral hazard as if to test the implicit government guarantee. Looks like it worked for Wall Street and Main Street gets to pay for their winning bet.

What the upshot will be is unclear, but it seems that both Fannie and Freddie will either be reorganized as essentially different institutions with a different structure and mission, or else they will be dropped entirely as government sponsored programs. There are a lot of people very unhappy about this rotten development.

Obama, McCain, Fannie and Freddie: A Troubled Love Story

Though Fannie and Freddie have been big lobbyists of Washington, they are hardly getting their money’s worth this year. Just before Labor Day, Sen. Obama derided Fannie and Freddie as a “weird blend,” advocating that “If these are public entities, then they’ve got to get out of the profit-making business, and if they’re private entities, then we don’t bail them out.” He said later that he has “no sympathy” for the CEOs of Fannie and Freddie, and that the government shouldn’t bail out “investors who had made a killing.”

McCain, similarly, railed in an editorial that “if elected, I’ll continue my crusade for the right reform of the institutions: making them go away. I will get real regulation that limits their ability to borrow, shrinks their size until they are no longer a threat to our economy, and privatizes and eliminates their links to the government.” McCain attributed the growth of the agencies to “crony capitalism,” and Washington selling out to Wall St.

I don't know that Bush is going to be off the hook for war crimes. There's no statute of limitations, and history often has a way of turning.

If this recession gets much worse or even turns into a depression, which is now no longer a small bet, "the people" will be restless. Someone will need to be blamed. If McCain is president he will dump as much of this as possible on Bush, and act like a crusading reformer in the Republican Party. Obama will be channeling the anger unto the Republicans, big business, Wall Street, and maybe even globalization. He'll draw the line at blaming capitalism, but there will be some real arguments afoot as to what went wrong with capitalism this time.

In any case, it is a very good bet that Alan Greenspan won't be showing up on television as frequently. He may keep his seat on the board of PIMCO, however.

Some Banks, unnamed here becuase of confidentiality, are selling tapes (packages) of Houses at $0.33 of current values.

These banks either need cash or they are very pessimistic about housing prices.

The real question is how much of this toxic stuff has been converted to "long-term investments" to avoid having to account for current losses.

Housing Wire, By: Paul Jackson, September 16

Anyone who really understands the mortgage markets understands one very important thing: securitization largely provides the critical liquidity that makes modern mortgage lending possible, something that holds true even in the agency market.

Which means that anything that fiddles with securitization has the potential to fundamentally alter mortgage lending as we know it; and while we were freaking out over the fate of American International Group (AIG: 2.0685 -44.84%) and Lehman Brothers Holdings Inc. (LEH: 0.1115 -62.83%), the Federal Accounting Standards Board served notice that it was moving forward with a project that may end up meaning more to the financial markets than either firm’s particular fate.

[...]

In particular, the proposed changes seek to amend two key accounting standards critical to modern securitization: FAS 140, which establishes the concept of a qualifying special-purpose entity, commonly called the Q; and FIN 46(R), which currently provides an exception for QSPEs. Both proposed changes would effectively kill the mechanism for off-balance sheet securitization.

Analysts have suggested that as much as $5 trillion would need to come back on the balance sheets of various financial institutions as a result of the proposed changes, tentatively “effective at the beginning of each reporting entity’s first fiscal year that begins after November 15, 2009,” according to the FASB’s statement. Which would force massive core capital needs at a time when liquidity is, at best, an endangered species; at the very least, regulatory capital ratios would come under severe stress.

[...]

The primary exposure drafts surrounding FAS 140 and FIN 46(R) are now subject to a 60 day comment period; and you can bet comments will be flowing in from market participants looking to quash the maneuver.

The conversion of a static asset like a home into a commodity to be tapped for cash began around 1995 with the creation of the home equity line of credit as an everyday product. Then Greenspan's 1.0% interest rates in 2001-2002 really jump started the housing boom.

Still, it would be nice to have on hand the $600 billion or so that has been spent in Iraq. Wouldn't it be ironic if the clean-up of the housing mess just about equaled the fortune squandered in Iraq?

The credit crisis is largely about the effects of debt securitization, the pooling of small obligations like mortgages, auto loans and credit card debt into securities in order to spread risk and free up reserves for more liquidity. Initially, this was a promising financial innovation that worked well at first.

Originally, this seemed like a relatively inexpensive and low-risk fountain of liquidity to create new capital for homes, etc., greatly expanding growth.

However, deregulation and lax oversight led to abuses that would eventually contradict the presuppositions of models used to measure these markets, leading to "the unthinkable."

Moreover, the anti-labor environment had allowed big business, especially finance, to capture an inordinate proportion of wealth creation through both increases in productivity and financial innovation. The result was an unhealthy expansion of debt, with insufficient income to service.

Now there is a mountain of insolvency that increasing liquidity is powerless to solve. Either there will be an unprecedented rise in bankruptcies along with general credit contraction and a resulting decrease in production/consumption with the falling of aggregate demand, or the government will have to step in and intervene massively. This will involve diluting the value of the currency, effectively devaluing the dollar. and threatening dollar hegemony, the underpinning of the global oil economy and US prosperity.

"there will be an unprecedented rise in bankruptcies "

The tax code in really nasty about treating foregiveness of debt as income in non-owner occupied (rental) properties. That is, these who invested in houses or renatl and have been forced to sell at a loss will be facing their losses as income for the tax year 2007.

My accountant is very pessamistic. And a little depressed about the situation of his clients.

I have one couple who bought two duplexes as investments. They will loose both. When I disussed their distress with CAR, the attorney's position (what a f...head) was "tough, they are speculators". I corrected him somewhat sharply.

It's funny how Wall Street has mainly "investors", and real estate mostly "speculators". There is some symphthy for investors, none for speculators.