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12 February 2009


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Robert Murray

Thank you for posting this Col. Lang.
Mr. Sale,
Superbly done.


Brilliant Write and summation of 20th century U.S. financial history.

Bash on Mr. Sale, and damned be he that cries enough, on the receiving end.

Well said!


Well, ISL, given that IYHO "we are not yet choosing the right solution"....

What is it?

John Howley

This evening, I heard Paul Solman (my favorite economics reporter) interview Jared Diamond (Collapse; Guns, Germs and Steel) on The News Hour. Solman wanted to hear his views on the present crisis in the United States; Diamond was “51 percent” optimistic because of our openness and flexibility as a society.

Solman then asked him to explain what, at the broadest level, distinguished societies that fail from those that succeed. Diamond responded that the most important factor was the extent to which the ruling elite shared the conditions of the majority because this determined their motivation to solve societal problems.

He contrasted New Orleans, where the wealthy lived on higher ground than everybody else and were not very interested in fixing the levees, with the Netherlands, where everybody lives on low ground and the flood protection is the finest in the world.

What would help in the current situation? “I’d like to see the rich and the politicians suffer more,” Diamond replied. Amen, brother.


June 15, 2007, James Grant, editor of Grant's Investment Weekly spoke the words below. The point he's arguing, and I find difficult to refute, is that the market is only as good as its participants. Grant, in another essay, described a Great Plains land bubble in the 19th century when none of the current paraphernalia, like the Federal Reserve existed. Our financial markets are like our democracy - its quality is dependent on the quality of its participants.

Human nature being what it is, I see the need to put in checks and balances, just like the Constitution tries to do.

Quote: ""Reading between {Federal Reserve Governor } Warsh's lines, it's apparent that the Federal Reserve carries a torch for the Efficient Markets Hypothesis. Are investors invariably cool and calculating? Are markets frictionless? Is information universally disseminated to all the lucid participants? Do they act on it? If you answer "yes" to these questions, you, too, may find the board of Governors of the Federal Reserve System a collegial place to work.

I will meet Warsh halfway. I will concede that markets are just as efficient as the people who operate in them. How efficient is that? Let us turn to mortgage finance to find out. Here is a living laboratory in complexity gone wrong.

During the long upswing, lenders were happy to credit a highly counterintuitive proposition. They accepted that a clump of low-rated mortgages could be transformed into a highly rated security. Only very smart people could dream up such a wonderful idea. And only educated people could accept it (they are taught to respect great minds, no matter what cockamamie conclusion those minds arrive at). What was the source of this alchemy? The reordering of cash flows to assure continuous payments to the holders of the senior claims. Risk of nonpayment, such as it was, was borne by the holders of the mezzanine and equity tranches. They bore it willingly. The ratings agencies lent their imprimatur to the assumptions and calculations on which the projections were based.

Investors bought with confidence. It reassured them to know that the ratings agencies deployed default probability generator models featuring a Monte Carlo multi-step default probability apparatus -- whatever that was. Besides, the mortgage scientists and ratings agency quants believed that diversification was their shield and armor. A given residential mortgage-backed security would contain mortgages from every region of the country. The diversity of collateral delivered low correlation in credit performance; they could hardly all default at once. As for house prices, the mortgage scientists observed that they almost invariably went up. And all agreed that home ownership was an unalloyed social benefit.

And if the lenders, borrowers, ratings agency analysts, investment bankers, appraisers, etc., hadn't been human, the story might have a happy ending. But it won't, because people in markets neglected to judge the effects of their actions on others. Uniquely uninhibited underwriting practices pushed up house prices and thereby coaxed more borrowers to employ greater leverage. Not wanting to be left behind, lenders completed with one another to offer the easiest terms. Loans tumbled out of the origination mills into the securitization factories, emerging as ABS or CDOs, investment-grade for the most part and thereby suitable for widows, orphans and foreign central banks. Thankfully, too, there were hedge funds and proprietary trading desks to absorb the residual credit risk of the lower-rated tranches. Warsh paid tribute to these social benefactors in his talk the other day: "By serving as willing counterparties in a variety of contracts, these institutions, in my view, are serving as a critical linchpin in the development of more complete markets."


Richard Sale's heartfelt post speaks to the outrage that many of us feel. IMO, dogmas are used as smoke screens to avoid transparency and for the pursuit of private agendas.

If we take the dogma of free trade as an example lets ask the question - is it free trade when the US, EU and many other countries subsidize private mega agribusinesses with billions in taxpayer funds? Is it free trade when China for example subsidizes its export sector by deliberately maintaining a non-convertible undervalued currency? Is it free trade when many countries have subtle barriers through compliance regulations, permits and licenses? Most reasonable people would agree that there is no free trade as that dogma would imply. But we live in an interconnected world with relative comparative advantages. If common sense would prevail then we would negotiate on the basis of each of our national interests a trade regime with compromises. But when we look at the current trade environment as Americans we should ask who are the beneficiaries? Its clearly not average American workers since their real wages have stagnated for years although trade volumes and our nominal GDP have increased. That would then prompt the next question - who does our government work for since they negotiate these agreements?

If we agree that the premise of our country is based on liberty - then every generation should ask the question what role should government play? Does our common good require that we establish food safety regulations and have our government enforce those rules. Most Americans would say yes. But if we ask the question should government pick marketplace winners and losers - there would likely be disagreement based on if you were in the winning group or not. As Richard Sale has pointed out through the decades we have seen collusion between financial and political elites to concentrate wealth and power. Cartels form naturally and more so with political connivance. And that is the antithesis of our concept of liberty.

Dogmas I believe are just a ruse since in the real world we cannot have either an Objectivist or Marxist utopia and some of the most dogmatic don’t really believe in their dogmas as witnessed by their actions. But we can have principles and in the experiment that is America we have demonstrated that where we have entrepreneurial capitalism with fair rules of the game that are enforced uniformly our people innovate and grow the pie building a large middle class. We don't begrudge the success of the entrepreneur nor do we condemn failure. Entrepreneurs know that success is built on many failures - that Schumpeter’s creative destruction is the natural order.

Richard Sale states "Clearly, it is not simply greed, but grave structural flaws that lie at the basis of our crisis, and if the government is the most efficient agent to correct these then let the government do it." My question is can the actors in our government correct these structural flaws when they are part and parcel of the flaws?

Lets take the example of Glass-Steagall. This act was passed in response to the banking crisis in the 30s and created FDIC and provided legal separation between commercial and investment banks. The group instrumental in its repeal represented leadership in both our political parties and those in government as well as the financial elites. They included Bill Clinton - President, Bob Rubin - Treasury Secretary, Larry Summers – Deputy Treasury Secretary, Alan Greenspan - Fed Chair, Phil Gramm - US Senator, Sandy Weill - CEO Travelers. Now lets look at the actors in our current government. Obama's economic transition team included James Rubin (Bob's son). Who did they pick? Tim Geithner & Larry Summers both Rubin proteges. If we perk up our memories we will remember that Bob Rubin became Chairman of Citigroup (the merged entity of Citibank and Travelers) that was made possible by the repeal of Glass-Steagall. And that is now insolvent and the largest recipient of taxpayer bailout funds and guarantees. Can we trust they will correct structural flaws when they were responsible for the flaws?

Common sense would lead us to agree that counter-cyclical government spending to increase employment and wages is beneficial in downturns with private sector deleveraging. However, the experience over the past several decades is that government spending increases no matter the economic environment. This spending by its nature crowds out the private sector which represents over 80% of our economy. Is this a structural flaw or the nature of our politics?

The response to the banking insolvency to date are ad hoc actions that are taxpayer subsidies and guarantees to private businesses with no demand for changes to management and stewardship. We don't know the extent of the losses because the government is an accomplice in preventing transparency. As part of Geithner's "stress test" he sends 100 examiners to Citigroup. Is that a joke or a con? Citi operates in 100 countries. Its operations span capital markets, commercial real estate, residential real estate, credit cards, foreign exchange, insurance and it deals in and trades for its own accounts swaps, asset backed securities and numerous other complex instruments. Are we expected to believe that these 100 examiners can evaluate Citi's balance sheet accurately in a reasonable timeframe? And the elephant in the room - who is going to take the writedowns on all the dodgy assets disgorged by the banks that are sitting on the Feds balance sheet? Of course we know it is going to be the taxpayer but our government plays games of obfuscation pretending that the asset values will return. Some of these assets can never be but worthless since they are the lower tranches of CDOs backed by mortgages that have already defaulted and there are no cash flows. The current actions to manage the insolvency of Wall Street banks smack of deep capture.

At the root what we have is a balance sheet problem. Too much debt and not enough income to service the debts. As a result our largest financial institutions are insolvent. Sooner or later this unsupportable debt has to be restructured. So the real debate ought to be how are we going to apportion the losses of Wall Street banks. If we apply common sense then the first step will be to determine the extent of the losses. Then comes loss sharing. I argue that shareholders should lose first, followed by bank bond holders and then the taxpayer. Consumers and businesses have already started the process of deleveraging through defaults, cutbacks and increased savings. There is a well founded argument that our government debt/GDP is relatively low and so the government has the ability to lever even more. But it does not take into account the off-balance sheet liabilities in social security, medicare and other entitlements that will be coming due shortly. The increased government debt since its in our own currency will no doubt be monetized. Bernanke is well along in that process. This once again will lead to a lower standard of living for those that can least afford it. Those with fixed incomes and no ability to move out on the risk curve like retirees. We can either deal with these problems in an open and honest manner or prolong the malaise as the Japanese did. Moving forward, how do we prevent this type of financial debacle which was much predicted? How do we ensure that the policy focus ought to be increasing real wages of average Americans not just the financial and political elite?

Our founders knew that the creation of a government while necessary to promote our common good would inevitably aggregate more power and lead to corruption unless the people were vigilant and ensured their sovereignty. We are now in an environment where we the people must demand transparency and open debate devoid of dogmas on our future economic strategy in an increasingly competitive world. I pray for the sake of our children that my fellow citizens not behave like the Japanese people who due to their complacency allowed their elites to cause a 20 year economic stagnation.

Sidney O. Smith III

I continue to defer to zanzibar, the wise one. And notwithstanding my profound lack of training in things financial and economic, my intuition tell me that I concur with zanzibar too.

I wonder if behind some of zanibar’s sentences we hear distant echoes of Ludwig Von Mises.

Regardless, zanzibar’s insights are extraordinarily well-written and done of behalf of America and in the name of liberty, imo

Thanks for taking the time to share such expertise -- one undoubtedly based on experience gained through participation in the financial world.

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