The Dukes of Moral Hazard: The Dangers of Quantitative Easing

 

This brilliant and terrifying column was originally published at ProPublica and is republished here under a Creative Commons license. cc

by Jesse Eisinger
ProPublica, Nov. 10, 2010, 2:40 p.m.

sinking_shipAcross the world, there are booms. Chinese Internet companies are flourishing. Energy companies are finding new sources of power. Commercial real estate is coming back.

Unfortunately, this isn’t happening in the real world, which is still crippled by sagging economies, but in the investing one.

If there’s a doggy stock, a dodgy loan or a slice of a complex credit security made to a questionable borrower — hedge funds want it now. Companies with junk bond ratings are flooding the markets with new issuance. If private equity firms bring a money-losing company saddled with debt to market, investors are eager to snap it up.

Thank the Federal Reserve. The central bank has embarked on its program of “quantitative easing,” a second round of experimental monetary policy in which the Fed buys up assets — like longer term government bonds — to bring down interest rates, which is supposed to spur lending and borrowing, thus reigniting the economy.

Nobody knows whether it will work to bring down the intractable rate of unemployment. But it has already worked in one significant way: the speculative juices of the markets are flowing.

What’s going on? As a Fed official explained it in a recent speech, one supposed benefit of the Fed policy is that it will add to “household wealth by keeping asset prices higher than they otherwise would be.”

So it’s levitation-by-decree. When the Fed moves, financial assets receive the opposite of collateral damage: universal blessing, deserved or not. Lower rates may or may not help more people find work. But there’s no doubt that the central bank has already helped the Henry Kravises and Lloyd Blankfeins of the world.

The Russell 2000 stock index, which is made up of smaller companies, has risen about 21 percent since September, when investors started to anticipate that the Fed would intervene in an aggressive fashion. A tiny Chinese Internet stock, China MediaExpress Holdings, is up more than 250 percent since mid-September. The private investors that own Harrah’s, the money-losing casino company, are bringing it public, and investors are going to gamble on it despite a crushing debt load.

Then there are something called B notes, bonds backed by commercial real estate loans. B-note holders are on the hook for the early losses if the loans go bad. They are as hot a commodity as everything else. Never mind that there’s a huge oversupply of commercial real estate in this country. Or that Wall Street just went through a disastrous episode for complex structured financial products of exactly this sort.

Without knowing a thing about finance, here’s how to tell it won’t work out well. Wall Street is the great master of the euphemism. The Street doesn’t call them junk bonds; they are “high yield.” Here, something isn’t just Triple A. It’s “Super Senior Triple A.” So when the best investment bankers can do is to dress something up with a lowly “B,” you know it’s trash.

Leverage, meanwhile, has made a glorious return. Interactive Brokers, a discount brokerage firm, has been running an advertising campaign that displays money spewing from printing presses. The firm will lend (for certain special customers)$566,000 for every $100,000. Ah, borrowing heavily for the purposes of trading in volatile markets. Maybe some Bear Stearns or Lehman Brothers bankers can explain the wisdom of this.

All of this is Finance 101. The cheaper money is to borrow, the more it makes sense to take a bigger risk with it.

But that doesn’t make it more palatable. It feels like an ominous replay of recent Federal Reserve emergency actions, which led to bigger and bigger bubbles. The Fed brokered the rescue of Long-Term Capital Management, bailing out the investment banks that had lent to the collapsing hedge fund. The Fed pumped money into the economy to save us from the Y2K computer bug. The Fed tried to rescue the economy from the bursting of the Nasdaq bubble, helping to create the housing bubble.

It’s like the exhausted “Saw” movie franchise; this isn’t just a sequel. It’s more like the third iteration of the second reboot — harder core, baser and for serious liquidity heads only.

Is this the price society has to pay for a better economy? Do we care if some hedge funders get rich as long as unemployment goes down, fewer people get thrown out of their homes and household debts are less crushing?

That would be a worthwhile tradeoff. But it’s far from clear that the Fed can get any real traction with its policies.

Over the past year, I’ve been investigating some of the more egregious conduct that occurred in the bubble years. In this column, I’ll be monitoring the financial markets to hold companies, executives and government officials accountable for their actions.

A main focus will be the spectacle of returning speculation. It’s commonplace to lament Wall Street’s lack of a historical memory. But there is something different at work. Professional investors have learned the lessons of the financial markets’ serial bubbles and learned them well.

The lesson is: When the next one comes, I’m going to get mine. I’ll just get out early this time.

You can contact Jesse Eisinger at jesse@propublica.org

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A brilliant and simple guide to how we are being lied to about the meltdown

First appeared at BlownMortgage.com

There has been a deliberately high signal-to-noise-ratio ("the ratio of a signal power to the noise power corrupting the signal") around the financial fiasco. The reason for this is the same reason that a magician does patter — to divert your attention from the sleight-of-hand.

We have heard long explanations about how no one could have seen this coming and how we can’t fire the people who got us into this mess to get us out of it and how we are going to borrow our way out of a debt crisis and how the value of loans shouldn’t reflect actual market conditions when the market is a mess. All of which can be translated to, "pay no attention to the man behind the curtain."

I am not sure if this rises to the exact level of a conspiracy or if it just coinciding self-interest by people who stand to lose a lot of money if that curtain is pulled back. I am sure that the effect is the same as a conspiracy.

However, Bill Black thinks it’s a conspiracy and that’s good enough for me. In an interview on Bill Moyer’s show Mr. Black — the senior regulator during the S&L crisis & now a prof of economy and law at U. of Missouri — applies a brilliantly sharp Occam’s Razor to the entire fiasco. In less than half-an-hour he explains what went wrong, why and why what we’re doing won’t work. This is a truly bipartisan dissection. Watch it and learn.

My favorite part is his conclusion (transcript here):

So stop that current system. We’re hiding the losses, instead of trying to find out the real losses. Stop that, because you need good information to make good decisions, right? Follow what works instead of what’s failed. Start appointing people who have records of success, instead of records of failure. That would be another nice place to start. There are lots of things we can do. Even today, as late as it is. Even though they’ve had a terrible start to the administration. They could change, and they could change within weeks. And by the way, the folks who are the better regulators, they paid their taxes. So, you can get them through the vetting process a lot quicker.

(Hat tip to Infectious Greed, Financial Armageddon, and Washington’s Blog)

Here’s part 1 of the interview, go here for part 2 and here for part 3.

"The tragedy of this crisis is that it didn’t have to happen at all." — William Black

Cut the bull and call it a Depression already

More of my happy thoughts from over at BlownMortgage:

Two weeks ago the National Bureau of Economic Research officially confirmed what we already knew: We have been in a recession for the past year. This begs the question, how long until we declare World Depression II?

The (disputed) technical definitions of Recession and Depression make them lagging economic nomenclature. Economists debate whether we are in a swamp while everyone else worries about the ever-increasing number of alligators. The lack of an official declaration of recession mostly just gives the chattering classes something to do while avoiding taking action.

“Is it a crisis?”

“There is no crisis!”

“Is there a large, green creature eating my leg?”

“There is no large, green creature eating your leg!”

Allow me to go out on a very, very sturdy limb and declare a Depression. The economy isn’t going to recover by the end of next year. There is a only a dim possibility it will recover the year after that. But no one in an “official” position is willing to be the bearer of that piece of bad news.

Doubt that it is (or soon will fit the technical definition of) a Depression? Look at the actual numbers…

Once there was a law that could have prevented all this …

By me, over at BlownMortgage.com:

Once upon a time the US actually had a law in place that would have at least hindered the current mess. Not surprisingly, that legislation – the Glass-Steagall Act – came out of the Great Depression. Just as unsurprisingly it was repealed in 1999 at a time when lawmakers and business no longer thought that “what goes up must come down” still applied to the economy.

Simply put, Glass-Steagall prevented the mingling of investment and commercial bank activities. If you did one, you couldn’t do the other. This happened because way back then it was thought that commercial banks were way too speculative – both with where they were investing their assets and also because they were buying stocks for resale to the public.

The kind of forward thinking people we want working on this problem

“These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” —  Rep. Barney Frank of Massachusetts, September, 2003. Frank is now the chair of House Financial Services Committee.

Frank spoke against a Bush administration plan to create an agency to oversee Fannie Mae and Freddie Mac. The proposed agency would have had the authority “to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios.”

Did mortgage crisis cause crash of flying saucer?

saucer houseA Chattanooga, TN, house shaped like a flying saucer recently sold for $135,000, far less than expected. The 38-year-old, structure is perched on six “landing gear” legs, has multiple levels, three bedrooms, two bathrooms and an entrance staircase that lowers and retracts with the push of a button. The new owner — who didn’t want to speak with the press — faces some uniquenterior decorating challenges as the curve of the exterior creates a sloping ceiling and short side walls. On the plus side the building has a striking curved bar and a custom designed bathtub.

A neighbor, Ron Parimore, told the Chattanooga Times Free Press that former owners in the 1970s got in an argument and the wife pulled up the stairway, drove her husband’s truck underneath it so he couldn’t get the stairs down and left him stuck inside.