How to fix the markets

Vanity | 18 September 2008 | JasonC

[JasonC]

Here is my modest proposal to address the immediate crisis in the financial markets.

I have already addressed elsewhere the longer term reforms needed, such as a clearing exchange for over the counter derivatives and swaps, simpler asset backed security structures, bans on deposit institutions lending to deadbeats, better monetary policy next time, etc. But there is also an immediate issue in the capital markets that needs to be solved immediately and on an impressive scale. This post is both a defense of the principle and a method to use.

The proposal is that the Federal Reserve begin conducting open market operations in corporate bonds, specifically buying investment grade securities for newly created dollars, left in the system. And that is do so with the conscious intention of both routing short speculators and making $1 trillion in trading profits. It should keep it up until that profit has been made.

Right now T-bills are well bid at 4 basis points. Basically the markets have such a high demand for safe cash right now, they will take anything safe enough without interest of any kind. Meanwhile, investment grade bonds especially of financial companies are trading at distressed or junk levels, and therefore offer yields of 10% or more. And they are not bid at those prices. This huge spread constitutes a standing invitation to *arbitrage*. And I propose that the Fed accept this invitation with both hands, exactly as would a *for profit* investor with its resources, at this time.

The only reason it hasn't, is that ideologues who pretend they are all for free markets and deprecate the mere existence of the Fed as an instrusion into their functioning, also expect the Fed to act in those markets - or rather, to refrain from acting - like a disinterested eunuch, with no profit motive and no appetite for well rewarded risks. These ideologues have conditioned the men running the Fed to act like machines rather than traders. They should stop, temporarily, and act like traders instead.

There is widespread public opposition to what are loosely called "bailouts", largely because the people are under the quite mistaken impression that these operations are always and must be unprofitable. So I propose we show them that is incorrect, by not intervening in a manner that only takes bum steer trades, but takes the attractive ones. And doesn't hand over the profits to private counterparties, but keeps them, for the public.

There are some conditions under which central banks cannot safely expand money supplied to the market in such a manner, without risking a reduction in trust in and use of the currency they issue. But this is emphatically not one of those times. Dollars are not unbid and avoided and spent as fast as possible. Traders are not demanding 10% and higher rates to hold them --- exactly the opposite. The Fed just had to extend huge swap lines to foreign central banks who did not have enough dollars for their own desired actions in their home financial markets. And rates are bid to zero. T-bills are currently the same in investment terms as currency stuffed under a mattress, and everyone and his brother is trying to pile into them anyway. There is no risk whatever of not finding men willing to take the new dollars.

Moreover, there is no risk whatever in the bonds being bought, either. You can't lose your shirt investing money created out of thin air for nothing and paying nothing, in top rated debts earning 10%. Especially when those bonds will be rendered sound precisely by the extra money made available and by a reduction in the rates corporations actually pay to borrow.

The present crisis is purely one of confidence and of liquidity preferences. No private investor can arb this spread the way the Fed can. Each individual investor faces the collective action problem, that there are two possible outcomes for each financial institution - one, in which is only pays 4% for its funds and is highly profitable, and another in which it must pay 14% and is bankrupt. The Fed can drive the market to the lower point, and can profit in doing so. But let's not be greedy - only drive it halfway, or until the Fed has made a $1 trillion profit. Others can join in at that point, if they like.

A large part of the present crisis is a mere mechanical effect of dedicated shorts getting richer every time they kill another company. They made billions on Fannie and Freddie and they instantly threw those billions at Lehman and Merrill and AIG. They made billions more on Lehman and AIG and threw them instantly at Morgan Stanley and Goldman Sachs, much sounder companies. They are now operating on momentum and their firepower, and not on fundamentals. They are striving to create the fundmentals they need to justify further bankruptcies, in the form of high rates and an inability to raise equity, for financial companies.

But nobody can match the firepower of the Fed. If they want to make it just about firepower, I say let's do so, and rout them. We know American business can and will earn trillions in the future. Let's take a trillion of it now, for the public, from the doom-mongering end-of-the-world trade terrorists.

All the Fed needs to do is pretend it is a profit seeking trader for a couple months, and arbitrage the ridiculously wide spreads between pure dollars and corporates. It is what any *for profit* bank with sufficient resources would do right now. Not only will it not cost the rest of us a dime, it will generate a staggering profit. The only losers will be the shorts.

That is my modest proposal. Comments are welcome.

[Lurker]

Who is doing the massive coordinated shorting?

JasonC said:

Well, Lurker on this thread for one.

What exactly are you accusing me of Jason? Please spell out exactly what 'treasonous' behavior you're accusing me of.

Be specific, because I do not take such charges lightly.

They made billions on Fannie and Freddie and they instantly threw those billions at Lehman and Merrill and AIG.

SO if Lehman and Merrill and AIG have all these 'billions' you say they do, why are they bankrupt?

They made billions more on Lehman and AIG and threw them instantly at Morgan Stanley and Goldman Sachs, much sounder companies.

So you're saying that these 'short sellers' made billions of dollars which they gave to companies which were bankrupt, and then made billions more dollars and are 'throwing them' at other companies which were doing exactly the same things the first three companies you mentioned were doing.

I have a question for you.

What color is the sky on your world?

L

[PhilosopherStones]

Sorry, I’m too drunk and tired to respond the way I want to at the moment.

Tomorrow I’ll explain why the derivatives are a convergent series (converging towards zero) and not a divergent series, to explain my previous response.

Nice chatting with you. Enjoyed it. Seriously!

[JasonC]

Ok, so in addition to being a short you are also a poor reader, or clueless, or perhaps most charitably, believe you can impose upon the credulity of others.

I said "They made billions on Fannie and Freddie and they instantly threw those billions at Lehman and Merrill and AIG." These are shorts making billions. How do shorts make billions? They sell what isn't his'n, and then buy it back before they go to prison. They sold millions of shares of Fannie and Freddie they did not own. Fannie and Freddie fell below $1 a share on massive volume. They bought back the millions of shares they had shorted at less than a dollar each. They made billions. Now they have extra billions in their brokerage accounts and their hedge funds. They use those billions as their margin as they sell millions more shares of Lehman and Merrill and AIG. Any strategy that profits enourmously from a previous trade naturally results in an increase in financial firepower for those exercising that strategy. The strategy didn't change, and the firepower increased. They couldn't make anything more shorting Fannie and Freddie, they still wanted to short financials. So they moved on to the next targets.

And blew away Lehman in less than a week, and AIG in a couple days. After which they were already firing away at Morgan Stanley and Goldman Sachs, despite their vastly better performance, recently confirmed. Why did a massive run against those two commence as they each posted outstanding results? Simple, the shorts from AIG were gorged on profits and full of vinegar, and looking for a fresh feast. And trying to keep the fear wave rolling along.

"so if Lehman and Merrill and AIG have all these 'billions' you say they do, why are they bankrupt?"

Shorts don't *give* money to the companies they clobber into oblivion, they *take* it from those company's shareholders.

"threw them instantly at" does not equal "gave to". It equals "sold short massive quantities of..."

Is it more charitable to think you understood perfectly but are attempting to impose on others who might not, or that you are honestly that stupid?

[Lurker]

Ok, so in addition to being a short you are also a poor reader, or clueless,

Don't patronize me punk.

How do shorts make billions? They sell what isn't his'n, and then buy it back before they go to prison.

So your position is that 'shorts' can sell things which don't legally belong to them. Have I got that right?

They sold millions of shares of Fannie and Freddie they did not own.

How does one 'sell' something which does not belong to them? What sort of fool 'buys' on this principle? Can you point out the Title and Section of the Federal Code which allows such behavior?

They bought back the millions of shares they had shorted at less than a dollar each.

We've gone form the bizarre to the surreal you and I. You're honestly telling me that these 'shorts' first sold something which didn't belong to them, which they had no legal authorization to sell things which didn't belong to them to depress the price, then they bought back their own value deflated assets?

What sort of moron would do that?

You make absolutely no sense. None whatsoever.

What is coming through loud and clear however, is the fact that you want the American taxpayer to 'bail out' these idiots to the tune of a couple of TRILLION dollars.

I've got a much simpler solution.

Got a pencil? Good. Here it is:

First, we form a mob. Actually we form two mobs. Mob 1 heads for Washington DC. Mob 2 heads for New York City. Both mobs have simple goals.

Mob 1 drags as many Congresscritters, Federal Appointees, Agency, Department, and Bureau Heads as they can find and then tars, feathers, and runs them out of town on rails.

Mob 2 repeats basically the same actions but on Wall Street.

Then the 'system' gets a much needed kick in the balls. Yea, it'll be tough for a few years, but in the long run we'll be better off as a Nation.

And we'll be rid of the real parasites. Those who engage in this sort of BS in the first place.

L

[JasonC]

This was fought out in 1791 by Hamilton, Jefferson, and Washington. It long antedates the Fed and the founders themselves directly ruled on it, in favor of the first bank of the United States. Hamilton was the one who argued the point. The textual basis is the necessary and proper clause.

Hamilton argued that the bank fell within that caluse as a means to realize the congress's powers to tax, to regulate the value of money, and to regulate and promote interstate and international commerce. He also proposed a test which has survived in constitutional law since, as to the scope of the necessary and proper clause. It was, if the measure was useful for carrying out a proper power and did not abridge an explicit right of any state or individual, then it was to be presumed constititional. Congress and the president by signing the law determined on the usefulness question.

Washington agreed with Hamilton's argument. There is no valid founding era argument against central banking, which Hamilton strongly supported and carried with the rest, in that era. As for the specific legal power under the scope of the Federal Reserve Act, that is provided most plausibly in section 13-3, the same section appealed to in the AIG financing.

[JasonC]

Now he is trying to pretend he doesn't even know what shorting a stock means.

Yes Virgina, shorting means selling something only borrowed, not owned. And these days they often don't even bother to borrow it first, they just make sure they buy it back before the settlement date several days later. And repeat as needed, thereby able to maintain the short position indefinitely. They also short using derivative contracts (OTC custom, OTC listed option, individual stock future, etc) which effectively outsources the actual shorting to a brokerage firm. Yes they deliberately want the price of what they sold to go down, because they never owned it in the first place and make the difference in the two prices they enter the two halves of the trade, at, and yes they make billions when it does, and no I don't remotely believe I have to tell you this for the first time. Nobody trying to discuss this matter could possibly be that ignorant.

[dragnet2]

But we just tried the experiment of giving $100,000 loans to deadbeats on mainstreet, in case everybody forgot.

We should have complained about those "deadbeats" to those poor AIG CEO's and others that were counting their million dollar bonuses before running their companies into the ground.

[JasonC]

AIG didn't make giant loans to deadbeats. But other men did. The deadbeats didn't pay what they promised to pay. The men who wrote the loans got stuck with them, but also couldn't pay, declared bankruptcy nearly 2 years ago now, and decamped. Several insurance companies, not AIG, wrote private mortgage insurance policies promising to pay if the original deadbeats didn't, but so many defaulted at once it blew out their limited capital. Regulators forced them to stop writing such policies and to save what capital they had left for existing risks, and reduce what they paid on them. Well the owners of the mortgages were a bunch of speculators and investors who borrowed much of the money used to carry them by issuing short term debt, commercial paper, to money market funds. When all the losses finally steamed up to them, they lost much of their capital. Their creditors refused to lend them more, and as their notes came due they might have honestly failed, or put up more of their own money. Instead they drew on bank credit lines to try to keep going, hoping for a rebound of some kind, until they were carrying mortgages falling in price against bank debt. As the price of the collateral fell still further, the banks realized they investor-owners weren't going to pay and were just playing "heads I win, tails you lose" with them. They seized the collateral. A few sold it, but there was little market for it by then, so mostly the banks were stuck with it. One of these banks was Lehman Brothers.

Fourth tier. Everybody above them defaulted, that is how they were left with the paper in question.

And what did AIG have to do with it? To that point, essentially nothing. Years earlier before any of it had happened, they wrote some derivative contract policies that were effectively guarantees to pay Lehman's debts if Lehman couldn't, at a time when it was earning 10 times its debt service and none of this was apparent to anyone.

AIGs collosal recklessness consisted of expecting an A rated Wall Street bank to be likely to be able to pay its debts over the next five years.

If enough people welsh, there isn't any such thing as sound finance.

And what happens when the shareholders of AIG stand and take the $150 billion hit that no one ahead of them would stand and take, losing nearly their entire fortunes, many of them, and a lot even for those more diversified? Everybody and his brother throws a crapstorm of hatred at the ones who stood up and took the hit for all the deadbeats prior. The original deadbeats, they've got entire political parties dedicated to helping them sue the crap out of people for having handed them hundreds of thousands of dollars and lost it all (the welshers sue the welshees, of course, this is America).

God how I hate whiners!

[dragnet2]

The deadbeats didn't pay what they promised to pay. The men who wrote the loans got stuck with them,

LOL! Those poor bankers and lenders. Their CEO's had to take the time from counting their annual multi-million dollar bonuses to find out they'd driven their own companies into the ground.

[dragnet2]

And what happens when the shareholders of AIG stand and take the $150 billion

If my private retirement investments go belly up, I'll call you and the Fedgov to come bail me out.

I expect you to be there in a timely manner with money in hand when things go south for me.

[JasonC]

Clash warfare is for communists, conservatives only care about the moral quality and the competence of human actions. Not how rich or poor the person conducting them is. You sound exactly like Barack Obama criticizing McCain for having too many houses. It is beneath contempt.

[dragnet2]

And what happens when the shareholders of AIG stand and take the $150 billion hit

Stop the whining.

Next time, those share holders ought to be more careful where they stick their money and invest, instead of winking and nodding at the fat cats and CEOs as they collected their annual multi-million dollar bonuses while the companies slid into a ditch.

[dragnet2]

Clash warfare is for communists

That's rich.

Everyone better pull themselves up by their bootstraps and don't expect government bailouts and handouts...

Except when it comes to *your* interest.

lol...

[JasonC]

I expect you to sign over all your social security benefits, medicare benefits, unemployment or disability benefits if ever needed, and deposit insurance benefits, to pay back JP Morgan, Citigroup, and Bank of America, for the $85 billion in corporate taxes you robbed them off over just the last 3 years, not to speak of the trillions financiers have paid to the US treasury in corporate and personal income taxes, and interest thereon, since 1783.

Oh wait, only you are allowed to practice one entry accounting.

US finance is the largest producer of positive economic externalities in this country's economy, and indeed in world history. The only things even in the same ballpark are scientific inventions and the personal valor of are servicemen. Compared to what they produce and give away to everyone around them as side effects, everyone else here is a useless layabout. Not that you are - plenty of other workers pull their own weight, some more than they own. Lots of others do not. But financiers are not among them.

If you doubt it, get through next week using only blueberry scones for transactions, and without touching any form of a means of payment of any kind, yours or anyone else's.

[JasonC]

I'm not in finance, I'm in software. I am just a patriot who wants to fix my country's number one problem.

[dragnet2]

So, can I too expect a bailout if my personal private investments take a bad turn?

Yes or no?

[dragnet2]

I expect you to sign over all your social security benefits, medicare benefits, unemployment

All that's going broke too. You haven't heard? The politicians looted those programs.

[dragnet2]

I expect you to sign over all your social security benefits, medicare benefits, unemployment or disability benefits if ever needed, and deposit insurance benefits, to pay back JP Morgan, Citigroup, and Bank of America, for the $85 billion in corporate taxes you robbed them of

I robbed them?

Look my money went to their CEO's million dollar annual bonuses...I paid, they just didn't notice my contribution. Obviously, I need to pay them much more, to rid myself of this guilt.

[JasonC]

Or, you could just drop the communist class warfare one entry smear games, and recognize that other free men have every right to their station in life, and as much call on their government in times of difficulty as anyone else. But then we can't expect miracles. Communists simply cannot get over a philosophy of hate and resentment.

[Tempest]

Were you high when wrote this?