September 2008

“The tree of capitalism must be refreshed from time to time with the
blood of investors and bankers.” — Angry Political Optimist


James Burke once wrote, in an essay entitled “Fit to Rule”, that the modern world was connected to root events having to do with Linnaeus. His penchant to catalog and organize nature led to Darwin’s Galapagos trip; and from that Karl Mark derived his economic theories giving rise to Communism. Nietzsche’s interpretation, itself misinterpreted, philosophically enabled Nazism and Hitler and the “manifest destiny” derivative in the hands of J. P. Morgan and Getty gave rise to capitalism. Finding root causes is always an interesting journey. So when one looks around today, especially with politicians eager to cast the blame on others, it’s good to try and establish what exactly the root cause of the current fiscal mess might, in fact, be.

The story begins in 1933 at the end of the Great Depression with the passing of the Glass-Steagall Act by Congress (F.D. Roosevelt administration) which prohibited banks from selling investments and created firewalls between investment banking, commercial banking and insurance. Soon after, in order to resolve the mismatch in maturities in loans, and because banks couldn’t loan enough to support the post WWII baby boom, the Federal National Mortgage Association or “Fannie Mae” was created as part of the New Deal in 1938 (FDR administration) to provide a secondary market for mortgages. This organization purchased loans from banks which then allowed them to continue to service and lend. And all was good — the greatest generation prospered.

For thirty years, FNMA had a near monopoly on the secondary market, then, in 1968, FNMA was privatized by L.B Johnson because of Vietnam War fiscal pressure. Now, as a private entity, FNMA could generate profits, yet FNMA still obtained special treatment under regulatory and tax laws. As a consequence of this, investors perceived minimal risk in the company. In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac, was created under the Emergency Home Finance Act. The FHLMC purchased mortgages on the secondary market, aggregated, tranched, and sold them as asset backed securities (ABS). Between them, FNMA and FHLMC was estimated to hold approximately 90% of all US mortgages accounting for 46% of the national debt.

Then Congress exempted FNMA and FHLMC from the FDIC Bank Holding Company Act capital/asset ratio reserve limit of 3%. Fannie and Freddie were free to leverage their assets. In 1999, the Graham-Leech-Bliley Act, supported by Robert Rubin (Clinton-Administration) repealed the 1933 Glass-Steagall Act and allowed banks to invest in securities, offer securities, and a cafeteria of financial services. This provided an immediate market for FNMA stock, especially as these shares were considered low risk investments and were returning high returns on investment. The 1995 interpretive letter approving low income mortgage securities as viable investments under the 1977 Community Reinvestment Act (12 CFR parts 25, 228, 345, and 563e) provided another market for FNMA. Commercial banks could now invest CRA dollars in FNMA legally. In 1992 Congress (H.W. Bush administration) mandated (GAO report number GAO-04-269T) that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers and specified that approval metrics such as the ratio test should henceforth include unemployment and welfare payments as sources of income. HUD (Clinton administration) established ‘quotas’ for FNMA and FHLMC to insure 50% of all their loans be to minorities by 2001. Since FNMA and FHLMC are secondary markets, they pressured originating banks to offer more minority loans.

(The story accelerates to Internet time.) FHA regulations are written with loopholes that allows 0% down-payment mortgages. Down payment assistance market develops to exploit the loophole. The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH) (G.W. Bush administration), requires the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. In 2005, FNMA revises its loan approval criteria to support post hurricane rebuilding.

The Rating Reform Act of 2006 passes into Law requiring the use of “Nationally Recognized Statistical Rating Organizations” or “NRSROs”. As a result, internal credit analysis at investment banks deteriorate. In 2007, FASB 157 is imposed on corporations requiring that assets be marked to market. Also in 2007, the Office of Federal Housing Enterprise Oversight (OFHEO) increased the FNMA conforming loan limit upwards to $729,750. This increase in allowed principle increased profit for FNMA. All these regulations and acts let FNMA and FHLMC offer securities at net interest margins that were extremely profitable. FHA mortgages with 0% down make it impossible for banks to compete. Banks have to match terms in order to compete. Financial houses have to develop new instruments in secondary markets to compete with FNMA and FHLMC.

At this point the dominoes are all aligned and ready to go. Backtrack in time slightly and pick up a second parallel thread. Two events occur: investors realize that a few lines of software, a pretty business plan, and a catchy name do not a market make; and two planes make unauthorized landings into downtown Manhattan. The 1-2 punch of the Internet bubble bursting and 9/11 sends the economy into a recession. The Federal Open Market Committee (“Fed”) ratchets interest rates lower and makes a horrible mistake, leaving them low for far too long. Liquidity is generated with nowhere to go since money markets and deposits are generating low returns. Well, there is always real estate.

Quants on Wall Street create new classes of securities to access this liquidity — Collateralized Mortgage Obligations (CMOs) and Structured Investment Vehicles (SIVs). Quants are not stupid and know that these are risky, so they create credit default swaps (CDSs) to cover and distribute the risk. Markets develop to trade these instruments. Purchases go global. Trillions of dollars are traded in these vehicles.

With easy money and low interest loans, more houses are constructed, exceeding the number of available buyers, even at 0% down. The value of real estate drops on market fundamentals (law of supply and demand). The underlying value of mortgages drop. Loans are valued at more than the house or real estate they are collateralized with. Because many houses were purchased on speculation, and the dollars invested are essentially zero, owners walk way leaving banks with securitized assets that are non-producing. The primary cascade starts.

As underlying values tank, derivatives such as CMOs and SIVs collapse and swap liabilities under CDS’s increase. FASB 157 requires assets to be marked to market and assets are devalued accordingly. As assets are devalued, new capital to make up the difference is required. However, the complex interconnection of derivatives and new investment vehicles do not provide mechanisms to evaluate risk. Few are willing to invest without an understanding of the risk involved. Bank and investment company outlooks become speculative and their stock prices reflect this. Rating agencies downgrade the companies. This triggers additional capital requirements written into the CDS contracts. The cascade increases. FASB 157 becomes virtually impossible to implement since there effectively is no market. Liquidity stops because 1) banks can’t value what they own; and 2) they don’t loan assets they have because they might need them for capital.

People don’t understand because political parties are off blaming each other. News commentators spew gloom and doom scenarios. Runs on money markets ensue. Money markets sell short term securities to cover withdrawals and the market for commercial paper, which is funded through the money markets, dries up. Liquidity in commercial loans drops. Companies cannot access their lines of credit by commercial paper (bonds, etc,) Companies have to restrict operations and downsize.

People without jobs cannot pay mortgages. Second stage of cascade begins. Consumers look at institutions and decide that their money isn’t safe. They withdraw funds — banks become insolvent and are seized by the FDIC. Other banks stocks fall as result. Confidence erodes further.


So if we look at the root cause of all this, while Wall Street has it’s share of responsibility, you don’t discipline a dog for urinating on a fire hydrant — he’s just being a dog. Similarly, investment bankers do what they do — borrow and lend money and attempt to make markets. In this case, the road to hell is paved with good intentions and shares of Fannie Mae stock.

Once there was a group, established by a society, which was endowed with a high level of respect. Members of this group were fragmented in their beliefs and practiced their craft in accordance with their beliefs. Some, enamored with righteousness and a belief in the primacy of the Church, believed that society’s ills were the work of demons and established laws and rituals to expunge them. Men of high status were called evil and their works questioned. Others, no less righteous, insisted that there were fundamental humours that were required to remain in balance for good health, and periodically vented and tapped these to release them from the body. As may be expected all this venting and tapping had some unintended consequences — the patient died. At some point, around the 1850s, some members of this group stepped back and performed a little critical analysis noting that the patients untreated had as much change of survival as patients treated. This observation led to a complete philosophical paradigm shift. A phrase was taught to all who entered this profession: “Primum non nocere —First, do no harm.” Physicians use this expression to note that human acts with good intentions may have unwanted consequences.

In the last few weeks, various treatments to the illness of the financial markets have been tried. These included federal takeover of Fannie Mae and Freddy Mac (Why are there two of them anyway?), the fire-sale manipulation of Bear Sterns, the abandonment and bleeding of Lehman Brothers, what amounts to the acquisition of AIG, and most recently the promise of some new and radically untried set of procedures. These include the suspension of short sales, the acquisition of asset backed securities by the government, the FDIC like insurance of money market mutual funds, and the opening of FED credit lines to cover corporate paper and short term liquidity needs.

In order to implement many of these policies, the regulatory bodies — the SEC, the FED, the Treasury — need Congressional approval. As any first year economics student is taught, actions and expenditures by the government have attached multipliers and consequences on the macroeconomic landscape, not all of which can be accurately predicted. It would prudent then for Congress to do the minimum necessary to treat the problem. Doctors Bernanke, Paulson and Cox have a prescribed treatment plan — one that doesn’t involve additional economic incentive payments, additional mortgage subsidies, or riders to support venting of additional humours. Congress should realize that these prescriptions are for Main Street and not for just Wall Street.

Keeping the Act to enable these prescriptions to the minimum necessary will surely test the wills of both sides of the aisle. It will be difficult enough to fill in the details without loading up the bill with each party’s pet programs and election-year incentives. And as for the details, a couple of suggestions:

  1. Let’s go easy on the shorts. Markets work best by including all information and short sales provide a valid channel of information. By all means, lets clamp down on the ‘naked’ shorts, but an accross-the-board ban on shorts is a bad thing.
  2. If the Treasury is going to buy securitized mortages, CMOs and SIVs, the so-called “toxic paper”, then let’s value the asset on the basis of discounted cash flows and not mark-to-market. Especially when a viable market doesn’t exist. Not only will this eliminate a bad accounting practice, but it will rapidly establish a mechanism for global markets to understand the risk/value of assets already on their books. It will also eliminate the death spiral of under-capitalization, Agency rating downgrades and further capitalization reserve requirements which are weighing down Goldman Sachs and Mogan Stanley. It probably would have helped Merrill Lynch and Lehman Brothers also.
  3. Providing FDIC-like insurance to Money Markets and Mutual Funds needs to be thought through. We don’t want to make the funds more attractive than deposits and cause a massive unintended shift of capital from the commercial banks. That would just shift the crises from Wall Street to Main Street. Perhaps insurance coverage could be adjusted to equalize over the return on investment on any given instrument — treating deposits and funds equally after weighting.

But most importantly, moderation and minimal intervention.

After all, when the heart surgeon cracks you for that triple bypass, he doesn’t usually divert to perform a liposuction, or have his OR technicians perform a manicure on the patient, no matter how beneficial to the patient’s image. Anything that diverts attention from the heart attack is to be avoided. Perhaps the Congressional motto should be changed to “Primun non nocere”. Congress take note.

The speculation that Comcast is going to impose download quotas on their Internet services has got me seeing red and has blood shooting out of my nose. Granted, a 250 GByte limit per month seems like a reasonable limit, and I really really do understand their concerns with peer-to-peer, but there is more here that should be addressed.

Now, as it happens, I have access to certain information about the network utilization at a large State University. The campus, having recently completed an expensive DWDM fiber ring to a major city, now has access to commodity rates for Internet connectivity and in aggregate has around 3 G/s available. The campus housing system, which consists of dorms and greek houses, is attached to the Internet on a rate limited basis. When the limit was 100 M/s the housing network was using, strangely enough, 100 M/s. When the rate limit was increased to 200 M/s, the utilization increased to 200 M/s in the time it took to press the final keystroke to the time it took to display the new statistics. Doubling the limit again resulted in similar results, from which I conclude that the housing network would consume exactly as much of the aggregate bandwith as was made available.

Now I find it hard to believe that any group of students browsing the web, IM-ing their fellow students, or emailing their friends and family could generate precisely this utilization statistic. Clearly this is a result of around 30,000 peer-to-peer programs running on their machines. So I, as I said, understand Comcast’s attempted strategy for maintaining some semblance of control over their bandwidth utilization.

What has me seeing red is the fact that I have no control over my utilization. When browsing the web, in the new ‘World according to Google’, my downlink is jammed up with Flash code, streaming video advertisments, and an enormous amount of crap I really don’t want to see. It is annoying enough to check the weather at Intellicast for the local doppler radar, and have to wait for all the connections to googleanalytics, doubleclick, and the ad servers to complete before executing the java script to allow me to mouse over the drop down menu to get to the listed radar link.

It used to be that a responsible company, when designing a site on the web, would load the important stuff first in the top third of the screen and run the appropriate scripts immediately so that you could click through fast to get where you need to be. None of this waiting around for Flash to load and paint pretty, extremely annoying, and totally worthless graphics all over the index page (just to show how clever and artistic their designers are.) Damn! If I wanted to see that crap I would go to the local art museum, which by the way has a great section on computer art and generated graphics. And if Flash wasn’t bad enough, video streams for microwindows of auto advertising where the designers set the buffering level at 100% before execution. Egad! The same university I spoke of recently redesigned their index page away from a relatively useful portal to a completely annoying top third flash graphic all in the name of “Branding” the university.

If I want to read something, like a news article, at most I need 300-500 bytes in the body section. Instead, I have to wait through a header which loads all the javascript functions, the Flash loads, the video buffers, the fancy scrolling marquees, and my 500 bytes. Frantically mousing over where the menus should be and getting squat — watching the bottom left where the google analytics activity flickers, and waiting not-so-patiently for the “Done”, that’s bad enough.

But then to hear that Comcast is going to limit me to some number of bytes down to my browser before they charge me overlimit fees or trim my rate — crimson pulses throbbing down my chin. I vote for an option that provides for in-line culling of crap. Go to a web site and any connection to google analytics or a google ad server gets nulled out — before it is counted against your quota. Or better yet: The Better Web and Sanity Seal of Approval. Approved sites, without the crap, gets exempted from the quotas.

Either way, slapping quotas on the users, under the assumption that they are peering, without some consideration for what drivel is forced down the link is not looking at the whole picture. If I am running limewire, then I deserve it. If I am researching patents, or trying to get the latest stock quote, or reading the weather map, and get limited, then I am looking for another provider.

Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke, and Treasury Staff have been working five weeks non-stop through weekends and away from wives and family to attempt to resolve one of the most complicated and interwoven nests of pit vipers ever conceived. First there was Bear Sterns, then Fannie Mae and Freddie Mac, then Lehman Brothers and Merill Lynch, followed immediately by AIG, and now what looks to be a rash of capital deficient investment houses and banks. Critics are everywhere and are second guessing their every move with front page news and breaking news reports on the crises entertainment channels. Our candidates for President, in spite of their economic illiteracy are formulating “plans” which, while having no bearing on reality, are spot-on to their philosophical leanings: Obama — we need more regulation and more government; McCain – we need to reform Wall Street as well as Washington.

But the best out of Washington comes from Congress. Both Republican and Democrat ranking members are a bit put out that Paulson has not included them in discussions and strategy plans to resolve the crisis. (A crisis they are largely responsible for.) It should be obvious to most that Paulson and Bernanke are a tad busy to put up with the posturing that would result, and have excluded them largely for the same reasons that generals exclude them during the execution of a battle plan.

Senate Majority Leader Harry Reid has indicated Wall Street is a problem — “a multi-trillion dollar issue.” But this requires study and can’t be done on an unrealistic timeline. House Financial Services Chairman Barney Frank and Senate Banking Chairman Chris Dodd both want to consider the problem, but believe that there is insufficient time to consider the issue this year, i.e., before they adjourn for the autumn political campaigning season. Dodd has postponed the Banking Committee meeting.

So while the evil Bush administration appointees are working in the worst pressure cooker of the century (so far) attempting to resolve a difficult set of problems, Congress is more concerned about the election, and would rather not perform any action that might be construed to be a position on the crisis that might affect their standing in the polls. In other words, … business as usual.

I have been waiting, watching and thinking about the current political landscape. With the annoyance of a two year campaign, I have kept my opinions pretty much to myself with a few exceptions which address issues more than candidates. As we plunge into the pre-November hysteria, I feel obligated to weigh in with a few thoughts.

As my readers might suspect, I have Republican leanings, although to be accurate, they are more Libertarian than true Republican. The whole earmark thing and growth of the bureaucracy makes me want to draw and quarter the Republicans. I have come to the conclusion that the first two years of Clinton and the first six years of Bush are two of the best arguments for never letting one party control the entire Government.

First, I am impressed by Obama. I think that he could very well be a decent president provided he was backed by a Republican Congress. ( I think that we can all agree here that a true third party is not in the cards.) He has very straight line liberal tendencies which I probably will not agree with, but I can see that he would be a catharsis to the nation — or an enema depending on your point of view.
At the very least, it would shut up the Jesse Jacksons and Al Sharptons of the world — an effect to be greatly desired in my book. A popular vote for Obama would dispell the myth that every white middle-class worker is a racist.

However, I will not vote for Obama because he is not going to have a Republican Congress. Pelosi, Reid and Obama is a triumvirate that gives me the shudders. Rather than the change we want and desire, we will be hamstrung by the special interests of labor, the environmentalists, and the redistributionists. While I am sure that that condition will exist only for two or at most four years, it will take an additional four to six years to undo and correct the policies that they will implement without adult supervision, just in tax policy and the economy alone. God knows what effects could occur in the state of the world that would be more persistent even permanent.

I wasn’t inclined to vote for McCain either. It strikes me that Congresscritters make poor Presidents as they are too much attuned to compromise and not enough to leadership. Certain things are not suitable for compromise — like your principles. This doesn’t leave me much choice if I want my vote to count. Voting for a third party, not voting, or writing in Mickey Mouse — same difference. McCain’s selection of Sarah Palin changed things however. Granted that she is as useful as a “bucket of warm spit” as they say in actual job responsibilities; she still brings true leadership ability to the ticket. To my way of thinking, leadership is what is important in the position. Even if McCain is a compromiser, the influence of Palin will be felt and that is a positive thing.

I believe that the media and Beltway pundits are overlooking the desire of the American people for leadership. They certainly don’t find it in Pelosi and Reid who called a recess rather than vote on off-shore drilling, which 74% of Americans support. They see the promise of leadership in Obama, but the actuality of leadership in Palin. McCain, in his selection of Sarah Palin, has won the White House in 2008 if only he has the sense to know it.

While I was driving across a bridge I happened across this incredibly awesome troll!

Bumper Sticker

…and when my messiah talked about change he meant turning water into wine!

Future history is the sine qua non of science fiction. Far term future history is fairly easy — say over the span of 600 years. Example — we have spaceflight to other planets, warp drives, transporter beams. Midterm, over the course of 5-50 years, is more difficult, although Stargate SG-1 comes close. The real challenge is to project from current technologies, political philosophies, and current events to short term events in the near future — 1 to 5 years. William Gibson (“Neuromancer”, “Count Zero”, “Johnny Mneumonic”) was able to successfully extrapolate trends and Neal Stephenson (“Snow Crash”, “Diamond Age”, “Cryptonomicon”) has had some success (if he could only learn how to end a book).

The following is a segment of the 12 Angry Men Blog dedicated to taking our philosophical biases and projecting our rants into a short term future history. Disclaimer: Any resemblance to persons living or dead, is entirely intentional.

Tehran President Barack Obama met today with Iranian President Mahmoud Ahmadinejad. Accompanying him were Secretary of State Biden and National Security Advisor Robert Wexler. In a two hour meeting, Iran pledged to stop increasing the number of its uranium separation centrifuges, currently estimated to be over 10,000, asserting that their production levels were now sufficient to meet their specified goals. Iran has been attempting to make itself energy independent, a goal which President Obama sympathized with. US average gasoline prices fell to $7.43/gallon on news of the reduction of tension with Iran. President Obama reiterated his conditions that any meaniful dialogue with the United States requires Iran to take an essentially neutral position with respect with Iraq. “The long and difficult struggle between the Iran and the previous Iraq state cannot be viewed as other than an inherent interest in the outcome of the current political process. The withdrawal of the United States from Iraq serves as a indication of our committment to allow the Iraqi people to decide their own fate without outside interference.” said Obama. President Obama further stated that “Iranian intervention would exacerbate an already intractable problem for the Iraqi people.”

National Security Advisor Wexler, in a later press release, declined to speculate on the probable outcome of the Iraqi civil war. Mr. Wexler did assert that it appeared likely that the most current shipments of weapons bearing Iranian issue markings were hijacked by rebel Shiite insurrectionists and that Iran should not be held responsible.

New York The Dow Jones Industrial Average today topped 3000 for the first time in 24 months signaling what analysts believe to be an end to the current bear market. Gainers favored losers by over a 3 to 1 margin. Financial analyst Coty Dubrowski from Bear-Sterns-Citi-Stanley(NYSE:BSCS) speaking at a dinner for independent analysts in New York, noted “The elimination of the uncertainity in corporate tax, income tax and government fiscal policy has allowed corporations for the first time in years to look ahead with some degree of confidence. The current marginal tax rates of 68% on individuals and 50% on corporations, while not conducive to growth, have allowed both individuals and corporations to plan for the future.” The S&P 200 fell slightly during after-hours trading from 151.35 to 151.2 off 9/100 of a basis point.

Springfield, IL Speaking from his Chicago office, Governor Rod Blagojovich, announced that he would remove upwards of $100 million from the proposed budget of the Illinois Board of Higher Education. The IBHE is responsible for the channeling of State money to the flagship educational institutions of the State including the University of Illinois. In addition, Governor Blagojovich indicated that the conditions of the State budget were so dire that it would be impossible to approve a capital spending bill for the state’s decaying infrastructure. From the University of Illinois, The Chancellor Richard Herman, speaking from the steps of Lincoln Hall, decried the Governor’s actions indicating that Lincoln Hall has been on the list of needed capital improvements for over ten years. Lisa Madigan, who was in attendance, noted that her priorities had to include the rebuilding of the I-74 bridges over the Mackinaw river and over the Illinois River at Peoria. Speaking from the crowd, Madigan reposted Herman saying “While higher education is an important element of Illinois’ future, I-74 is responsible for shipment of food across the state and must enjoy a higher priority.” Madigan has been endorsed by the Illinois Teamsters Union.

Author’s Note. This was written July 16th, prior to Senator Obama’s selection of Biden as his running mate. Apparently, Obama decided that he needed a VP with foreign policy experience more than a Secretary of State.

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