Monday, December 1, 2008

Is "trillion" really a number?

No warning can save a people determined to become suddenly rich. -- Lord Overstone

In this week's Sift:

  • The Scale of the Bail. How can bailing out the financial system possibly cost this much money?
  • Tea-leaf-reading the Transition. I'd love to tell you exactly what Obama's appointments mean for the next four years, but I can't. And don't think anyone else can, either.
  • Media Corruption. Wouldn't it be nice to watch a TV talking head without needing to wonder who's paying him?
  • Short Notes. When I figure something out about Mumbai, you'll be the first to know. It's a tough winter for squirrels in Washington. The Evangelical sex problem. And Nixon as the father of modern Republicanism.


The Scale of the Bail
From the beginning, the strangest thing about the economic crisis has been its scale. The amounts of money being thrown around to solve it are way out of proportion to the size of any suggested cause. And even those sums don't solve it.

TPM took a whack at listing all the government bailout programs, being careful to separate out direct loans and investments from less direct stuff like loan guarantees. If you just blindly total it up, you wind up in the $5-$10 trillion range. Presumably a bunch of that will get paid back, and the government might even make a profit on some of it, but still it's one of those size-of-the-universe numbers that's hard to relate to anything. (For example, the total federal debt at the end of the Clinton administration was about $5.7 trillion. It took two centuries to run that up, not a few months.)

So what caused our many-trillion-dollars-so-far problem? Ask anybody and you'll hear about the housing bubble, subprime mortgages, defaults, falling house prices, and so on. But the New Yorker did a long article on Fed chief Ben Bernanke recently, and gave this account of why Bernanke didn't see the crisis coming:
Relative to the fourteen trillion dollars in mortgage debt outstanding in the United States, the two-trillion-dollar subprime market seemed trivial. Moreover, internal Fed estimates of the total losses likely to be suffered on subprime mortgages were roughly equivalent to a single day’s movement in the stock market, hardly enough to spark a financial conflagration.
In other words: When this started, all the mortgages in the United States were $14 trillion, including $2 trillion of subprime. As of mid-summer, about 90% of all mortgages had their payments up to date, and even the ones that will eventually default are not going to be total losses. The underlying houses are worth something, after all, even in cases where they won't cover the outstanding value of the loan.

So let's do a back-of-the-envelope calculation: Say the 10% of mortgages with late payments all end up in foreclosure. Ten percent of $14 trillion is $1.4 trillion. Now let say that the underlying properties are only worth 80% of the outstanding value on the loan, so there will be a 20% loss for the banks and investors to eat. That gets you a $280 billion loss.

The point of that calculation isn't to be exactly right, but to establish scale. (Suppose another 10% of mortgages eventually go under; now you're up to $560 billion.) Where do we wind up with a $10 trillion problem? To get a $10 trillion loss just from mortgages, you'd have to have all mortgages default, and then underlying properties only sell for about 30% of the value of the loan.

Well, there's a reason for the scale, but it's way more complicated than the people-bought-houses-they-couldn't-afford version. (And, by the way, all those conservative attempts to blame the crisis on too much government regulation depend on the people-bought-houses-they-couldn't-afford explanation.) The real problem isn't in the mortgages themselves, it's in what happened to those mortgages after Wall Street got hold of them. It's a two-step process.

The first step is known as securitization. (Alan Greenspan attributed the current crisis to "not the subprime problem itself, but to the securitization of subprime.") There's a pretty good article about this on Wikipedia, along with a very good diagram, so I won't go into a lot of detail. Here's the important point: A mortgage-backed security can wind up being worthless, even if the houses the mortgages are based on still have value. This is because the mortgage pool gets sliced up in such a way that one set of investors gets first call on any payments, then the next set of investors gets paid, and so on down to maybe a fifth tier, who will probably lose everything.

Securitization re-arranges the losses and creates uncertainty that freezes the system. (Imagine throwing one poison M&M into a bag. Who's going to eat anything out that bag?) But to blow the problem completely out of scale you need the second step: short selling. This is the part of the problem that most people don't understand at all. Fortunately, there's finally a good recent article about it by Michael Lewis, author of the book Liar's Poker about the boom-bust cycle on junk bonds in the 1980s.

It a nutshell, short selling means selling something you don't own. When you put it like that, it sounds like it ought to be illegal, but it goes back to the very beginnings of our market system. (If you're the kind of person who learns stuff best from fiction, pick up the novel The Coffee Trader by David Liss. It's set in the Amsterdam commodities exchange in the 1600s. You can also learn about short selling from the Eddie Murphy/Dan Ackroyd movie Trading Places. If I remember right, the film includes this pithy rhyme by 19th-century financier Daniel Drew: "He who sells what isn't his'n // must buy it back or go to prison.")

In 17th-century Amsterdam, the commodity traders would sell (for future delivery) the cargo of ships that hadn't arrived yet. If a ship sunk, the trader would have to buy the commodity somewhere else to make his contract good. Eventually somebody noticed that you could sell the cargo of a non-existent ship, and if the commodity price dropped before the ship was supposed to come in, you could cover your contract for less than you got by selling it. (If the price went up, on the other hand, you had a problem.) Short selling was born. It continues to be completely legal on investment exchanges of all sorts.

So as a strategy, short-selling works like this: You believe the price of something is going to go down, so you sell it (even though you don't own it). After the price goes down, you clean the slate by buying back the thing you sold. Because it costs less now, you made a profit.

Now imagine that you were one of the first people to figure out that these mortgage-backed securities were going to turn out to be worthless. (Such a person is the main character in Lewis' article.) You could sell them short, and after the rest of the world figured out that they were worthless, buying them back would cost you nothing. 100% profit, in other words.

But trading doesn't create value, so one person's trading gain is another person's trading loss. That means somebody bought a mortgage-backed security that never really existed in the first place and lost money on it.

And that's why the losses might be so huge. Short-sellers walked away with vast sums of money, and the banks and investment banks -- and now you the taxpayer -- might wind up with losses that are far larger than the losses on the underlying bad mortgages. And the short-sellers aren't even villains. They were just right. It's as if Lehman Brothers took their clients' money and made a vast bet on the Patriots to win last year's Super Bowl (which seemed like a good bet at the time). The people who bet on the Giants (and wound up with the money) wouldn't be the villains in the story. The villains would be the lax regulators (who let Lehman do it), the investment-rating services (who did the equivalent of guaranteeing that the Patriots would win), and Lehman Brothers themselves.

Matt Yglesias raises a very good point concerning banks that are "too big to fail" and hence require government bailouts: Why don't we rig the system to discourage such banks from forming in the first place? It wouldn't be that hard and shouldn't even require any Standard-Oil-type breakups. Just make it a rule of thumb that the bigger you are, the more stringently you're regulated. If you're a giant-bank CEO who finds the regulations oppressive, you just have to spin off some subsidiaries and get small again.
So far it's taking about $150 billion of federal money to keep insurance giant AIG -- once a very profitable company -- from going bankrupt. Probably if your on-the-job screw-ups were vying for a place in The Guiness Book of World Records, it wouldn't occur to you to expect a bonus. But the economy works differently for the corporate elite. (The people who wrecked Wachovia Bank are dividing $100 million, just to give one example.) So AIG got a lot of good publicity by announcing that its top execs won't get bonuses this year.

Except ... it turns out that 130 AIG managers will get "retention payments" -- in one case as much as $3 million. Naturally, there's an explanation: If AIG loses these executives it might be harder to sell off the parts of the company they run, which is how AIG is supposed to pay the government back. So the retention payments aren't just throwing good money after bad, they're protecting the public's investment.

I can't decide whether I want this explanation to be true or not. I mean, if it's false, then insurance executives are blatantly ripping off the taxpayer in full public view. I'd hate to think that's happening.

But if the explanation is true, it means that AIG executives are in demand. They're in such demand that we have to make special payments (over and above their already-high salaries) to avoid having them hired away (in this job market, no less) by companies who want to give their own stockholders the benefits of AIG-style management. Doesn't that thought make you shiver?

There's a lot of discussion going on about what kind of stimulus package Obama should put together, and this given new relevance to academic discussions about the Depression and the New Deal. Paul Krugman has been arguing that FDR's only mistake was not being bold enough: He worried too much about ballooning the deficit, and should have been more aggressive in spending on things like public works. Meanwhile, Price Fishback agrees that the New Deal wasn't that big a stimulus (and that even World War II wasn't that big an economic stimulus when you factor in the inflation hidden by price controls), but draws the conclusion that we don't really know what ended the Great Depression. So he's skeptical about the usefulness of a big stimulus plan in turning things around now.


Tea-leaf-reading the Transition
Political analysts are at their worst when they really want to find an answer, but there just isn't enough information to go on.

That's what's been happening with the transition these last few weeks. Blogs and mainstream pundits alike have put a lot of energy into analyzing what Obama's appointments and rumored appointments mean, but it's really impossible to say. Eight years ago some people looked at Colin Powell and foolishly got hopeful about Bush's foreign policy. But how much was that insight worth?

Basically, Obama's appointments are a Rorschach test. If you're the kind of liberal who believes that we always get screwed somehow, and that the Establishment always finds a way to co-opt the will of the People, then that's what you're seeing. Conversely, if you have a basic faith in Obama to assemble the best people and do the right thing, then you're seeing that.

Personally, I'm still in the faith-in-Obama camp, though I recognize that (like everybody else) I'm projecting my reaction onto events rather than genuinely reacting. My own decision-making philosophy amounts to this: You don't always have to follow the conventional wisdom, but you should always know what it says; and when you don't follow it, you should know why you're not following it. Unlike Bush and all his heckuva-job-Brownie appointments, Obama is picking people who will know the conventional wisdom. I'm hoping they'll also find reasons to violate it in a bunch of areas, but we'll see.
The Bush administration's push to politicize the non-political parts of government will continue right up to the inauguration. The Washington Post has been covering the process called "burrowing" -- in which people move from political appointments they're about to lose to permanent civil service jobs. Together with all the people already hired inappropriately for political reasons, these folks may form a Republican fifth column inside the Obama administration. The Bill Kristols and Rush Limbaughs should have a steady stream of embarrassing leaks for the next four years.


Media Corruption
One of my running themes is the media corruption we take for granted these days. For the most part, the pundits you see on TV or read on the op-ed pages are just saying what they want you to believe; it's not clear they believe it themselves. Their future is tied to their partisan identity, not to the insight or information they bring to you. Karl Rove doesn't plan to live on what Fox News pays him; he hopes to get back into power someday.

Well, sometimes the corruption goes way beyond this subtle where's-my-true-loyalty variety and becomes ordinary give-me-the-money corruption. This fall Dick Morris used his position as a Fox News commentator to push for viewers to donate to GOP Trust, a PAC that ran Jeremiah Wright ads against Obama late in the campaign. Guess what? Morris was being paid not just by Fox News, but by GOP Trust.

Sunday, the NYT ran a long article on the vast conflict-of-interest that is retired General Barry McCaffrey. The system works like this: McCaffrey (like a few dozen other former officers) uses his influence as an NBC commentator to sell the Pentagon's point-of-view to the public. This buys him influence with the Pentagon, which he uses to get contracts for Defense Solutions, a company that pays McCaffrey a whopping salary. Keep all this in mind the next time you see McCaffrey (or any retired general) on TV. He's not working for you, he's working on you.

Remember those reports that Sarah Palin didn't know Africa was a continent? Well, maybe that informed source wasn't as informed as we thought. Just be patient, I'm sure Sarah will say enough stupid things that we won't have to make any up.

As we get closer to taking action on greenhouse gases, expect to see more articles like this one in Politico: "Scientists urge caution on global warming." The article refers to a "growing accumulation of global cooling science", but doesn't quote a single global-cooling climatologist or refer to a single study from this "growing accumulation". (A meteorologist writing in the Old Farmers' Almanac doesn't count.) Maybe that's because there actually is no story here, and the Politico was manipulated by industries that make money off of fossil fuels. Grist's David Roberts debunks.

One of my favorite annual lists: Project Censored's Top 25 Censored Stories. Important information is lying around, but nobody picks it up.


Short Notes
The biggest thing that happened this week was the Mumbai terror attacks. I'm not ignoring them, but in the Sift I try to restrict myself to topics where I have some insight to add. So far, I'm just watching CNN like everybody else.

I'll confess to being glad that the attack happened before Obama takes office. There's not a lot an American president can do about this directly, and if it had happened on January 21, Obama would look weak no matter how he responded.

The election still isn't over in at least two states. The runoff in the Georgia senate race is tomorrow, and polls favor incumbant Republican Saxby Chambliss. In Minnesota, they're still recounting ballots.

Sign of the Apocalypse: There's a famine going on in the squirrel kingdom, and nobody seems to know why. Apparently the oaks around D.C. (and a few other parts of the country) didn't produce acorns this year. First the mysterious disappearance of honey bees (it's even got a name: "colony collapse disorder"), and now this.

I believe the traditional solution to this kind of situation involves the king's son joining a squirrel and a bee on a quest. But maybe in this democratic and egalitarian age one of the Obama girls could do something.

The best analysis of the Republican Party I've seen in a while was by Neal Gabler in Sunday's L.A. Times. Most people tell the Republicans' recent history ideologically, and trace the royal lineage from Goldwater to Reagan to W. Gabler focuses more on campaign tactics and identity politics, tracing the lineage from Joe McCarthy to Nixon to W. The pivotal role of Nixon is also the subject of Rick Perlstein's Nixonland, which I will have to read soon.

Meanwhile, Matt Yglesias (who has been on a roll lately, I find myself quoting him a lot) is not letting Republicans get away with their Bush-wasn't-a-real-conservative spin. He's running occasion historical pieces pointing out how syncophantic those same conservatives were when Bush was popular. I like this 2004 quote from The Weekly Standard: "It’s obvious not only that George W. Bush has already earned his Great President badge (which might even outrank the Silver Star) but that much of the opposition to Bush has a remarkable and very special
quality; one might be tempted to call it 'lunacy'.”

In case you missed it: Keith Olbermann's moving comment on same-sex marriage. Keith's special comments are usually a little too overwrought for my taste -- Rachel Maddow's irony and dry humor work better for me than Olbermann's seriousness -- but this one is dead on.

Evangelicals and sex -- what could make a more interesting article? Basically, if you rely on abstinence education (which doesn't work) and then you tell kids that condoms don't work, and that it would be sinful to plan ahead about sex -- you get a real mess.

1 comment:

DavidW in SF said...

Excellent and informative as always.

A correction though: In your story about the Palin & Africa hoax, your conclusion that Palin is off the hook on this one is incorrect according the article you link.

The actual hoax is that the person ("Michael Eisenstadt") who claimed *after the fact* to be the source was perpetrating a hoax about his own identity. The money quote:

"The pranksters behind Eisenstadt acknowledge that he was not, through them, the anonymous source of the Palin leak. He just claimed falsely that he was the leaker -- and they say they have no reason to cast doubt on the original story. For its part, Fox News Channel continues to stand behind its story."

So as far as we know, the question of whether Palin actually believed Africa was a country is still unanswered. And in a question of credibility between Sarah Palin and Fox News, we may never know.