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Fostering a Liquidity Crisis

From The Wall Street Journal, How the Next Financial Crisis Will Happen by Stephen Schwarzman:

Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.

The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling. A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.

Why should we care? Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. With individuals suffering losses and companies not able to raise capital, the economy will contract with layoffs, lower tax revenues and pain for middle- and lower-income Americans.

Small business owners will be particularly vulnerable because the number of community banks declined by 41% between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserveand Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline. Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis. We must revisit Dodd-Frank’s application to community banks because of their special relationship with borrowers in agriculture, small business and local real estate.


The lack of liquidity in the bond market is already being felt and is increasing volatility. We also see private companies starting to emerge to fill the void from lackluster bank lending.

Systemic changes such as Dodd Frank have some improvements but they tend to fight the last war without realizing their role in the next one.

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Financial Bloat

A black hole for our best and brightest by Frank Tankersley at The Washington Post

It’s not that finance is inherently bad — on the contrary, a well-functioning financial system is critical to a market economy. The problem is, America’s financial system has grown much larger than it should have, based on how well the industry performs.

To understand how and why that is, think of money as water and the financial system as a series of pipes. Ideally, the pipes deliver the water from people who have stockpiled it (investors) to people who want to put it to productive use (entrepreneurs, executives, home buyers, etc.).

Over the past half-century, America’s financial industry built a whole bunch of new pipes. The sector grew six times as fast as the economy overall during the past three decades. Other advanced countries didn’t see anywhere close to that growth in their financial sectors.

Some of America’s growth was driven by Washington. Lawmakers kept encouraging financial innovation, which built a market for smarter investment bankers. They did that by changing the tax code to encourage businesses to hire financial whizzes who could spin ordinary income into certain, preferred types of investment income, and by loosening restrictions on the kinds of financial activities that the titans of Wall Street could engage in.

But starting at about the time that Jackson joined Goldman, when Congress began tweaking investment-tax rates, Wall Street started drawing more educated workers. This made the average finance salary go up — from less than $50,000 a year in 1981 (which is about $100,000 in today’s dollars) to more than $350,000 a year in 2012.

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Why Tax Cuts are Disproportionate

Kevin Williamson writes Blue Voodoo in National Review.


 The cartoon version of conservative economic thinking — that we should subsidize gazillionaires in order to create work opportunities for yacht painters, monocle polishers, and truffle graters — is fundamentally at odds with the facts. The supply-siders may have wrong economic ideas, but they do not have those wrong economic ideas. President Ronald Reagan, for example, loved to boast of the number of poor and modestly-off Americans his policies had removed from the federal tax rolls entirely. George W. Bush promised that he’d take the poorest fifth of taxpaying U.S. households off the federal tax rolls; Heritage estimates that he succeeded in doing so for about 10 million low-income households.

One of the perverse consequences of conservatives’ success in lowering the federal income-tax burdens of those on the left half of the earnings bell curve is that we have finally arrived at the point where our critics are partly correct: Most conservative plans for tax cuts at this point in history do disproportionately favor the wealthy and the high-income, for the mathematically unavoidable reason that they pay a steeply disproportionate share of federal income taxes, making it very difficult to design a tax-cut plan that does not disproportionately benefit them. It’s hard to cut taxes without cutting them for the taxpayers.


The more progressive the tax system is the more that the economy is dependent on the wealthy and thus subject to the same volatility. Tax cuts will favor the rich if the lower income have paid no taxes.

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Leveraging Ignorance

John Paulson

The Greatest Trade Ever by Gregory Zuckerman is the story of John Paulson and a handful of other traders who took positions against the mortgage market and made fortunes in a very short period of time.  Their primary method was to buy credit default swaps.  These swaps acted as insurance against the default of mortgage backed bonds, and were sold very cheaply by those who held the mortgage securities in order to spice the yield.

The trade started with the observation that housing prices were a bubble.  Housing had advanced far beyond a trend line and would have to drop 40% or more just to return to the trend line.  They also noted the tremendous growth in subprime mortgages, variable rate mortgages, LIAR loans, interest only loans and other varieties of mortgages that strongly indicated a much weaker ability of borrowers to fulfill their commitments.  In searching for the right tool to profit from shorting the mortgage market these investors stumbled across the credit default swaps.  The market for these swaps was very thin and most of the brokers did not know about them or fully understand them.

At the time John Paulson and other were taking these positions against the mortgage market,  most of Wall Street thought them fools and were too willing to find investors willing to sell swaps on their positions.  Given that housing was constantly rising it seemed like easy money to sell swaps to those who foresaw Armageddon in the housing market.  Major firms like Lehman, Bear Sterns, and almost all of the major names had huge positions in collateralized debt obligations or CDOs; interest bearing securities backed by pools of mortgages.

But very, very few could visualize this house of cards the way Paulson and the other contrarians did, and even fewer still were confident enough in such a contrarian position to make such strong trades, putting a lot of money where their mouth was.

The first to see the opportunity was Michael Burry.  Trained as a doctor, Burry retained an interest in trading and eventually started his own fund, but he had a difficult time attracting traders who both understood his position and had the nerves and patience to endure the trade.

The big Kahuna in the trade was John Paulson who was able to attract investors to two funds and was able to maintain control to ride the trade to its peak.  Paulson’s two funds averaged a gain of 440% in a year that the stock market was up only 3.5%. His firm racked up a profit of $15 billion and his personal take was almost $4 billion.

With the exception of Greg Lippman at Deutsche Bank, these traders were outside the mainstream of investing, unassociated with the big name Wall Street firms. This speaks volumes about the level of group think in the industry even when markets move to extremes.  Well paid analysts sporting sophisticated mathematical models were assuring their investors and the public that the housing market was sound and even if prices stopped climbing that there was very little risk in the market.

Government agency  leaders such as Fed Chief Bernanke, retired Fed Chief Greenspan, and Treasury chief Hank Paulson (no relation to John, at least none was noted in the book) assured the public that nothing drastic was afoot.

When markets move to extreme it often pays to be a contrarian.  But the market did not move precisely timed with their trade. Early in the trade the markets moved against them and their racked up losses.  Even when housing prices declined they could not figure out why the securities derived from mortgages did not drop with the housing market.  Investors in their funds became very nervous, and many headed for the exists. But eventually the thinking proved correct and their bets earned huge returns.

Did these traders contribute to investor losses?  To the extent that firms had to make good in the credit default swaps they chose to sell to Paulson and others, yes.  But the same firms made money on the swaps as they sold them. They just made bad bets.

Seeking more securities to trade in a thinly traded market, Paulson encouraged Goldman to create a CDO with low quality mortgages just so he could short it.  Goldman was held to account for this action, but no charges were brought against Paulson.

While such trades are rare, and those with the nerves and ability to capitalize on them are very, very few, this book is an excellent look at the thinking of contrarians.  While it shows the value of truly independent thinking, it equally shows the danger of blind groupthink that grips our government and financial institutions.

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And Now for the Rest of the Story…

The outcome of the 2008 election centered around the financial collapse that hit just months before the vote.  Even the most committed capitalists were taken by surprise at what seemed like a significant failure of capitalism.  Outrage was magnified as taxpayer dollars were used to bail out Wall Street millionaires.  In the months before the election we had little insight as to what caused this catastrophe.

Three years later we have collected insights from several good books on the subject.  With the clarity of hindsight we see that there was much more than Wall Street greed involved.  This is not to excuse the behavior of the self proclaimed financial masters of the universe who created self acknowledged crappy products as long as they could find suckers somewhere on the planet to buy their crap.  Their hubris rationalized absurd leverage because they bought into the “this time it’s different” mindset that seems to accompany every financial collapse.  They replaced an old school philosophical understanding of risk with a delusional mathematical certainty based on mathematical models that had soon to be realized severe limitations when applied to human action.   It is amazing what people will believe when they get paid outrageous sums.

But this was not enough to explain what happened.  As Thomas Sowell noted, blaming this collapse on greed is like blaming an airplane crash on gravity.  Greed has always been with us; why would it show so strongly at this time?

This excess was fed by the very institutions that claim to protect us.  Rating agencies gave higher ratings than merited because of implied government guarantees. Worldwide investors poured money into this market because because of the high scores from the ratings agencies.  But the center of the implosion was the housing market and this bust was the direct effect of Federal housing policies and the two Macs; Freddie and Fannie.  Wall Street served the political aims of a government that thought everyone should own a home, regardless of whether they could afford it.  To facilitate this objective Freddie and Fannie threw prudent lending out the window.

At The American Peter J. Wallison and Edward Pinto write Why the Left Is Losing the Argument over the Financial Crisis, 12/27/11.


To the extent that we have had any success in challenging the conventional narrative about the causes of the crisis, it is because fair-minded people are persuaded by facts, not invective. Our argument is and has been that the financial crisis would not have occurred but for government housing policy implemented principally through Fannie and Freddie and the Department of Housing and Urban Development (HUD). Although there were a number of such policies, the most important were the affordable housing requirements first imposed on Fannie and Freddie in 1992 and expanded and tightened by HUD through 2007.

All told, after adding the SEC’s new data to our original estimates, there were approximately 28 million subprime and Alt-A loans outstanding on June 30, 2008, before the financial crisis, with a value of approximately $4.8 trillion. This was half of all mortgages in the United States. Of these loans, over 74 percent were on the books of U.S. government agencies and firms subject to government housing finance policies. This shows where the demand for these low quality loans came from. Fannie and Freddie were themselves exposed to more than 13 million subprime or Alt-A loans, or 65 percent of the government total.

HKO further comment:

We are only now beginning to see Washington take responsibility for their role in this crisis.  Any effort, law, or regulation that seeks to either solve this problem or prevent such a crisis from being repeated, that does not acknowledge and address this important factor is doomed to fail.