I went on a shopping trip today to buy a desk for my two youngest children (10, 6), both girls.  As I drove, I listened to radio C-Span, because it is “guilt week” for the NPR stations in the area.  In hindsight, I would have rather listened to the begging from the NPR affiliates than what I heard on C-Span.

The program that I heard was hearings on the financial crisis.  All of the testimony fell into the bucket of “not me, there are evil people who tricked us.”  My daughters must have found my negative commentary to be funny.

We have the government that we deserve.  Congress listens to self-interested loonies, rather than seek out those with intelligence that don’t have an axe to grind.  When I wrote the pieces, Blame Game, and Blame Game, Redux, what I tried to express is that there are a lot of parties to blame in our current crisis, and that everyone should ‘fess up their culpability.

With that, I want to add on a few more responsible parties:

29) FICO srcoring enabled loan underwriting to decouple from the local bank investigating the character of the borrower.  There is something lost when the underwriter does not explore the qualitative aspects of the borrower.

30) The fools who wrote that said that it is easy to make money in stocks or real estate.  They always show up near the end of the cycle.

31) Dojo suggests the Prime Brokers — How about the Prime Brokerage business model followed by most banks and investment banks which allowed their speculative clients to go “nuclear” in any marketplace as long as they had a credit facility and a cell phone. A $10 million hedge fund run out of a basement in Westchester County NY or Orange County CA could control $1 Billion worth of goodies in many cases. Yikes!! A bit severe, but there is some validity there.

32) dlr suggests the FDIC — The bank regulators at the FDIC. It was their JOB to maintain oversight of the banking industry. Every regulator who allowed the banks they were monitoring to giving liar loans, or pick a rate loans, or zero down payment loans, and didn’t call a halt, should be fired for malfeasance. The regulators who had oversight of Washington Mutual and Indy Mac should be fired. And their BOSSES should be fired. Right up to Shiela [sic] Blair. I think that all of the banking regulators deserve blame here, plus the Bush administration, who encouraged malign neglect.

My main point is this: if you are defending your core constituency in this crisis, you are at least partially wrong.  There are so many culpable parties, that few are blameless.

Final note: in many ways, this is a proper comeuppance to US policy that encourages home ownership.  Policy was trying to push home ownership to 70%+, when reality should have said “be happy with a stable 60%.”  Home ownership is not an unmitigated good.  Many cannot truly afford it, and the government tricks them into buying what they cannot afford with reasonable probability.

Just a brief note on corporate bonds.  When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves.  It was a tough time.  But what kind of inversion am I talking about?

Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security.  This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.

The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries.  This indicates moderate worry over the credit risk of the company in question.  (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)

Next is an inverted yield curve, where short term yields are moderately higher than long term yields.  This indicates significant worry over the credit risk of the company.

Finally, there is an inverted dollar (price) curve for the company.  This is where default is viewed as a likelihood.  The prices of the longest-dated bonds reflect current estimated recovery levels after default.  Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)

This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress.  What percentage of the market falls into each bucket?

• Not inverted
• Inverted spread curve
• Inverted yield curve
• Inverted dollar price curve
• In default

The more names in lower categories, the greater the degree of credit stress.  For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies.  (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)

Wait, that’s not quite a close, and not an aside.  That is another way to lookat corporate bonds.  As the implied volatility of the equity gets higher, the more they migrate down the list.  Remember, leaving aside bank loans, usually only stable companies issue corporate debt.  As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.

After reading jck’s piece Securitization: Not Guilty, I said to myself, “well said.” He cited a study that showed that misaligned incentives were more to blame than secutritization itself.  (Academic paper here.)  And he cited this clever piece from the seemingly erstwhile blog Going Private.

Here’s my view.  I have lived through the first era of securitization, and I always thought that the equity/originator got off too easily.  They got their money out of the transaction too quickly, allowing themselves to profit if the deal survived for a while, and then died.  The equity of the deal should take the largest risks, rather than the subordinate certificates (most junior aside from equity).

Here’s my solution.  Require that the deal sponsor and originators retain the full equity piece, and that the size be regulated to make it significant.  Further require that the equity is a zero interest tranche, where the excess interest builds up to protect the subordinate securities.  They get paid last out of any residual cash flows of the deal.  The size of the equity piece might vary from 1% of principal on credit card, auto and stranded cost ABS, to 10% on CDOs.  Note that the equity pieces cannot be traded here, they must be owned by the sponsors or originators.

Now, if the equity only gets paid at the end, several things occur:

• Sponsors/Originators have to be well capitalized.
• They will be a lot more careful about credit selection, and not accept high-interest risky borrowers.
• The subordinate certificates will get paid less interest, but with more certainty.

Does this change the nature of securitization?  Yes, and in a good way.  Securitization is useful, but in its initial phases, it suffered from the equity not having enough at risk.  My proposal solves that.  Put the equity at the back of the cash flow bus, such that the originator never makes a gain on sale, and that part of the financial system will be sound once again.

Ordinarily, when I sit down top blog, I know what I want to write.  That’s not true now.  Yes, I could do a few book reviews.  I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.  If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.  Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).  As jck noted yesterday, this has led to a selloff in Treasuries.  (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.  The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.  Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.  But watch for the discussion of yields and prices (if there is any).  It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.  Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.  This is good for the nation, and we won’t be around for a decade.  You want to be a survivor, right?  You want friendly regulators when we review the levels at which you are marking your illiquid assets?  We thought so.  Sign here.”  (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.  State regulation, particularly when you are a local champion, is much more flexible.  Just ask AIG. )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.  It’s one thing to bolster their balance sheets.  It is another to get them to lend, particularly in the bear phase of the credit cycle.  Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.  Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.  In the UK, it pushes the national debt to GDP ratio to 100%.  As it gets closer to 150%, the international debt markets usually start to choke.  We have traded bank credit risk for national solvency risk at the margin.  Maybe that will be different here, if only government creditworthiness is perceived to be safe.  It is a “new era,” right?

I find it interesting that Barclays is refusing help.  Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.  Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.  The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.  That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.  Also remember that LIBOR has become somewhat of a fiction at present.  There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

• TAF expanded to $900 billion.
• New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.  Terms here.  FAQ here.  This is big, and it is much easier to start such a program than to end it.  It is difficult to end any program where credit is granted on less than commercial terms.  My guess is that it will be extended past its April 30th, 2009 planned expiry date.
• Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
• The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.  In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.  No, we have to delever, and the US Gowernment is included in the list of those that need to delever.  There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.  I would not get overly excited about the rally yesterday.  As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.  The question is whether it will persist.  I was a net seller into the rally toward the end of the day.  I think we have more troubles ahead.  Two things to watch:

• LIBOR, CP yields and the TED spread. (The short end)
• Overall yields of medium-to-long Treasuries and other long-dated debt.  (The long end.)

I expect yields to rise, even if some spread relationships fall.  The added financing needed by the US government is large.  Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.  Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.  We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”  As it is, I am looking for companies with blaance sheets strong enough to survive the worst.  That is my task for the next few days.

Back to the crisis.  I want to be a bull, really.  I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.  I have used that for profit in the past.  I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.  For more, consider the discounts on closed-end funds — they are lower than ever.  Or, consider that the IPO market is closed.  Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.  The yield curve of the US is wide.  Fed policy is accommodative; don’t fight the Fed.  Consider that well-respected value investors like Marty Whitman are finally excited about the market.  Credit spreads are at record highs in the money markets and in the corporate bond markets.  Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.  I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.  I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.  If that is the case, we should see many abnormalities:

• The Treasury has shifted the TARP plan in order to recapitalize banks.  Good move, if late.
• Similar things are afoot in the UK and Germany.
• Many European banks are in trouble.

This is a global crisis, affecting most governments and firms.   Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.   I can dig up the references at RealMoney if necessary.  Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?  If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

When I write, I don’t always know what will be popular, and what won’t.  Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.  Well, perhaps no surprise, the crisis has the attention of all of us.  I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.  Let me expand on them:

21) The Rating Agencies — that was a popular choice.  Yes, the rating agencies messed up.  They always do.  Their job is an impossible one.  Should they be proactive or reactive?  Should they rate over the cycle, or be instantaneous?  Should they care about systemic risk issues?

Where they did err?  They competed for business, leading underwriting standards lower in structured finance.  They overrated the financial guarantors, who were their major clients.  Away from that, they made mistakes, but every firm offereing opinions makes mistakes.  I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add - the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.  That encouraged diminished underwriting standards.

23) Investment banks.  They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.  They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives…

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.  Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.  It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.  They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.  Hedge funds are weak holding structures for assets.  In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.  They were relentless cheerleaders for the bull markets in stock and housing.  This isn’t a compliment, but financial radio makes CNBC sound cautious.  FInancial radio seems to be a home for hucksters.

And, that’s all for now.  If you have more parties to blame, feel free to respond.  One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.  There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.  In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.  High quality short-term debt does wonders to reduce the volatility of results.  Other hedges are less certain.  Nothing beats cash, even when money market funds are open to question.

Some people don’t like the concept of blame.  They view it as useless because it wastes time in looking for a solution.  I will tell you differently.  Blame is useful because it identifies offenders, which is the first step in eliminating the problem.  The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.  This was a good discussion, unlike many that I hear.  But the discussion (on NPR) eventually focused on “who should we blame?”  Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.  For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.  Rates were reduced before significant pain was felt by those who had borrowed too much.  The 1% Fed funds rate in 2003 was the pinnacle of that effort.  It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.  Gotta do that.  Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.  They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.  The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.  Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.  I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.  There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.  Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).  In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.  Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.  Hucksters.

3) Lenders steered borrowers to bad loans.  There was often implicit fraud, and in some cases, fraud.  The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.  What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?  Regardless of the housing price mania, you should have gone slower, and done more homework.  Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.  They just sold it away.  Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.  They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.  Many hoped to make money after joining private industry later.

12) America.  We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.  This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.  Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.  As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.  In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.  It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.  Capitalistic economies are unstable by nature!  Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.  Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.  Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.  It is hard to write about what could go wrong in the markets.  Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.  The system is biased in favor of happy talk.  Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.  Maybe our financial interests made us look like we were talking our books.  I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.  Now I am getting my just desserts.

This is an incomplete list.  I invite you to add others to the list in your comments.

Let’s take a short break from “all credit crisis, all the time.”  I want to talk about an issue that troubles us in a number of ways.  The legal doctrine of “insurable interest” [II] is critical to the life insurance industry.  II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person.  The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.

This protection exists for several reasons:

• Insurance exists to reduce risk, not promote gambling.
• The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured.  Absent that, the IRS will eliminate those favors.
• We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person.  Even though murder by the policyholder would invalidate the claim, that can be hard to catch.

Now, those who know me as a life actuary know where I am going next.  I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like.  Good guess; I’ve written about those before.  I’ve turned down job offers in that area for ethical reasons.  You only get one reputation in the business, so you better guard it carefully.

But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed.  I’m going to write about credit default swaps.

Wait.  What do credit default swaps have to do with insurable interest?  Legally, nothing at present.  This article will suggest that there should be a link.

Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm.  Corporations are corporate persons under the legal code.  Should they not get the same protection?

Credit default swaps pay off when a corporation “dies.”  I know there are additional complexities here, but play along with me for now.  There are parties that get hurt when a corporation dies:

• Suppliers
• Employees
• Sponsored pension funds
• Debt/loan holders
• Stockholders
• And maybe more…

They have an insurable interest in the continued well-being of the corporation.  They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more.  Any excess exposure is gambling, not insurance, and should be forbidden by law.

Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds.  Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.

Now, if you see my logic, forward this article to your Senators and Congressmen.  Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.

At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.

As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.  I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”  For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.  Why might a company do that?  Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.  Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.  As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.  The agents will write all that they can.  One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.  Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.  Credit triggers are designed to deal with small issues, not large ones.  Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.  But where have we seen this before?

• Life Insurers with fixed rate GICs (early 90s)
• Life Insurers with floating rate GICs (late 90s)
• Utilities in the early 2000s (think Enron-like structures)
• P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.  Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.  Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.  Normal companies stay away from the cliff.  Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.  Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.  Now we suffer for it, while bad debts get liquidated, or inflated away.

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.  Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.  That’s an estimate on my part.  Why does balance sheet quality at the Fed matter?  If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.  Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”  I know Tyler and de Tocqueville said something like that as well.  At a time like this there are a lot of demands on the public treasury, and they are growing:

• U.S. May Help Private Funds To Purchase Troubled Assets
• Fed Will Lend Directly to Corporations

There is a trouble here.  In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?  This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.  As in the Great Depression, there was too much debt financing of assets.  The debt was more liquid than the assets, as well.  Borrow short, lend long.  Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).  Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.  That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

• Inflation when the Fed monetizes the debt,
• Depression from vastly increased taxes,
• Debt repudiation (whether internal, external, or both), or
• Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)  No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.  Trouble is, we don’t internally fund our debts.  At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.  Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.  Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.  Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.  There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.  My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”  The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.  I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.  Yeah, the pain’s gotta go someplace