A Tale Of 5 Memos


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A crisis of political economy, a game changing crisis of legitimacy , policy imbalance,crony capitalism and corruption of thoughts

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A Tale Of 5 Memos

  1. 1. Shamik’s Memo :-Socialising and distributing the debt being created via tax payer money funded bailouts when wealthcreation is privatized and this wealth was created in free, take all, environment is a moral hazard. Thisinvites nay underwrites large scale violation of trust and reflects duplicity of epic proportions. Thefailure of credit markets has been bought about due to a failure of confidence, trust, credibility in thefinancial value chain.That is a failure of ratings agencies, regulatory supervision, risk management and in combination withpoor lending decision, poor government involvement and potentially large scale fraud and deceptioninside large financial institutions.A bank leveraged 30: 1 ie. for a 20 billion dollar balance sheet has a 600 billion dollar trade book inmortgages and derivatives is gambling with stock owners money and its employees jobs and future. Ifsuch an institution < Bear Sterns and or Lehman Brothers > fails the govt. cannot make that wholeagain with tax payer funds That is equivalent to a financial band aid and it will not solve the primarycause for the problem. Bad risky behaviour, greedy trading, no risk control ie. poor management.If a government does make such behaviour acceptable via bailouts ( citing that the bank is too big toofail – Wachovia in USA or RBS in UK then that is repeating 1950-70’s India’s fabian socialism sobeloved of Nehru and the subsequent government policy of Indira Gandhi. Those policies createdwidespread corruption, expansion of civil service ( the license, quota permit Raj )and wasted enormousamounts of tax payer funds over 4 – 5 decades in state owned monopolies which went nowhere fast andbecame bastions of patronage and inept performance.This is also not mercantile capitalism and free market global finance that anglo saxon model led byAmericans have been preaching to the world for so long.Shamik BhoseCalcutta dec’ 2008Part 1 ; A Memo Found In The StreetFrom: Wall Street to Washington D.C. Ref : Credit CrisisDear D.C.,Wow, weve made quite a mess of things here on Wall Street: Fannie and Freddie in conservatorship,investment banks in the tank, AIG nationalized. Thanks for sending us your new trillion-dollar bailout.We on Wall Street feel somewhat compelled to take at least some responsibility. We used excessiveleverage, failed to maintain adequate capital, engaged in reckless speculation, created new complexderivatives. We focused on short-term profits at the expense of sustainability.We not only undermined our own firms, we destabilized the financial sector and roiled the globaleconomy, to boot. And we got huge bonuses.But heres a news flash for you, D.C.: We could not have done it without you.We may be drunks, butyou were our enablers: Your legislative, executive, and administrative decisions made possible all that
  2. 2. we did. Our recklessness would not have reached its soaring heights but for your governmentalincompetence. This memo provides a brief history of your actions that helped create this crisis.1997: Federal Reserve Chairman Alan Greenspans famous "irrational exuberance" speech in 1996 wassomehow ignored by, um, Fed Chairman Greenspan.The Fed missed the opportunity to change marginrequirements. Had the Fed acted, the bubble would not have inflated as much, and the subsequentcrash would not have been as severe.1998: Long Term Capital Management was undercapitalized, used enormous amounts of leverage topurchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of theFederal Reserve a "private-sector" rescue plan was cobbled together. Had these bankers suffered biglosses from LTCM, they might have thought twice before jumping into the exact same business model ofundercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed BenjaminDisraelis famous aphorism: "What we learn from history is that we do not learn from history."1999: The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated thecommercial-banking industry from Wall Street, and the two industries, plus insurance, came togetheragain. Banks became bigger, clumsier, and hard to manage. Apparently, risk-management became allbut impossible, even as banks had greater access to larger pools of capital.2000: The Commodities Futures Modernization Act defined financial commodities such as "interestrates, currency prices, and stock indexes" as "excluded commodities." They could trade off the futuresexchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither theSecurities and Exchange Commission, nor the Federal Reserve, nor any state insurance regulators hadthe ability to supervise or regulate the writing of credit-default swaps by hedge funds, investment banksor insurance companies.2001-03: Alan Greenspans Fed dropped federal-fund rates to 1%. Lulled into a false belief thatinflation was not a problem, the Fed then kept rates at 1% for more than an year. This set off aninflationary spiral in housing, and a desperate hunt for yield by fixed-income managers.2003-07: The Federal Reserve failed to use its supervisory and regulatory authority over banks,mortgage underwriters and other lenders, who abandoned such standards as employment history,income, down payments, credit rating, assets, property loan-to-value ratio and debt-servicing ability.The borrowers ability to repay these mortgages was replaced with the lenders ability to securitize andrepackage them.2004: The SEC waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to amaximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leveragerule. Only five firms -- Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and MorganStanley -- were granted this exemption; they promptly levered up 20, 30 and even 40 to 1. 2005-07: Unscrupulous home appraisers found that they could attract more business by inflatingappraisals. Intrinsic value was ignored, so referrals kept coming in. This helped borrowers obtainfinancing at prices that were increasingly unsupportable. When honest appraisers petitioned bothCongress and the bureaucracy to intervene in the widespread fraud, neither branch of governmentacted. Theres actually a lot more we could add to these items. We could mention impotent supervisionof Fannie and Freddie by the Office of Federal Housing Enterprise Oversight; the negligent oversight onratings agencies; the Boskin Commissions monkeying around with how inflation gets measured; the"Greenspan Put," etc. We could mention former Fed Governor Edward Gramlich, who warned about makinghome loans to people who could not afford them, and who said the runaway subprime-mortgageindustry would create problems in housing and the credit markets. But Gramlich was up against a Fedchairman who apparently believed that markets can regulate themselves. (Gramlich died last year, threemonths after the housing bubble started to deflate.)
  3. 3. We on Wall Street do not deny our part. We created these securities, we rated them triple-A, we traded them without understanding them. Now that they have gone bad, we are real close to getting the rest of the country to take them off our hands. Thanks, D.C. None of this would have been possible without you. Very truly yours, Wall Street In Financial Food Chains, Little Guys Can’t Win By BEN STEIN Published: September 27, 2008IMAGINE, if you will, that a man who had much to do with creating the present credit crisis now says he isthe man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so ofyour money. Then add that this man thinks he is so indispensable that he wants Congress to forbid anyjudicial or administrative questioning of anything he does with your money. Related you might think of alatter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of TreasurySecretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.But I am getting ahead of myself.First, I am furious at what the traders, speculators, hedge funds and the government have done to everyonewho is saving and investing for retirement and future security. Millions of us did nothing wrong, according tothe accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as wewere urged to do. Because the market wasn’t at ridiculously high levels, it seemed prudent to invest in broadindexes, foreign indexes and small- and large-cap indexes.Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The“earnings” part of those price-to-earnings ratios turns out to have been fiction for some financial companies,which normally account for a big part of total corporate earnings. In fact, earnings of giant finance playerswere often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregateearnings of the Dow 30 were negative. The current negativity occurred because of wild, casino-type operationsof big finance players, creating liabilities way beyond anything we could have reasonably expected. This looksa lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.Second, according to what I hear from my betters in the world of finance, the most serious problems are notwith the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell —but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially anattempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are animmense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
  4. 4. These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly$62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprimemortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E.Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is nowinvesting in Goldman Sachs.)The swaps market has been unregulated. It has been just a lot of people making bets with one another. Someof them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps astheir wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were bigenough to cripple the part of Wall Street on the losing side of the bets.Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let’s get back to the man ofthe hour. Why didn’t Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, animmense player in the swaps world. Didn’t people at Treasury have a clue? If they didn’t, what was going onin their heads? If they did, why didn’t they do something about it a year ago, when saving the world wouldhave been a lot cheaper?If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn’t see this train coming, whatelse have they missed? What other freight train is barreling down the track at us? All of this would be badenough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulsondemanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout.This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct andabove the law, but so would the actions of his pals in the banking world in connection with this bailout.The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace ofmind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy SystemFund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared considerthis plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning thisshocking request.By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annulthese credit-default swap contracts? With that done, the incomprehensibly large liability of the banks wouldcease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay someof the price?WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be theside bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over.Maybe we should just get rid of these exotic bets and start again without them. “Insurance” on market movesis always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them— as in the disastrous effect of “portfolio insurance” in the 1987 crash.Then there was Mr. Paulson’s insistence that there be no compensation caps for executives of companiesbeing bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told askeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn’tparticipate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape
  5. 5. so that petulant executives can simply opt out rather than live on a few million a year, maybe we don’t needthe bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced bypeople with more sense and more patriotism.One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but ofhomeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilizethe markets, stabilize the debt associated with the markets and take the gain out of the credit-default swapsfor the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson’s plan for buying debt frombanks. Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasurysecretaries don’t know any of those people. Memo 3 & 4 ; The price of salvation; by Simon Johnson and James Kwak The government plans to bail out the banking sector by buying up to $700bn (for now) of "impaired assets" … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay "fair market value", which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a "fire sale" and proposed paying "hold-to- maturity" prices. But what does this mean? There are five different prices that the government theoretically might pay for an MBS: P1. The par value of the security (largely irrelevant at this point). P2. The current book value on the holders balance sheet: because of the accounting rules for banks, and because banks today have a strong incentive to overvalue these assets, these book values may be artificially high. P3. Fair market value (FMV) in a market free of government intervention: Until September 17, this was set by actual transactions between buyers and sellers, such as Merrill Lynchs sale in July at 22 cents on the dollar. However, for most securities it was impossible to determine the FMV, because there were few comparable transactions. P4. FMV with government intervention: Since the bailout was announced, the prices of MBS have drifted upward, on the assumption that the government has an incentive to pay artificially high prices (the point of the bailout being to pay prices high enough to ensure banks solvency). P5. Model value: The people who buy MBS on behalf of the government will use their own models of long-term cash flows to estimate their value. The banks would like to get P2, since that would leave their capital levels where they are, but this amounts to paying whatever price the banks have decided their assets are worth, which is obviously foolish. An ordinary fund manager would pay P3, but if that were the entire transaction, it would defeat
  6. 6. the purpose of the bailout; banks could sell at P3 today, but cannot absorb the collateral damage totheir balance sheets. As Bernanke acknowledged in Tuesdays Congressional testimony, the plan is topay more than current market prices, which is another way of saying that Treasury will be overpaying tosave the banks.Bernankes comments can be interpreted in two ways. He could be saying the governments liquidity andcapacity to bear risk will create a new market equilibrium, and that Treasury will pay the new marketprice (P4). Alternatively, his "hold-to-maturity" price could be the output of a long-term cash flow model(P5). The two are not necessarily exclusive.But either possibility raises problems. First, the valuation models that produce hold-to-maturity pricesare highly sensitive to their assumptions, and can be used to justify virtually any price, removing anyconstraints on overpayment. Second, in either case it will be impossible to determine P3, the priceabsent government intervention, and hence the real amount of overpayment - making it impossible toknow how much wealth has been transferred from taxpayers to banks. Third, what if neither P4 nor P5is high enough to ensure bank solvency? In that case the bailout would fail to accomplish its mostimportant task: to recapitalize the banks.But there is another solution. Given the need to (a) take these "toxic" assets off the hands of the banksand (b) make sure that they get more money than they would get on the open market, the answer is toseparate the two parts of the transaction. In the first step, Treasury would pay FMV for the securities; inthe second step, after assessing the banks resulting condition, Treasury would do a capital injection bybuying newly issued preferred shares. In order to determine FMV in the first step for a given tranche ofsecurities, a portion of the debt could be auctioned to the private sector. Any debt bought by the privatesector will have no further recourse to the government, i.e., it is "bailout free". Properly designed, thisauction will indicate P3, the fair market value in a free market. The government would then acquire thesecurities not bought by the private sector, at the price established in the auction. With their MBS gone,it will be easier to assess banks solvency and determine the appropriate terms for a governmentrecapitalization.By explicitly identifying the FMV of the assets and distinguishing the asset purchase from the capitalinjection, this mechanism provides transparency to the operations of the proposed fund and limits therisk of overpayment. More fundamentally, it provides the much-needed assurance that the overall planis fair to the American taxpayer and not simply a handout to the banking sector.Simon Johnson, former chief economist at the International Monetary Fund, is a professor at the SloanSchool of Management, MIT, and a senior fellow at the Peterson Institute for International Economics.James Kwak is a student at Yale Law School. Bernanke Is the Best Stimulus Right Now as a zero interest rate isnt the last weapon in the Fed arsenal.
  7. 7. ByROBERT E. LUCAS JR.The Federal Reserves lowering of interest rates last Tuesday was welcome, but it was alsoreceived with skepticism. Once the federal-funds rate is reduced to zero, or near zero,doesnt this mean that monetary policy has gone as far as it can go? This widely held viewwas appealed to in the 19303 to rationalize the Feds passive role as the U.S. economyslid into deep depression.It was used again by the Bank of Japan to rationalize its unwillingness to counteract thedeflation and recession of the 19905. In both cases, constructive monetary policies werein fact available but remained unused. Fed Chairman Ben Bernankes statement lastTuesday made it clear that he does not share this view and intends to continue to takeactions to stimulate spending.There should be no mystery about what he has in mind. Over the past four months theFed has put more than $600 billion of new reserves into the private sector, using them todiscount — lend against ~ a wide variety of securities held by a variety of financialinstitutions. (The addition is to be weighed against September 2007*5 total outstandinglevel of reserves of about $50 billion.)This action has been the boldest exercise of the Feds lender-of-last-resort function in thehistory of the Federal Reserve System. Mr. Bernanke said that he is prepared to continueor expand this discounting activity as long as the situation dictates.Why do I describe this as an action to stimulate spending? Financial markets are in thegrip of a "flight to quality" that is very much analogous to the "flight to currency" thatcrippled the economy in the 19305. Everyone wants to get into government-issued andgovernment-insured assets, for reasons of both liquidity and safety. Individuals have triedto do this by selling other securities, but without an increase in the supply of "quality"securities these attempts do nothing but drive down the prices of other assets. The onlyother action people can take as individuals is to build up their stock of cash andgovernment-issued claims to cash by reducing spending. This reduction is a main factorin inducing or worsening the recession.Adding directly to reserves — the ultimate liquid, safe asset — adds to supply of "quality"and relieves the perceived need to reduce spending.When the Fed wants to stimulatespending in normal times, it uses reserves to buy Treasury bills in the federal-fundsmarket, reducing the funds rate. But as the rate nears zero, Treasury bills becomeequivalent to cash, and such open-market operations have no more effect than trading a$20 bill for two $ios. There is no effect on the total supply of "quality" assets.A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves — or"printing money" — to buy securities other than Treasury bills. This is the way the $600billion got out into the private sector.
  8. 8. This expansion of Fed lending has not violated the constraint that "the" interest ratecannot be less than zero, nor will it do so in the future. There are thousands of differentinterest rates out there and the yield differences among them have grown dramatically inrecent months. The yield on short-term governments is now about the same as the yieldon cash: zero. But the spreads between governments and privately-issued bonds are largeat all maturities. The flight to quality means exactly that many are eager to trade privatepaper for non-interest bearing (or low-interest bearing) reserves and with the Feds helpthey are doing so every day.Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed islending on terms that private banks are not willing to offer. They are not searching forunder-priced "bargains" on behalf of the public, nor is it their mission to do so. Theirmission is to provide liquidity to the system by acting as lender-of-last-resort. We dontcare about the quality of the assets the Fed acquires in doing this. We care about thequantity of its liabilities.There are many ways to stimulate spending, and many of these methods are now underserious consideration. How could it be otherwise? But monetary policy as Mr. Bernankeimplements it has been the most helpful counter-recession action taken to date, in myopinion, and it will continue to have many advantages in future months. It is fast andflexible. There is no other way that so much cash could have been put into the system asfast as this $600 billion was, and if necessary it can be taken out just as quickly. Thecash comes in the form of loans. It entails no new government enterprises, no governmentequity positions in private enterprises, no price fixing or other controls on the operation ofindividual businesses, and no government role in the allocation of capital across differentactivities. These seem to me important virtues.Mr. Lucas, a professor of economics at the University of Chicago, received the NobelPrize in Economic Sciences in 1995.