This short post will in no way suffice to communicate the high regard I have for Anna Schwartz. She is a true modern-day American hero.
It is a rare treat for her to make public comments, so I am especially pleased to point out two recent appearances:
Legendary economist Anna Schwartz says the feds have misjudged the financial crisis.
3rd Hour Special Edition with Eric King & Guests
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Dr. Anna Schwartz, Economist
Dear Mr President,
It is almost unfair to criticize you given the extraordinary circumstances surrounding this country when you took the oath of office. Time was a precious commodity and you were forced to make urgent decisions. To be clear, I cannot think of anyone else I would rather have at the helm now than you. Choosing generals was job number one and, for the most part, you did a fantastic job.
However, we clearly find ourselves in a severe financial crisis that, due to improper handling and an initial failure to recognize the scope of the problem, has mutated into a full blown economic crisis. Continued failure to right the ship is increasing the chances of a total global economic and social breakdown. In 2007, Bernanke and Paulson’s assurances that the subprime mortgage crisis would be contained only served to illustrate their complete lack of understanding of the circumstances. The crisis was no more about subprime mortgages than an influenza outbreak is about runny noses.
People smarter than me will tell you that a large contributor to economic growth over the last 10 years (some would say 20) was fueled by increasing levels of debt. Debt came to pervade every aspect of developed economies from consumers, to corporations and financial institutions, all the way up to local and federal governments. This debt came in the form of credit cards, auto loans, school loans, residential mortgages, commercial real estate loans, corporate bonds, municipal bonds as well as Treasury bills, notes, and bonds.
Scholars will debate the true causes for decades, but let me offer this as a plausible explanation. Pension funds, endowments, and trusts have financial obligations that are met by targeting a given level of return on investments made over a period of time. When the Federal Reserve, in conjunction with global counterparts, brought interests rates below 4% in 2001, these pension funds, endowments, and trusts found it increasingly difficult to meet their obligations. This forced them to move away from traditional safe investments such as Treasury bonds and into other investments that appeared safe, yet paid higher rates of return. In fact, many investors were restricted to securities that were christened the coveted AAA rating from ratings agencies such as Moodys, S&P, and Fitch.
The investment instrument that many of these funds turned to was something called a collateralized debt obligation (CDO). There are many fantastic explanations of CDOs around the web, e.g. see This American Life for mortgage CDOs. Think of a CDO as a bunch of debt sources (some listed above) whose interest payments are pooled together into a cashflow waterfall. The advantage of having a pool is that it is less susceptible to borrowers not making payments. For example, if you gave one person a loan and you depended on them making their interest payments so that you could pay your own bills, you’d be in trouble if they stopped paying. But if you were receiving interest payments from 1,000 loans, the impact of single borrower stopping payments is less severe.
A CDO goes one step further. A CDO takes this waterfall and redistributes the cashflows in a way very much reminiscent of the champagne tower. As long as some borrowers continue to make interest payments, the top champagne glass is likely to always be full. Ratings agencies then published models that attempted to assess the risk that the top glass may run dry in order to facilitate the design of these pools. The goal was to achieve a AAA rating on that top champagne glass so that the banks could sell them (the cashflows, not the loans) to pension funds, endowments, and trusts that were starving for safe investments that paid more than traditional safe investments rendered unattractive by the Federal Reserve and the Treasury Department.
This was a boon for the ratings agencies because they charge fees to rate securities. If a bank owned a bunch of loans and wanted to get them off their balance sheets to free up capital, they’d structure them into a CDO, plug a few parameters into the ratings model, and essentially pay the ratings agency to christen the top champagne glass AAA. In some cases, the loans in the pool were so risky that even the top champagne glass was not sound enough to warrant a AAA rating. In such cases, the insurance companies were happy to step in, and for a fee, would guarantee that the top glass always remained full.
Now, Mr President, I understand that you are already familiar with CDOs. Nevertheless, I hope this short description was helpful because it sets the stage for what I need to say next. Statements by Bernanke, Paulson, and now Geithner have focused on the mortgage market because that was the first symptom to appear. If the problems were confined to mortgages, Geithner’s plan might have a chance to succeed. Unfortunately, the scope of the problem is more accurately described as a global epidemic infecting all forms of debt. Banks have been pooling together every form of debt imaginable and constructing CDOs from the interest payments. There are CDOs of auto loans. There are CDOs of school loans. There are CDOs of residential mortgages. There are CDOs of commercial real estate loans. There are CDOs of corporates bonds. There are CDOs of municipal bonds. There are even CDOs of other CDOs.
I’m sorry Mr President, but you do not have enough money to back stop all of these legacy assets. Drastic measures are needed and they are needed now. As incomprehensible as it may sound, I believe that you should consider using your Executive power to declare a national emergency. Seize the investment banks and give a blanket guarantee on existing bank deposits to avoid bank runs, while setting rates on new deposits close to zero to avoid draining foreign capital from other struggling countries. Halt the issuance of new CDOs. Impose a temporary 90% tax on all income in excess of $1,000,000.00 to temporarily reduce the need to raise funds from foreign central banks who are dealing with their own problems. Transfer all outstanding credit derivatives to an exchange and enforce punitive taxation on over-the-counter (OTC) derivatives transactions to encourage the swift migration to transparent exchanges, while offering substantive tax incentives for financial institutions who can demonstrate they have completely migrated and no longer participate in the opaque OTC derivatives market.
Your advisors will surely tell you that the OTC market should not be demonized and serves an important role in the market place. I say they are wrong and you should be looking for ideas outside of the establishment. I would be glad to argue my case for any of these proposals on a point by point basis. I would not suggest such radical measures if anyone other than you were in office. Your knowledge and personal conviction in the sanctity of the United States Constitution places you in a unique position to be able to make it work without destroying the foundations of this country.
Many people in the United States are not happy. Some are outraged. Some are confused. Personally, I am outraged by what is going on at the Federal Reserve, The Treasury Department, and on Wall Street and am determined to educate anyone who will listen to me. I hope that includes you. However, the general outrage has not reached critical mass yet. It is not too late to correct course. I am writing these letters because I am still audacious enough to have Hope in your ability to steer this country back to prosperity for all Americans, not just Wall Street cronies living in their echo chambers.
Despite progress you may be making on other fronts, you will ultimately be judged by how well you manage the economic crisis. You’ve chosen your generals and have placed your trust in them. It is time you consider that perhaps you have made a mistake. Geithner and Bernanke are not up to the problems that face them. It is not too late to change course. Listen to Krugman. Listen to Volcker. Listen to Roubini. They are capable and willing to help, but so far you have turned a def ear to them.
The last time public outrage began to overflow was in the 1960’s and 1970’s during the Vietnam War. At that time, many people found their voice in music. I want to leave you by pointing to an example of what makes this country great. Jonathan Mann is an amazingly talented writer and musician who, like me and millions others, have the audacity to continue to have Hope. But, as I said in an earlier letter, the only thing more audacious than the audacity of Hope would be the audacity of squandering that Hope. In this song, Jonathan powerfully communicates the internal struggle many of us feel as we hang on to our remaining strands of Hope:
How can you recognize a hero when you see one? Do they glow from within on the battlefield? Do rays of sunlight shine on them from every angle as they stand on the hilltop? Sometimes heros are not obviously recognized as heros until after the smoke has settled and the history books are being written. When the history books are written about this chapter in American history, many of the heros will turn out to be bloggers. The late Tanta of Calculated Risk was surely a hero. At this moment in time, the person for whom the clouds have parted and the sun is shining would be Yves Smith of Naked Capitalism.
Her sharp, crisp, no-nonsense analysis is inspiring. President Obama would do well by paying close attention to what she has to say, but sadly, the chance of that happening is not looking very good. Despite operating a White House Blog and being more in touch with technology than any prior president, his comments recently in The New York Times display a somewhat surprising closed mindedness:
Part of the reason we don’t spend a lot of time looking at blogs is because if you haven’t looked at it very carefully, then you may be under the impression that somehow there’s a clean answer one way or another — well, you just nationalize all the banks, or you just leave them alone and they’ll be fine.
I beg to differ. Bloggers such as Yves Smith, (Tanta), Barry Ritholz, Brad Setser, among others spend(spent) a lot of time thinking about the issues that we face today. To ignore them is to ignore some of the finest, not to mention crucial, analysis available.
Lately Yves Smith has been on fire. I hope that Timothy Geithner reads Naked Capitalism
Not only is Yves spot on, she also does a fine job with guest posts. Here are some recent gems:
We need more heros like Yves. I learned long ago that I am no hero, but I will do the best I can to highlight those that should be recognized sooner rather than later for what they are: modern-day American heros.