Milton Friedman on Hayek

Perception: Milton Friedman was a conservative.

Reality: Friedman, and Hayek, saw themselves as radical in attacking the root of the problem [socialism].

Tyler Cowen from Marginal Revolution recommended this C-SPAN Book TV video from 1994 featuring Milton Friedman being interviewed by Brian Lamb about the 50th anniversary release of Hayek's book The Road to Serfdom. At the 50:30 mark, when asked about Kenneth Galbraith, Friedman explains beautifully about the difference between socialism and freedom and why he is no conservative, as we now -- now being the latter half of the 20th century, hey the dude was born in 1912 -- define it. So while someone like Friedman would probably have issues with the particulars of specific Tea Party proposals, I believe he would have supported the movement itself.

How good was Milton Friedman? He's been dead for 5 years and the hyper-partisan Paul Krugman is still afraid to cross him.

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David Friedman on Stockholders vs Stakeholders

David Friedman weighs on on an interesting issue; Should stakeholders [all people affected by the corporation's decisions] be given more protection or a bigger say in how corporations are managed?

First a Friedman primer on what incentive issues exist in how corporations operate today:

The holder of a share of stock, like an individual voter, knows that his vote is very unlikely to change the outcome and so has little incentive to spend time and energy judging how well the firm is being run in order to exercise his voting power. But votes in the corporate context, unlike votes in the political context, are transferable; each is attached to a share of stock, and shares can be bought and sold. If a corporation is doing a sufficiently bad job of maximizing stockholder value, someone with the necessary assets and expertise can buy up lots of shares at a price reflecting the current performance of the corporation. Since owning lots of shares gives you lots of votes, he can then, perhaps in alliance with other large shareholders, vote out the board, replace management and, when it becomes clear to others that the firm is now doing better for its stockholders, sell his shares at a higher price and go looking for another badly run firm to buy stock in. Takeover bids generally get a bad press, possibly due to the efforts of incumbent managers who would prefer not to be replaced, but they provide people running corporations with an incentive not to deviate too far from doing what, in theory, they are supposed to do.

Friedman on why stockholders need greater protection than shareholders:

But my situation as customer and employee is very much better in this respect than my situation as a stockholder. It is true that, as a stockholder, I have the option of selling my shares of stock, which at first glance looks rather like my option as a consumer of not buying a product or as a worker of quitting a job. But the apparent similarity is an illusion.

If I choose not to spend twenty thousand dollars buying a car from Ford, Ford has one more unsold car and twenty thousand dollars less money. If I choose to sell twenty thousand dollars of Ford stock, on the other hand, the money I get is not coming at Ford's expense. Another investor has paid me the money and now owns the stock, leaving Ford itself unaffected. From the standpoint of the firm's incentives, it is as if, every time a customer wished to stop buying from a store, he was required to first find a new customer willing to take his place, or as if an employee could only quit if he provided a replacement willing to do the same job at the same pay.

The stockholder's view of the value of the stock directly affects the firm only if the firm wishes to raise capital by selling a new issue of stock. So far as existing stock is concerned, the shareholder is locked in, even if the fact is not immediately obvious. If the firm is being run in a way that fails to maximize stockholder value, he cannot escape that cost by selling his share, since the price he can sell it for will reflect the reduction in future profits and dividends, insofar as it can be estimated by other stockholders.

It follows that stockholders, unlike customers and employees, receive no direct protection from the market on which they deal with the firm. As a customer of Apple, I am to some limited degree locked in; I can switch to hardware and software from another firm, but only at a significant cost. The same is true of my situation as an employee of Santa Clara University. In both cases, I have born what are now sunk costs as a result of my initial decision to buy a product or accept a job. But as a stockholder in Apple, I am entirely locked in; all of my cost is sunk. If Steve Jobs announces tomorrow that he plans to run Apple entirely for the benefit of its employees and customers, never paying another dividend, the fact that I can respond by selling my stock provides me no protection.

It follows that the stockholder is dependent, very much more than the other stakeholders, on other mechanisms for controlling a firm to make it act in his interest. That is a strong argument in favor of the current mechanism for corporate control and the current legal rules defining the fiduciary obligation of the directors.

The complete Friedman post from his blog is copied in full at end of post.

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David Friedman
Tuesday, November 03, 2009
Controlling Corporations: Stockholders vs Stakeholders

In theory, private corporations are run for the benefit of their stockholders. Insofar as the theory is enforced in practice, it is through two different mechanisms. One is the fiduciary obligation of corporate directors, the fact that they are legally obliged to run the firm in the interest of its stockholders. How much effect that obligation has is not clear, given the obvious difficulties with having a court second guess the decisions of the firm. The second and more important mechanism is the fact that the board of directors, which has the power to hire and fire management, is itself elected by a vote of the stockholders. If holders of a majority of the shares are unhappy with how the corporation is being run, they can replace the existing board, and so the existing management, with people who will run it more nearly as they wish.

This mechanism, like democratic voting in the political arena, faces an obvious problem; the holder of a share of stock, like an individual voter, knows that his vote is very unlikely to change the outcome and so has little incentive to spend time and energy judging how well the firm is being run in order to exercise his voting power. But votes in the corporate context, unlike votes in the political context, are transferable; each is attached to a share of stock, and shares can be bought and sold. If a corporation is doing a sufficiently bad job of maximizing stockholder value, someone with the necessary assets and expertise can buy up lots of shares at a price reflecting the current performance of the corporation. Since owning lots of shares gives you lots of votes, he can then, perhaps in alliance with other large shareholders, vote out the board, replace management and, when it becomes clear to others that the firm is now doing better for its stockholders, sell his shares at a higher price and go looking for another badly run firm to buy stock in. Takeover bids generally get a bad press, possibly due to the efforts of incumbent managers who would prefer not to be replaced, but they provide people running corporations with an incentive not to deviate too far from doing what, in theory, they are supposed to do.

Some people—including a colleague of mine whose recent work inspired this essay—argue that the theory itself is wrong. Decisions made by a corporation affect not only the stockholders but other people as well, most obviously its customers and employees. Why not alter the legal rules in ways designed to give all "stakeholders," all people affected by the corporation's decisions, a voice—either by altering the legal rules to broaden the fiduciary obligation of directors or by changing the rules on how directors are chosen to give (at least) customers and employees some votes as well?

There are a number of problems with the argument; in this post I will focus on one of them.

Corporations are constrained in at least three different ways. Two of them are the legal obligations of the directors and the mechanisms for electing them. The third constraint is the market on which a corporation sells its outputs and buys its inputs. A customer who finds that the corporation is not serving his interests, that its products are more expensive or less desirable than those offered by competitors, does not have to intervene in the internal affairs of the corporation in order to solve the problem. He can simply stop buying what the corporation is selling. An employee who finds that the corporation is offering less money for a less attractive job than alternative employers can quit. Since the corporation requires customers to provide the money with which it pays dividends to its stockholders and salaries and bonuses to its management, and requires employees to produce the goods and services that it sells to those customers, it has a direct and immediate incentive to produce what customers want to buy and provide employment terms that employees are willing to accept.

Like most mechanisms, this one is imperfect. Customers are not perfectly informed about what they are getting or the alternatives, and some customers for some goods and services are to some degree locked in by previous choices. Having spent time and effort learning to use the hardware and software on which I am writing this, I would be willing to switch only if the quality went down quite a lot or the price up quite a lot, so the firms providing the hardware and software have some ability to benefit themselves at my expense without losing my business. Having accepted my current job, there would be significant costs to shifting to another—costs of learning my way around a different university, perhaps of moving to a different location. Hence my employer as well has some ability to benefit itself at my expense.

But my situation as customer and employee is very much better in this respect than my situation as a stockholder. It is true that, as a stockholder, I have the option of selling my shares of stock, which at first glance looks rather like my option as a consumer of not buying a product or as a worker of quitting a job. But the apparent similarity is an illusion.

If I choose not to spend twenty thousand dollars buying a car from Ford, Ford has one more unsold car and twenty thousand dollars less money. If I choose to sell twenty thousand dollars of Ford stock, on the other hand, the money I get is not coming at Ford's expense. Another investor has paid me the money and now owns the stock, leaving Ford itself unaffected. From the standpoint of the firm's incentives, it is as if, every time a customer wished to stop buying from a store, he was required to first find a new customer willing to take his place, or as if an employee could only quit if he provided a replacement willing to do the same job at the same pay.

The stockholder's view of the value of the stock directly affects the firm only if the firm wishes to raise capital by selling a new issue of stock. So far as existing stock is concerned, the shareholder is locked in, even if the fact is not immediately obvious. If the firm is being run in a way that fails to maximize stockholder value, he cannot escape that cost by selling his share, since the price he can sell it for will reflect the reduction in future profits and dividends, insofar as it can be estimated by other stockholders.

It follows that stockholders, unlike customers and employees, receive no direct protection from the market on which they deal with the firm. As a customer of Apple, I am to some limited degree locked in; I can switch to hardware and software from another firm, but only at a significant cost. The same is true of my situation as an employee of Santa Clara University. In both cases, I have born what are now sunk costs as a result of my initial decision to buy a product or accept a job. But as a stockholder in Apple, I am entirely locked in; all of my cost is sunk. If Steve Jobs announces tomorrow that he plans to run Apple entirely for the benefit of its employees and customers, never paying another dividend, the fact that I can respond by selling my stock provides me no protection.

It follows that the stockholder is dependent, very much more than the other stakeholders, on other mechanisms for controlling a firm to make it act in his interest. That is a strong argument in favor of the current mechanism for corporate control and the current legal rules defining the fiduciary obligation of the directors.

Indeed, it is an argument for more than that. It is an argument for strengthening stockholder control in order to provide more protection to the most vulnerable party in the network of relationships that makes up a corporation. One way of doing so would be by removing current legal barriers that make takeover bids more difficult, and so protect managers and directors from the consequences of serving their own interests at the expense of the stockholders whose interests they are supposed to be serving.
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Blogging Economists: The No Clear Win Zone

Welcome to The Show: The Blogosphere in 2009 - the greatest economics discussion group that could possibly be imagined. As if the wealth of information available wasn't enough, the Eco Gods threw in a financial crisis to spice it up. You've heard of the No Spin Zone, at the high end of blogging economists, there is a No Clear Win Zone. Every strongly held position by the Best and Brightest barely holding up under the latest article, study, post or comment. It is almost as much fun as the Florida Marlins 2009 season, but not quite, since economists don't bring up rookie starters with nearly enough consistency.

Let's see where we stand on the the Cap and Trade issue. Read as Greg Mankiw explains the economics of the climate change legislation:

Suppose the government imposed a tax on carbon-based products and used the proceeds to cut other taxes. People would have an incentive to shift their consumption toward less carbon-intensive products. A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

So far so good. The government, with the support of most economists, uses incentives in the tax system to move people away from carbon-based products. So what can go wrong? To get the votes for the legislation, the government literally gives away monies that it could have received in an auction. Why is that bad? Mankiw again:

The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.

Well maybe our President doesn't realize that? Ugh, no. Mankiw points out where Obama outlined those very issues in discussing the issue as a candidate.

Candidate Obama: One of the mistakes the Europeans made in setting up a cap-and-trade system was to give too many of those permits away.

Yet the current legislation in Congress today gives away many of those permits. Those darn politicians. But wait, we're not done thinking about this. Another non-lefty economist, Steven Landsburg, makes the case for giving away those permits:

The primary goal of cap-and-trade is to make firms behave better in the future, and as Professor Mankiw points out, that goal is served equally well whether we give the permits out for free or require firms to buy them. But the latter option not only creates an incentive for good future behavior; it simultaneously punishes bad past behavior. The firm that recently invested in a million-dollar machine that now can't be operated without a half-million dollar permit is effectively paying a half-million dollar fine for behavior that was perfectly legal a year ago.

The larger question, then, is this: When people do things that are socially destructive but nevertheless perfectly legal (like, say, owning slaves in the 19th century or leaving an excessive carbon footprint in the 21st), ought they be punished ex post facto? The answer is far from obvious.

Great, I started reading to get some facts to beat Democrats over the head with on the cap and trade issue, and end up wondering if people who do things that are socially destructive, but legal, ought they be punished. If I answer no [which is where I lean], can I still be against giving away the permits?

Classic the more you know, the more you know you don't know. I'm hooked so I'll keep on reading, but cognizant of the fact that whatever my views are today, likely they are a product of whatever was published yesterday that I happened upon.

Freddi I know you're reading this, please start Cameron Maybin the rest of the season.

Mankiw article referenced are copied in full at end of post.

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August 9, 2009 - Economic View - A Missed Opportunity on Climate Change
By N. GREGORY MANKIW

DURING the presidential campaign of 2008, Barack Obama distinguished himself on the economics of climate change, speaking far more sensibly about the issue than most of his rivals. Unfortunately, now that he is president, Mr. Obama may sign a climate bill that falls far short of his aspirations. Indeed, the legislation making its way to his desk could well be worse than nothing at all.

Let’s start with the basics. The essential problem of climate change, scientists tell us, is that humans are emitting too much carbon into the atmosphere, which tends to raise world temperatures. Emitting carbon is what economists call a “negative externality”— an adverse side effect of certain market activities on bystanders.

The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. Suppose the government imposed a tax on carbon-based products and used the proceeds to cut other taxes. People would have an incentive to shift their consumption toward less carbon-intensive products. A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

When he was still a candidate, Mr. Obama did not exactly endorse a carbon tax. He wanted to be elected, and embracing any tax that hits millions of middle-class voters is not a recipe for electoral success. But he did come tantalizingly close.

What Mr. Obama proposed was a cap-and-trade system for carbon, with all the allowances sold at auction. In short, the system would put a ceiling on the amount of carbon released, and companies would bid on the right to emit carbon into the atmosphere.

Such a system is tantamount to a carbon tax. The auction price of an emission right is effectively a tax on carbon. The revenue raised by the auction gives the government the resources to cut other taxes that distort behavior, like income or payroll taxes.

So far, so good. The problem occurred as this sensible idea made the trip from the campaign trail through the legislative process. Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

The numbers involved are not trivial. From Congressional Budget Office estimates, one can calculate that if all the allowances were auctioned, the government could raise $989 billion in proceeds over 10 years. But in the bill as written, the auction proceeds are only $276 billion.

Mr. Obama understood these risks. When asked about a carbon tax in an interview in July 2007, he said: “I believe that, depending on how it is designed, a carbon tax accomplishes much of the same thing that a cap-and-trade program accomplishes. The danger in a cap-and-trade system is that the permits to emit greenhouse gases are given away for free as opposed to priced at auction. One of the mistakes the Europeans made in setting up a cap-and-trade system was to give too many of those permits away.”

Congress is now in the process of sending President Obama a bill that makes exactly this mistake.

How much does it matter? For the purpose of efficiently allocating the carbon rights, it doesn’t. Even if these rights are handed out on political rather than economic grounds, the “trade” part of “cap and trade” will take care of the rest. Those companies with the most need to emit carbon will buy carbon allowances on newly formed exchanges. Those without such pressing needs will sell whatever allowances they are given and enjoy the profits that resulted from Congress’s largess.

The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.

The hard question is whether, on net, such a policy is good or bad. Here you can find policy wonks on both sides. To those who view climate change as an impending catastrophe and the distorting effects of the tax system as a mere annoyance, an imperfect bill is better than none at all. To those not fully convinced of the enormity of global warming but deeply worried about the adverse effects of high current and prospective tax rates, the bill is a step in the wrong direction.

What everyone should agree on is that the legislation making its way through Congress is a missed opportunity. President Obama knows what a good climate bill would look like. But despite his immense popularity and personal charisma, he appears unable to persuade Congress to go along.

As for me, I hope the president refuses to sign a bill that fails to auction most of the allowances. Some might say a veto would make the best the enemy of the good. But sometimes good is not good enough.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.
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Buy a House, Get a Visa

The always interesting Marginal Revolution blog, endorses an idea so simple and smart, it must have no chance of succeeding. Thomas Friedman describes the source of the idea:

Leave it to a brainy Indian to come up with the cheapest and surest way to stimulate our economy: immigration.

Gary Shilling outlines the idea:

The Obama administration should seriously consider granting resident status to foreigners who buy surplus houses in this country. This makes more sense than the president's $275 billion housing bailout plan, which Americans greeted with a Bronx cheer.

The housing bailout ... doesn't get to the basic problem -- the huge inventory of excess houses. We estimate that 2.4 million houses over and above normal working inventories are left over from the 1996-2005 housing bubble. That's a lot, considering the long-term average annual construction of 1.5 million single- and multi-family units.

Excess inventory is the mortal enemy of house prices, which have already fallen 27% since the peak in early 2006. We predict another 14% drop through the end of 2010 if nothing is done to eliminate the surplus.

Doing nothing to eliminate the excess inventory might well push the recession through 2010 and into a depression. Declining home values, for example, are eliminating the home equity that has funded oversized consumer spending for years.

A better idea is to offer permanent residence status to the many foreigners who are clamoring to get into the U.S. -- if they buy houses of minimal values (not shacks). They wouldn't need to live in those houses, but in order to remove the unit from the total housing market, they couldn't rent them. Their temporary resident status granted upon purchase would become permanent after, perhaps, five years, if they still owned the houses and maintained clean records. The mere announcement of this program might well stop the ongoing collapse in house prices, especially in cities such as Las Vegas, Miami, Phoenix and San Francisco, where prices are down 40% -- but where many foreigners like to live.

All articles referenced are copied in full at end of post.

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Immigrants Can Help Fix the Housing Bubble

MARCH 17, 2009, 9:49 A.M. ET

By RICHARD S. LEFRAK and A. GARY SHILLING

The Obama administration should seriously consider granting resident status to foreigners who buy surplus houses in this country. This makes more sense than the president's $275 billion housing bailout plan, which Americans greeted with a Bronx cheer.

The federal bailout forces taxpayers to subsidize overextended homeowners who bet on ever-rising house prices and used their abodes as ATMs, and it doesn't get to the basic problem -- the huge inventory of excess houses. We estimate that 2.4 million houses over and above normal working inventories are left over from the 1996-2005 housing bubble. That's a lot, considering the long-term average annual construction of 1.5 million single- and multi-family units.

Excess inventory is the mortal enemy of house prices, which have already fallen 27% since the peak in early 2006. We predict another 14% drop through the end of 2010 if nothing is done to eliminate the surplus.

Doing nothing to eliminate the excess inventory might well push the recession through 2010 and into a depression. Declining home values, for example, are eliminating the home equity that has funded oversized consumer spending for years.

As consumers retrench, production is cut, payrolls are slashed, and consumer confidence, incomes and spending are savaged in a self-feeding downward economic spiral. But if the government buys surplus houses and sells them at low market-clearing prices, other house prices will drop, destroying more home equity and driving many more mortgages under water. Bulldozing excess houses would be an inefficient end for perfectly habitable structures.

A better idea is to offer permanent residence status to the many foreigners who are clamoring to get into the U.S. -- if they buy houses of minimal values (not shacks). They wouldn't need to live in those houses, but in order to remove the unit from the total housing market, they couldn't rent them. Their temporary resident status granted upon purchase would become permanent after, perhaps, five years, if they still owned the houses and maintained clean records. The mere announcement of this program might well stop the ongoing collapse in house prices, especially in cities such as Las Vegas, Miami, Phoenix and San Francisco, where prices are down 40% -- but where many foreigners like to live.

Each year, 85,000 H-1B visas are granted for foreigners with advanced skills and education, and last year, 163,000 petitions were filed in the first five days after applications were accepted. The Ewing Marion Kauffman Foundation estimates that as of Sept. 30, 2006, 500,040 residents of the U.S. and 59,915 individuals living abroad were waiting for employment-based visas. Many would buy homes if their immigration conditions were settled.

These people tend to be highly productive. In 2006, foreign nationals residing in the U.S. were listed as inventors on 25.6% of the patent applications filed in the U.S., up from 7.6% in 1998. A Council of Graduate Schools survey found that in the fall of 2007, 241,095 non-U.S. citizens were enrolled in graduate programs. Some 55% were in engineering and the biological and physical sciences, compared with only 16% of U.S. citizens. In 2007, more people on temporary visas received doctorates in physical sciences and engineering than U.S. citizens.

There is a high correlation between education and incomes, and in today's uncertain economic climate, many wealthy foreigners desire U.S. resident status just as a number in Hong Kong secured residences in Singapore and Canada before the British handover to China in 1997. They rapidly became over a quarter of Vancouver's population, and brought in billions of dollars to buy houses and make other investments.

We could benefit from such an influx. Merrill Lynch estimates that in 2007 there were 10.1 million individuals in the world, 7.1 million outside the U.S., with at least $1 million in financial assets that totaled $29 trillion. If new immigrants bought the 2.4 million excess houses at today's $184,000 median price with funds from abroad, they would bring untold billions. The immigrants would also buy consumer goods, pay taxes, and start many new businesses.

The blueprint for a program to sell surplus housing to immigrants is already in place with the EB-5 visa program. Each year, 10,000 EB-5 visas for this country are available for foreigners who each invest $1 million in a new enterprise ($500,000 in economically depressed areas) that creates at least 10 full-time jobs. After two years, the entrepreneur and his family can become permanent residents.

America's relatively open immigration policy makes this country better off than many other developed lands whose governments also must fund the pensions and health care for growing numbers of retirees. Yet there's still a huge need for more productive and skilled people, both current residents and immigrants, who will produce enough goods and services to provide for their own needs and for those in retirement. Otherwise, entitlement spending eventually will touch off intergenerational warfare.

Granting permanent resident status to foreigners who buy houses in this country will curtail a primary driver of the deepening recession and financial crises -- excess house inventories and the resulting collapse of prices. Since the people who will buy these houses will tend to have money, education, skills and entrepreneurial talents, they will be substantial assets to America in both the short and long runs.

Mr. LeFrak is chairman and CEO of LeFrak Organization, a real estate builder and developer. Mr. Shilling, an economic consultant and investment adviser, is president of A. Gary Shilling & Co.
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Buy a House, Get a Visa (2)

The buy a house, get a visa program which I have been pushing for some time is getting some serious play. Writing in the WSJ, Richard Lefrak and Gary Shilling note:

The blueprint for a program to sell surplus housing to immigrants is already in place with the EB-5 visa program. Each year, 10,000 EB-5 visas for this country are available for foreigners who each invest $1 million in a new enterprise ($500,000 in economically depressed areas) that creates at least 10 full-time jobs. After two years, the entrepreneur and his family can become permanent residents.

Why not reduce the investment required and expand the program to 100,000?

Barry Ritholz has further thoughts and links. Thanks to Jim Ward for the pointer.

Posted by Alex Tabarrok on March 22, 2009 at 07:40 AM in Economics | Permalink
Comments

The no free lunch department requests an accounting of the downsides. (Other than the "foreigners suck our jobs away" argument which is a known issue.)

Posted by: Andrew at Mar 22, 2009 8:01:00 AM

Possible TINSTAAFL side-effects for Andrew:

Rich foreigners who otherwise wouldn't meet the requirements to get in might be able to find easier access through this.

All some of this investment could go to less-useful programs, though it seems they'd go to less-useful programs in the US and the "more useful" programs would be over seas. So less efficient global allocation of capital.

Foreign capital crowds out native US investors who would otherwise have invested in these opportunities, potentially driving US capital overseas.

All of these seem pretty benign to me. I really like this idea. We always like to tell ourselves that one of the things that makes the US great is the freedom it offers. Seems like if we're concerned about strengthening this country, we should be willing to use this as a selling point to bring in foreign capital and foreign skilled laborers.

Posted by: mravery at Mar 22, 2009 10:26:08 AM

In the last 10 years the average the average number of people utilizing the EB-5 visa is less than 800 per year.

Posted by: Zack at Mar 22, 2009 10:57:00 AM

The downside is that sooner or later, bleeding hearts will start whining about how unfair this is to immigrants who can't afford a house. At that point, congress will figure out a way to subsidize it.

Posted by: ian at Mar 22, 2009 11:26:29 AM

This is an interesting idea.

But what about starting new programs? Like: 1) Individuals who owe backtaxes get a pass if they buy a foreclosed home; 2) nature conservancies can get a matching grant from the government if that non-profit turns swaths of depressed/ghost-towns into nature preserves; 3) people in depressed areas are paid to moved to high-growth areas; etc.

Honestly, those would do better than expanding the EB-5 program.

Possibly some of the reasons why foreign capitalists are not applying to this program is droves are: 1) the US is not THAT desirable to rich foreigners; 2) rich foreigners do not see an economic advantage coming to the US or gaining US citizenship (which one might believe cause sneaking around taxes in Spain, Italy, Turkey, Laos, etc. is easier than in the US); 3) once rich foreigners become rich Americans their assets and earned income anywhere in the world are taxable by the IRS & due to new-ish agreements with secret banking states (the Swiss, Luxembourg, etc) offshore accounts are now easier to identify; and 4) if you had the money to life anywhere in the world would you really WANT to live in Detroit or some other economically depressed US city/state? (Put another way, if you one the Powerball, what incentive would you need to move to Moscow or Bombay or Mexico City [and those are fun cities]?)

Posted by: Jim at Mar 22, 2009 11:30:22 AM
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The Open-Door Bailout By THOMAS L. FRIEDMAN

February 11, 2009 - Bangalore, India

Leave it to a brainy Indian to come up with the cheapest and surest way to stimulate our economy: immigration.

“All you need to do is grant visas to two million Indians, Chinese and Koreans,” said Shekhar Gupta, editor of The Indian Express newspaper. “We will buy up all the subprime homes. We will work 18 hours a day to pay for them. We will immediately improve your savings rate — no Indian bank today has more than 2 percent nonperforming loans because not paying your mortgage is considered shameful here. And we will start new companies to create our own jobs and jobs for more Americans.”

While his tongue was slightly in cheek, Gupta and many other Indian business people I spoke to this week were trying to make a point that sometimes non-Americans can make best: “Dear America, please remember how you got to be the wealthiest country in history. It wasn’t through protectionism, or state-owned banks or fearing free trade. No, the formula was very simple: build this really flexible, really open economy, tolerate creative destruction so dead capital is quickly redeployed to better ideas and companies, pour into it the most diverse, smart and energetic immigrants from every corner of the world and then stir and repeat, stir and repeat, stir and repeat, stir and repeat.”

While I think President Obama has been doing his best to keep the worst protectionist impulses in Congress out of his stimulus plan, the U.S. Senate unfortunately voted on Feb. 6 to restrict banks and other financial institutions that receive taxpayer bailout money from hiring high-skilled immigrants on temporary work permits known as H-1B visas.

Bad signal. In an age when attracting the first-round intellectual draft choices from around the world is the most important competitive advantage a knowledge economy can have, why would we add barriers against such brainpower — anywhere? That’s called “Old Europe.” That’s spelled: S-T-U-P-I-D.

“If you do this, it will be one of the best things for India and one of the worst for Americans, [because] Indians will be forced to innovate at home,” said Subhash B. Dhar, a member of the executive council that runs Infosys, the well-known Indian technology company that sends Indian workers to the U.S. to support a wide range of firms. “We protected our jobs for many years and look where it got us. Do you know that for an Indian company, it is still easier to do business with a company in the U.S. than it is to do business today with another Indian state?”

Each Indian state tries to protect its little economy with its own rules. America should not be trying to copy that. “Your attitude,” said Dhar, should be “ ‘whoever can make us competitive and dominant, let’s bring them in.’ ”

If there is one thing we know for absolute certain, it’s this: Protectionism did not cause the Great Depression, but it sure helped to make it “Great.” From 1929 to 1934, world trade plunged by more than 60 percent — and we were all worse off.

We live in a technological age where every study shows that the more knowledge you have as a worker and the more knowledge workers you have as an economy, the faster your incomes will rise. Therefore, the centerpiece of our stimulus, the core driving principle, should be to stimulate everything that makes us smarter and attracts more smart people to our shores. That is the best way to create good jobs.

According to research by Vivek Wadhwa, a senior research associate at the Labor and Worklife Program at Harvard Law School, more than half of Silicon Valley start-ups were founded by immigrants over the last decade. These immigrant-founded tech companies employed 450,000 workers and had sales of $52 billion in 2005, said Wadhwa in an essay published this week on BusinessWeek.com.

He also cited a recent study by William R. Kerr of Harvard Business School and William F. Lincoln of the University of Michigan that “found that in periods when H-1B visa numbers went down, so did patent applications filed by immigrants [in the U.S.]. And when H-1B visa numbers went up, patent applications followed suit.”

We don’t want to come out of this crisis with just inflation, a mountain of debt and more shovel-ready jobs. We want to — we have to — come out of it with a new Intel, Google, Microsoft and Apple. I would have loved to have seen the stimulus package include a government-funded venture capital bank to help finance all the start-ups that are clearly not starting up today — in the clean-energy space they’re dying like flies — because of a lack of liquidity from traditional lending sources.

Newsweek had an essay this week that began: “Could Silicon Valley become another Detroit?” Well, yes, it could. When the best brains in the world are on sale, you don’t shut them out. You open your doors wider. We need to attack this financial crisis with green cards not just greenbacks, and with start-ups not just bailouts. One Detroit is enough.
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How Do You Know You Have a Monopoly?

I read this on Paul Krugman's blog:

I’m working at home today, waiting for the Fios [fiber-optic internet] guy. Which means that I’m probably going to drop off the face of the earth for much of today.

Which amazed me. I also read one of the comments on the post which put it in perspective:

Wow, you won a Nobel prize and you’re still stuck at home between 9 AM and 5 PM waiting for the cable guy. Glad to hear that you’re still one of the proles!— Ramesh Mantha

There might be better indicators, but poor customer service has to be one of the best tell tale signs of an oligopoly or quasi-monopoly markets. Cable companies customer service is terrible and even their wealthier customers can't pay their way out of it.

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Perfect Villains?

Just when the lefty powers that be seemingly found their perfect villains, bailout enabled bonuses, but along comes Henry Blodget with some really inconvenient facts. The House recently passed a 90% tax on any household income exceeding $250,000 for employees of firms that have accepted federal bailout funds. Blodget points out the following:

• The U.S. taxpayers bailed out those firms to ensure they survived.
• The U.S. taxpayers now own a major stake in those firms.
• When young professionals at those firms realize that their family's pay will be capped at $250,000 indefinitely, they will have a strong incentive to leave those firms.
• Which ones will stay? The ones who don't have the ambition, skill, or time to make more than $250,000 a year.

So in effect, we U.S. taxpayers have invested in companies which will increasingly by staffed by persons who would not be hired elsewhere. Would you want to buy stock in that company?

Blodget summarizes:

The frantic passage of the Populist Rage [90%] Tax was a new low in the US government's response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery--by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what's left of our economy.

Seriously, you gotta feel for the left. It was just so much easier to hate President Bush.

Article referenced is copied in full at end of post.

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90% Tax? Now We Really ARE Screwed

Henry Blodget|Mar. 19, 2009, 10:01 PM|comment168

The frantic passage of the Populist Rage Tax was a new low in the US government's response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery--by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what's left of our economy.

In case you've been too outraged by AIG (justifiably) to notice what happened, here's a recap:

If the "TARP bonus" bill the House passed today becomes law, any of the hundreds of thousands of people who work for Citigroup, Bank of America, AIG, and nine other major US corporations will have to fork over 90 cents of every bonus dollar that puts their household income over $250,000.

That's household income, not individual income. If you're married and filing singly, you'll have to surrender anything over $125,000. Indefinitely.* [See the comments below for a discussion of the mechanics of this.]

Is $250,000 per household a lot of money? Sure. But it's not a lot of money for two moderately successful corporate executives. Or a corporate secretary married to a lawyer. (If you're a $40,000 a year telemarketer at a TARP company married to a $210,000 lawyer, any bonus will be taxed). So this tax will be felt by a lot more than the handful of execs at AIG and Merrill who ran off with several million dollars apiece.

But that's not the really distressing part. The really distressing part is what this tax will do to the corporations that we now own and are supposedly trying to save.

(Remember? That's the reason we bailed Citigroup, AIG, GM, and the rest of them out--to save them. Because we convinced ourselves that civilization would end if we didn't.)

Thanks to our stupidity bailouts, we now own major stakes in these firms--at mind-boggling expense. So it's not clear why we want to destroy them. But that's what we seem determined to do.

Believe it or not, hidden inside these companies are thousands of decent, competent people whose households bring in more than $250,000 a year. Many of these folks had NOTHING to do with the gambling addiction that bankrupted their firms. Many of them still have a choice where to work. And now that they've learned that their family's pay will be capped at $250,000 indefinitely, many of them will quickly decide that now is a good time to pursue their careers elsewhere. (That is, unless their firm takes the easy and obvious step of just paying them a fatter salary, which just renders the whole thing a farce.)

Will everyone leave these firms? No. The folks whose households don't have the education, desire, ambition, skill, or time to make more than $250,000 a year won't. But a lot of the rest will. And however little our massive investments in these companies are worth now, they will soon be worth a lot less.

The real lesson here, unfortunately, is that it's a disaster for the government to run private companies. We used to understand that. But ever since we started telling ourselves that we had to save bankrupt institutions by taking them over and pretending not to "nationalize" them, we have apparently forgotten.

Originally, I read the bill as applying to all income over $250,000. As you can see in the comments, several readers believe it applies only to bonuses, not income.

I feel the same way about the tax even if it only applies to bonuses, because then it is preposterously easy to get around (just raise base salary) and will be almost equally bad for the companies (pay will no longer will pay have anything to do with performance, and the best folks will still leave.) I've included the relevant section of the bill below:

(1) IN GENERAL- The term `TARP bonus' means, with respect to any individual for any taxable year, the lesser of--
(A) the aggregate disqualified bonus payments received from covered TARP recipients during such taxable year, or
(B) the excess of--
(i) the adjusted gross income of the taxpayer for such taxable year, over
(ii) $250,000 ($125,000 in the case of a married individual filing a separate return).

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Real March Madness

The Real March Madness - By RICHARD VEDDER and MATTHEW DENHART

MARCH 20, 2009

The economy may be tanking and our pocketbooks are slimmer, but we can rejoice in one thing: March Madness is here and we can watch our favorite teams participate in the annual NCAA college men's basketball tournament. Behind all the hoopla, however, is the reality that the players who entertain us receive compensation that amounts to only a very small percentage of what they would have earned if they sold their services in a competitive market.

Take Kevin Durant, for instance. After a stunning freshman season with the Texas Longhorns in 2008, Mr. Durant elected to forgo his final three years of college and entered the NBA draft. Selected by the Seattle Supersonics (now the Oklahoma City Thunder), he agreed to a contract paying $3.5 million in the first year. By contrast, his yearly compensation (in the form of room, board, books and tuition fees at Texas) amounted to about $33,120, less than 1% of what was offered by the Supersonics.

Football is the other major revenue generating sport. In 2006, Heisman Trophy winner Reggie Bush skipped his senior year at the University of Southern California and entered the NFL draft. Selected by the New Orleans Saints, he agreed to a six-year contract guaranteeing $26.3 million with the possibility of huge performance bonuses. The compensation package of about $44,000 offered by USC paled in comparison to Mr. Bush's true market value.

Top-level college sports is big business, but very little of this flows to the student-athletes. Ohio State, for example, receives about $110 million in revenue each year from ticket sales, television rights, concessions, parking, logo sales, etc. -- over one-fifth of what it receives in tuition revenue from its more than 50,000 students. And its basketball players are paid about $29,500 each.

In a competitive market, companies cannot exploit workers in this way for long, as rival firms will hire them away at higher salaries. In basketball, however, the NCAA cartel prevents that, dictating limits on pay (essentially college costs) and even penalizing transfers to other schools. Strict rules also prevent college athletes from signing lucrative endorsement deals or accepting gifts beyond a certain amount. Soon after entering the NBA, Mr. Durant further augmented his earnings by signing a $72 million deal with Nike; he inked other endorsement contracts with Gatorade, EA Sports and Upper Deck.

If all of that money from ticket sales and television rights isn't going to student-athletes, where does it end up? In 2006, salaries for coaches and administrators accounted for nearly 32% of total athletic-department expenses. Many head football coaches at top universities earn five times the salary of their university president. At a time when most schools are tightening their belts with salary freezes, staff layoffs and the like, the University of Tennessee just announced it was going to start paying two assistant football coaches $650,000 or more each (the head coach makes $2 million). Jim Calhoun, head coach of the University of Connecticut men's basketball team, recently made headlines when he launched into a tirade at a blogger who questioned his $1.6 million annual compensation. Those high salaries are financed from the talents of unpaid student-athletes. (Talk about income inequality.) So not only are the young being exploited, but the exploitation is being committed by their adult mentors.

Maybe it's time the players did something about this situation. Usually when workers think they are getting a raw deal, they form a labor union. For example, to preserve their current amateur status, football and basketball players (and perhaps even all college athletes) might demand that they receive 25% of gate receipts and television revenues, to be placed in escrow to finance annuities for them payable beginning with college completion.

But should we really feel sorry for the players? In a sense, college football is like the minor leagues in baseball -- a steppingstone to the top. But top-flight AAA minor league players typically get a "living wage" of about $50,000 and sometimes considerably more a year, none of which need be spent on classes they don't have time to show up for.

Of course, for the students who go on to the pros, putting off their financial bonanza won't be a big deal. But most college athletes do not make the pros. They may not even end up with the basic skills necessary to succeed in other workplaces, since only a minority of student-athletes in major sports even graduate (25% in top-ranked University of Connecticut men's basketball, for example). Long practices and missed classes make it difficult to succeed academically. A recent study funded by the Andrew W. Mellon Foundation shows the academic performance of athletes is lower than non-athletes even at Division III schools.

So why haven't players unionized already? First, the "workers" are around for only three or at most four playing seasons, making it hard to build up much of a movement. Second, coaches control playing time and enormously influence career success, so it is the rare college kid who will incur the coach's wrath to form any kind of insurrection. Finally, most players don't have a lot of contact with the members of other teams. But if you see them whispering before the tipoffs this weekend, you'll know why.

Mr. Vedder directs the Center for College Affordability and Productivity, where Matthew Denhart, a student at Ohio University, serves as a research associate.
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The Law of Unintended Consequences

From the Freakonomics blog, comes an example of how a law designed to prevent discrimination will actually encourage discrimination. This example deals with the Americans With Disabilities Act:

A Los Angeles orthopedic surgeon named Andrew Brooks. When a deaf patient came to him for a consultation, he realized that the A.D.A. required him to hire a sign-language interpreter for each visit if that’s what the patient wanted. The interpreter would cost $120 an hour, with a two-hour minimum, and Brooks wouldn’t be reimbursed by the insurance company:

That would mean laying out $240 to conduct an exam for which the woman’s insurance company would pay him $58 — a loss of more than $180 even before accounting for taxes and overhead.

Brooks saw the patient and paid for the interpreter out of his pocket; fortunately, she didn’t need surgery. But the incident made him conclude that if doctors have such a strong financial disincentive in such a case, “this kind of patient will end up getting passed on and passed on, getting the runaround, not understanding why she’s not getting good care.”

Article referenced are copied in full at end of post.

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The Price of Disability Law - by Stephen J. Dubner

March 10, 2009, 10:51 am

We wrote a column a while back about a variety of powerful unintended consequences.

One example was the Americans With Disabilities Act, and we told the story of a Los Angeles orthopedic surgeon named Andrew Brooks. When a deaf patient came to him for a consultation, he realized that the A.D.A. required him to hire a sign-language interpreter for each visit if that’s what the patient wanted. The interpreter would cost $120 an hour, with a two-hour minimum, and Brooks wouldn’t be reimbursed by the insurance company:

That would mean laying out $240 to conduct an exam for which the woman’s insurance company would pay him $58 — a loss of more than $180 even before accounting for taxes and overhead.

Brooks saw the patient and paid for the interpreter out of his pocket; fortunately, she didn’t need surgery. But the incident made him conclude that if doctors have such a strong financial disincentive in such a case, “this kind of patient will end up getting passed on and passed on, getting the runaround, not understanding why she’s not getting good care.”

One can expect Brooks’s prediction to come true a bit more often in light of a recent lawsuit in which a New Jersey rheumatologist was required to pay a $400,000 settlement, including punitive damages, to a deaf patient. From MedicalJustice.com:

The court concluded Dr. Fogari’s transgression was failure to provide an interpreter for his deaf patient. Such an interpreter apparently costs ~$150 to $200 per visit. And Medicare only reimbursed ~$49 per visit. Apparently, Dr. Fogari communicated by exchanging written notes with the patient assisted by family members.

Dr. Fogari treated the patient for lupus and care mainly involved follow-up visits monitoring her medication. The patient experienced no complications and there were no allegations of negligence. The patient transferred her care to another doctor.

Medical Justice, which is dedicated to “relentlessly protecting physicians from frivolous suits,” does find a silver lining in the disability law:

If you, as a small business owner, hire an employee with a recognized disability, you are potentially eligible for tax credits in the thousands. And, if that individual understands sign language, you have killed two birds with one stone.

That said, it is hard to believe that this kind of lawsuit won’t make more doctors do their best to avoid seeing similar patients in the future. In which case a law designed to prevent discrimination will, yes, encourage discrimination.
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Sports Marketing and it's PC Problem

There is a very interesting post over at the Biz of Baseball about how sports marketing expenditures from companies which received government bail-out money are coming under attack and how they are attempting, or not, to respond. To me something falls under the heading of PC [politically correct], if someone or something disagrees with an accusation made of them, but they capitulate to the accusations because they doubt their ability to make a more nuanced argument through the media din [i.e. headlines repeated ad nauseaum]. This from Toms' article:

In the midst of this public and political turmoil, Nielsen Media Research has released some figures that show banking companies have decreased spending by 10 percent over the last year, but have increased the amount that they are spending on sports advertisement by 36 percent in 2008, showing that these businesses see sports as great return on investment.

According to Nielsen, "Banks spent $122 million - or 18.7% of all its TV ad dollars - on sports event programming in 2008. In 2007, the banking industry spent $90 million on sports broadcasts, or 12.5% of the industry’s total TV ad expenditures."

That's why Bank of America has a PC problem. They walked away from a sponsorship for the new Yankee Stadium, despite the fact that sports advertising is a considered a good buy in their industry.

As an aside, you can read the article by Pete Toms just as an example of why online articles are not a competitor, but a great compliment to, the regular media. Toms article gives the casual reader input on the issue from a variety of sources. But to those who are really interested and would have tried to read up further, absent his article, he just saved us [trust me on this], at least a couple of hours of research.

I became aware of the article through Shyster Ball, Craig Calcaterra's blog, another good source of baseball related writing. I know the web can appear to be made up of angry people. But it can also be viewed as a community of bright people who learn about 'stuff' and are happy to share and encourage others to do the same. I met a few local bloggers recently at Tobacco Road. Perhaps I am guilty of too much much Hobbes in my cereal, but I'm always slightly amazed and appreciative of the random generosity I've encountered in the on-line community. Toms and Calcaterra are good examples of that.

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Geeky But Still Funny

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Samuelson [Wade] vs. Krugman [Kobe]

Robert Samuelson is a top economist who gets a wide audience, mostly due to his Newsweek column. I find him to be the most consistently politically-neutral economist around, think of him as the Dwyane Wade of economists; talented, hard-working and responsible. You get the sense that he goes wherever the data leads him. Here is an example of that fairness in his most recent column:

What suppressed inflation was the brutal 1981-82 recession undertaken by Federal Reserve Chairman Paul Volcker and supported by the newly elected Ronald Reagan. ... Volcker and Reagan embarked on a deliberate effort to quell inflationary psychology; the question was whether the recession could be maintained long enough to do the job.

That may seem like an uncontroversial formulation, but to economist's with a leftist agenda--which is most of them in academia--giving Reagan any credit is harder than getting a New York Yankees fan to show class.

Speaking of unlovable losers, that brings us to the New York Times Paul Krugman. Think of Krugman as the Kobe Bryant of economists; mad skills and does not play well with others, i.e. unreliable. He is so talented, that he will just make the data fit into his views. An example from his latest column:

Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans.

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

Can you see Kobe quitting in the 2nd half of game 7 in the 2006 playoff series against Phoenix in that analysis? Krugman relies on a 1980's code phrase, voodoo economics, to get his readers in the proper frame of mind--an attack. But who is he attacking you ask? "Many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration," Paulie oh so gently explicates. Geez! That sound you just heard must have been his testicles falling off.

Later on he demonstrates that his fecklessness, like his former body parts, travels in pairs. He writes, "what I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch." That additional sound you just heard were the aforementioned body parts being placed in a freezer ziplock bag.

Here's my point. Please follow through. Either explain without an agenda or attack with one, both are fine. But don't come in like a lion [voodoo economics] and go out like a Kobe [possibly, without realizing it]. People who mix metaphors aside, those people are the worst [man]!

Both columns referenced and Bill Simmons' Kobe mail bag are copied in full at end of post - click on 'Read More!

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The Great Foreboding
January 19, 2009

By Robert Samuelson

WASHINGTON -- For Barack Obama, the Great Foreboding is both an enormous burden and a splendid opportunity. We are now suffering from more than depressed retail sales, stock prices and production. Americans have drifted, or been dragged, into a state of collective despair and bewilderment. They don't know what lies ahead and wonder whether anyone does. Americans have lost their sense of mastery over the future, and if Obama can restore that, he will have gone a long way toward reviving the economy and ensuring a successful presidency.

It is not the present economy that most disturbs people. That's bad, but not unprecedented. Despite recent increases, the unemployment rate of 7.2 percent in December remains below the average peak unemployment of 7.6 percent in the previous 10 post-World War II recessions. What unsettles and scares people is the vague notion that we're headed into something new, menacing and enduring. Unemployment, predicted to reach 9 percent or more, will remain high. Expansion will resume grudgingly, if at all. Income gains will be slight or nonexistent.

Precisely this specter explains why the word "depression" is now so routinely deployed, even though we're a long way from the bread lines of the 1930s. But the Great Depression also signifies a period when we lost control. For all the New Deal programs, the Depression lasted a decade and ended only with World War II. Even in 1940, unemployment averaged almost 15 percent. It's the worry that government won't triumph over today's economy that justifies, for many people, the bleak analogies.

The pessimism stretches across class and political lines. A December survey by the Pew Research Center asked whether economic conditions would be worse in a year. Among those with incomes under $30,000, 51 percent thought so; for those with incomes exceeding $100,000, the response was almost identical, 53 percent. Another question was whether unemployment would rise in the next year; 57 percent of Democrats, 64 percent of independents and 66 percent of Republicans said yes.

This democratic (with a small "d") despondency has many causes. As more Americans invested in stocks, more became exposed to the market's wild psychological and financial swings. The plunge in home values has made many workers with secure jobs poorer. And, of course, layoffs themselves have become more democratic. Once, the young and blue-collar workers bore the brunt of firings. Now, managers, investment bankers, journalists, scientists -- almost anyone -- can be canned. Age confers little security. In December, almost a third of the jobless were 45 and over.

What offends middle-class Americans, most of us, is economic capriciousness. People crave order, predictability and security. They want to believe that personal virtues of studying, working hard and planning will be rewarded in the marketplace. Even in good times, these ambitions are often frustrated. But in today's economy, the disconnect has widened. Setbacks and losses seem increasingly divorced from personal effort. Our whole values system seems besieged.

Since World War II, Americans have only once before experienced a similar economic trauma: the double-digit inflation of the 1970s (13 percent in 1979). Work and thrift were undermined, because inflation threatened the worth of wages, salaries and savings accounts. Then as now, people were terrified, because inflation seemed uncontrollable. Starting with Lyndon Johnson, four presidents had failed. No one knew how high it might go. Then as now, we seemed unable to chart our destiny.

What suppressed inflation was the brutal 1981-82 recession undertaken by Federal Reserve Chairman Paul Volcker and supported by the newly elected Ronald Reagan. Unemployment reached a peak of 10.8 percent, but gluts of jobless workers and idle factories broke the wage-price spiral and ushered in two decades of strong economic growth. Reagan won a landslide victory in 1984; his campaign featured a signature TV spot boasting that "It's morning again in America."

Up to a point, there are parallels for Obama. Today's misery is a political opportunity. Reagan's popularity soared on the belief that he had re-established economic order. The country had reasserted control of its future. These gains offset the recession's severity and its hangover. In 1984, unemployment still averaged 7.5 percent.

If Obama can overcome the sense of helplessness, he will surely reap much political credit. There need not be a boom -- the economy must achieve just enough sustained growth to convince most people that it's manageable and that we have not descended into a new dark age.

Here, the parallels break down. Volcker and Reagan embarked on a deliberate effort to quell inflationary psychology; the question was whether the recession could be maintained long enough to do the job. Obama faces a global recession brought on by murky forces barely understood. The effort to counteract them and to prevent further economic damage is a grand and confused experiment. If it fails, Obama's burden will be back-breaking.

Copyright 2009, Washington Post Writers Group
Page Printed from: http://www.realclearpolitics.com/articles/2009/01/the_great_foreboding.html at January 19, 2009 - 05:57:56 AM PST
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Wall Street Voodoo
January 19, 2009
Op-Ed Columnist

By PAUL KRUGMAN

Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans.

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

The current buzz suggests, however, that policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward a compromise approach: moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” that would resemble the Resolution Trust Corporation, but without seizing the banks first.

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, recently tried to describe how this would work: “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?

What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value” purchases of toxic assets.

Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks.

Unfortunately, the price of this retreat into superstition may be high. I hope I’m wrong, but I suspect that taxpayers are about to get another raw deal — and that we’re about to get another financial rescue plan that fails to do the job.
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Kobe letters: Second thoughts on second half

Monday, May 8, 2006

Bill Simmons - ESPN.com

Editor's Note: Here's a selection of letters to Page 2's Bill Simmons about Kobe Bryant's performance in Game 7 of the first-round series loss to the Suns.

Looks like the voters got it right ... at least the part about not giving the award to Kobe. There is no way that the league MVP would score just one point in the second half of a Game 7 in a playoff series. There's just no way that would happen. I hope this puts to rest all the Kobe/Jordan comparisons that are still floating around out there. Kobe is not on his level. He never will be. Quite frankly, it's not even close.
-- Geoff, Agawam, Mass.

Kobe Bryant
It's the third quarter -- and Kobe's not looking too good.

Game 7 of the Laker-Suns series was like in grade school when you challenge a big kid to race only after it starts he just jogs halfway and lets you win. You're right, the MJ comparisons stop now.
-- Rick M., New York

Let me first make you understand that I am a LIFELONG Lakers fan -- I was born, I grew up, and now live less than one mile from the Fabulous Forum -- and I have listened to the whole "Kobe has no supporting cast"/"Kobe is transforming"/"Kobe is becoming MJ" thing. And now I will remind you of the exact evidence as to why Kobe is not the next MJ. Is he more talented than MJ at his age? YES. Is he the next basketball savior? NO.

Because at the end of the day let's remember: 1) The reason Kobe has no supporting cast is because he wanted it that way AND 2) Kobe only cares about Kobe, from the day he left Eddie Jones wide open for 3 in the corner while he took a 40-foot airball against Utah in his first playoff series (and eventually got him traded away too), to the time in Sacto when the "hacks" were saying he was taking too many shots (so he purposely didn't shoot the whole game), to tonight when he decided that he would get ultimate revenge against Phil's whole "team concept" and the "hacks" saying he shot too much in Game 6 by "just running the offense" in a deciding Game 7.

At the end of the day Kobe has never felt the "hunger" for basketball like MJ (or Magic or Bird) did, because through it all he was already coddled and never paid his dues. At the end of the day Kobe believes his own hype, and Kobe goes out of his way to TRY to show that basketball "needs" him more than he "needs" it -- and it is that basic difference that will separate the two -- because we are at 10 years and counting and he hasn't changed yet.
-- Dorian, Inglewood, Calif.

Did the other Laker starters play above themselves for four games or was Kobe gracious in sharing the ball, thus allowing the team to reap the rewards? I think it's the former. I don't want to play the role of "I-told-you-so" revisionist historian (but I will anyway), but when everyone was praising Kobe for sharing the ball, I was telling everyone that if the other Lakers had played like this all year long, he'd have given them they keys to the car long before now. It's like when Robert Downey Jr. checks out of rehab and seems to have his act together, but you're never quite sure if he's really clean and you aren't the least bit suprised when he relapses. It's almost like we got a glimpse into an alternate universe where Kobe had decent teammates.

And I can't wait to hear the criticisms about Kobe taking too few shots (presumably these people would prefer Kobe to score 40, so that the Lakers would only have lost by 20, paving the way for Kobe getting blamed for not getting everyone involved). And I really can't wait for people to wisely begin observing that "at least Shaq is still playing" as if Chicago and Phoenix are anywhere remotely on the same level.
-- DeAngelo L., Santa Monica, Calif.

An MVP does NOT throw in the towel during the second half of a Game 7. I don't know if Kobe was trying to make some kind of statement or what, but that's not what an MVP does. Period.
-- Alex, Provo, Utah

After Kobe's Game 7 performance, not only should MJ comparisons be forbidden, he should have to give up his self-proclaimed status as Black Mamba. Maybe he could call himself the Mottled Garter Snake or something like that. No way MJ disappears like that in a Game 7. Ever.
-- Chuck J., Centreville, Va.

Someone please explain what happened to Kobe in the second half. I consider myself a Laker fan of the highest order. Diehard. I cheered like crazy for Magic Johnson, James Worthy, Shaq, Kobe, Fish, and even Cedric Ceballos and Chucky Atkins. I've been with them all the way. And yet I don't get the second half. Defending Kobe's integrity for the last 10 years suddenly feels futile and pointless.
-- Gov D., Metro Manila, Philippines

Kobe would be great on "The Apprentice." When it became clear that the Lakers had lost Game 7, Kobe went into his "boardroom defense" strategy. At the time, he was shooting over 50 percent and had 23 first-half points. Why should he bother to shoot in the second half? How could he be fired by passing the ball and getting his teammates involved? How easy it is to blame it on the Project Manager's (Phil's) game plan? Congrats on your boardroom victory, Kobe.
-- Rick S., San Diego

So apparently Kobe was trying to get teammates into a rhythm during the second half. Funny, I must have missed his drives and dishes, and his post-ups that drew double-teams and created open shots. I did, however, see Kobe harmlessly swing the ball around the 3-point line quite a bit. Has any other "superstar" been so passive with the season on the line? You can debate whether Kobe should be MVP but there's no debate whether he makes his teammates better. Either he doesn't know how or Saturday he didn't want to try. And if he didn't want to try and he didn't want to shoot, then he quit.
-- Jonathan, Venice, Calif.

How much is Kobe trying to stick it to Phil Jackson and the media right now? Criticized for "shooting" too much in all of the Lakers' losses, he's willing to let the Lakers lose this series to prove a point that this is his team (and his success that got him to this point, not Phil's great coaching). The Mamba is tricky like that -- just when you think you have him figured out . . .
-- Jonathan, Morgantown, W. Va.

Watching Kobe in the second half -- wow. What blew me away was that, time after time, he would catch the ball, get doubled, give it up, and then DO NOTHING, literally just stand there. Your team is down 20-plus late in the third quarter in Game 7, no one on the floor except you should be allowed in the same ZIP code as a basketball player, and you're not going to try to take over the game? You're not going to start, I don't know, making some cuts or something after you're forced to give the ball up, in an attempt to get it back?

I doubt they would have won either way, but Kobe's performance in the second half was absolutely baffling. Which is why I'm convinced he's blown tens of millions on ice for his wife, is secretly in debt to the Stucci brothers, and was therefore forced to throw the game. It makes more sense than anything else I can come up with.

There's some solace in this, however: I'd been forced to acknowledge Kobe's brilliance recently, simply because I'd been watching him so much. This was an uncomfortable situation for me to be in, because a) I'm a Boston fan and b) Kobe's a jerk. Now I have reason to dislike him again. So even though I was robbed of an entertaining Game 7, it wasn't a total wash.
-- Jesse S., Boston

No more MJ comparisons. It's over. Three shots in the second half? He mailed it in with half a game to play! Kobe as MVP? What a joke [because] (a) MVP's shouldn't lose Game 7s; (b) if they're going to, I want them to lose by shooting 45 shots, making 10, and breaking their face because they dove for too many loose balls. What a disgrace. I don't even like basketball, and guys like Kobe are why. There's too little heart in the NBA and way too much posturing.
-- Mike, NYC

How about Kobe tanking the entire second half of Game 7? The great thing about egomaniacal prima donnas is that you can always count on them to showcase their true colors sooner or later with some grand spectacle of unprofessional petulance (see Carter, Vince). Snaps to Mamba on setting back the resuscitation of his image another 4-6 months. Oh and sweet mid-career number change. Awful.
-- Matt, Washington, D.C.

How come no one is talking about Kobe completely stabbing his teammates in the back in the second half of Game 7? There's a difference between (a) not taking 40 shots and (b) completely taking yourself out of the offense by standing at half court the entire half. Kobe was clearly trying to distance himself from the loss and let the blame fall squarely on his teammates. And then in the postgame interview Kobe made it sound like the Lakers never had chance -- like they were the Generals and the Suns were the Globetrotters. Are you really telling me that Kobe would have sounded like that if Thomas's 3 had been a half-inch off at the end of Game 6? The man is incapable of admitting that he got beat. It's like when you're playing against a cocky [player] in a pickup game, who realizes he's going to lose, and stops trying at all just to let everyone know that they didn't beat him when he was trying. That crap works at the Y, but it doesn't work in Game 7 of an NBA series.
-- Scott, Washington, D.C.

Michael Jordan
It didn't end well in Washington, but a history of clutch performances earned Michael Jordan a victory lap or two.

Second half of Game 7 points out all that needs to be said about your MVP pick (not that Nash had a great game). But Kobe giving up after an amazing first half to keep them even in the picture was unbelievable. I never liked him, but I respected his talent, his skills, and his competitiveness -- now I have no respect at all. He gave up, didn't want to be blamed for the loss and, to top it off, pulled an Isiah and walked off the court without shaking hands. He is simply a classless individual who will never win another title. The media must now observe a permanent moratorium on all comparisons to MJ (which were insane from the beginning).
-- Chris, Richmond, Va.

I'm sure you're getting tons of these emails, but no matter what Kobe does the rest of his career, the Kobe/Jordan comparison is officially over. Jordan would NEVER let any of his teams lose by 30 in a Game 7. You could put Jordan with me and three other of my slow, overweight friends and we still wouldn't lose by 30.
-- Avi, Brooklyn, N.Y.

Maybe you should come up with a "Failed Vengeance Scale" to cover events such as Kobe seeming like he'd get revenge, then going splat. His teammates didn't help, but do you really think Michael Jordan would have launched only three shots in the seconnd half?
-- Fritz, New Orleans, La.

Kobe's second-half performance in Game 7 against the Suns had to rank among the weirdest I've ever seen. Was the Phoenix defense that good? Doubtful. Was he mailing it in? Was he trying to prove a point (the weakness of his supporting cast, his importance to the team)? Zero field goals in the second half!? One measly technical free throw!? He didn't attack the basket once! Yes, Phoenix had a 15-point lead at the half. Daunting? Yes. Insurmountable? No way. Simply inexplicable. No more MJ comparisons, please. No way MJ mails in a Game 7. EVER. And no more MVP whining, either. I have no desire to get acquainted with Kobe's demons, but there's something strange going on in there. I watched in disbelief (and with glee).
-- Adam Caress, Manchester, Mass.

And don't know what is more satisfying: Being a Suns fan and having to endure a week where every sportswriter in the country wrote about the impending Lakers/Clips duel . . . but then, hold on, wait . . . I got your Hallway Series right . . . HERE! Or watching Mamba flat-out quit during the second half in a Game 7 of a playoff series. (Do MVP's actually do this?!) What a beautiful week!
-- Nick, Chippewa Falls, Wis.

Watching Bryant quit in the second half of Game 7 was like watching as if Ray Lewis were to raise up his hands and say "[forget] it" in the middle of a wild-card game. MVPs do not put on their pouty face when things don't go their way. It doesn't work for me in real life and it most certainly doesn't work in Game 7 of the playoffs. I can't help but feel sorry for Lakers fans, something I never thought I would EVER say, given that I cheer for the Celtics. Kobe now ranks alongside Barry Bonds and Marcus Vick on the list of "Holy Crap I Can't Believe He's Actually Doing That" performances of this century.
-- Brian H., Brighton, Mass.

Poor David Blaine. He spends a week in a water-filled bubble only to have Kobe come along and pull the greatest disappearing act of all time. What a shame.
-- Neil L., Burns Lake, British Columbia
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Deregulation vs. a Lack of Regulation

I dislike the 'both parties are at fault' argument. Strikes me as lazy, a way to avoid really thinking about an issue. Unfortunately, I found a good example of the 'both sides' argument in the debate over what went wrong in the financial crisis.

The issue is deregulation. Actually that's the problem. What's thought of as 'deregulation' really has two components. Deregulation occurs when existing regulations are removed. If there are financial instruments which have never been covered by regulatory laws, that properly understood, is not 'deregulation.' That is a lack of regulation or no regulation. The reasons for no regulation may be philosophical, insufficient political will or just a lack of understanding about how to regulate effectively.

In the current crisis, when 'deregulation' is blamed, defenders--like Peter Wallison from Bloomberg.com--point out the following:

• There has been a great deal of deregulation in our economy over the last 30 years, but none of it has been in the financial sector or has had anything to do with the current crisis.
• The repeal of portions of the Glass-Steagall Act in 1999 -- often cited by people who know nothing about that law -- has no relevance whatsoever to the financial crisis, with one major exception: it permitted banks to be affiliated with firms that underwrite securities.

A 60 Minutes segment on Oct 5th did a very good job of highlighting the difference. The lack of regulation which existed at the highest end of the financial sector, specifically with credit default swaps [CDS], is shocking to hear described. Michael Greenberger, former director of trading and markets at the Commodity Futures Trading Commission [CFTC], defines the financial instrument:

A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails.

It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated.

That federal law referred to is the Commodity Futures Modernization Act of 2000. Who was behind that law? A CNN/Money.com article explains:

The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and [Clinton] Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. Republican Senator Phil Gramm crowed that the new law "protects financial institutions from over-regulation and it guarantees that the US will maintain its global dominance of financial markets." Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

Another perspective from a Dow Jones newswire:

Putting regulation of credit-default swaps on the table a decade ago led to the idea being shot down. In May 1998, the CFTC issued a so-called concept release asking what kind of regulation might be appropriate. The release didn't suggest that such swaps be traded on exchanges, but outlined alternatives that would provide authority to combat fraud and manipulation, and set standards for capital adequacy of those backing the swaps.

A backlash to the proposal quickly came from Alan Greenspan, then the Fed chairman, [Clinton] Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt, and from Congress. After, it was never formally taken up by the CFTC.

Finally, in reading up on this stuff I came across 2 incredible items:

1. The Daily Kos - a popular left-wing blog - comes to the same conclusion that "not regulating, as opposed to deregulating" is the real problem.
2. The amount of outstanding credit derivatives is $16.4 trillion at the end of March 2008. For reference and perspective, the US GDP for 2007 was $13.8 trillion, while the world's GDP for 2007 was estimated at $54.3 trillion. [Insert incredulous noises here].

All articles referenced are copied in full at end of post.

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A Look At Wall Street's Shadow Market

Oct. 5, 2008(CBS) On Friday Congress finally passed - and President Bush signed into law - a financial rescue package in which the taxpayers will buy up Wall Street's bad investments.

The numbers are staggering, but they don't begin to explain the greed and incompetence that created this mess.

It began with a terrible bet that was magnified by reckless borrowing, complex securities, and a vast, unregulated shadow market worth nearly $60 trillion that hid the risks until it was too late to do anything about them.

And as correspondent Steve Kroft reports, it's far from being over.

It started out 16 months ago as a mortgage crisis, and then slowly evolved into a credit crisis. Now it's something entirely different and much more serious.

What kind of crisis it is today?

"This is a full-blown financial storm and one that comes around perhaps once every 50 or 100 years. This is the real thing," says Jim Grant, the editor of "Grant's Interest Rate Observer."

Grant is one of the country’s foremost experts on credit markets. He says it didn't have to happen, that this disaster was created entirely by Wall Street itself, during a time of relative prosperity. And they did it by placing a trillion dollar bet, with mostly borrowed money, that the riskiest mortgages in the country could be turned into gold-plated investments.

"If you look at how this started with the subprime crisis, it doesn't seem to be a good bet to put your money behind the idea that people with the lowest income and the poorest credit ratings are gonna be able to pay off their mortgages," Kroft points out.

"The idea that you could lend money to someone who couldn't pay it back is not an inherently attractive idea to the layman, right. However, it seemed to fly with people who were making $10 million a year," Grant says.

With its clients clamoring for safe investments with above average return, the big Wall Street investment houses bought up millions of the least dependable mortgages, chopped them up into tiny bits and pieces, and repackaged them as exotic investment securities that hardly anyone could understand.

60 Minutes looked at one of the selling documents of such a security with Frank Partnoy, a former derivatives broker and corporate securities attorney, who now teaches law at the University of San Diego.

"It's hundreds and hundreds of pages of very small print, a lot of detail here," Partnoy explains.

Asked if he thinks anyone ever reads all this fine-print, Partnoy says, "I doubt many people read it."

These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.

"Obviously they turned out to be wrong," Partnoy says.

Asked why, he says, "Because you can't model human behavior with math."

"How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy…and sell?" Kroft asks Jim Grant.

"The instruments themselves are at the heart of this mess," Grant says. "They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."

"People don't know what they're made up of, how they're gonna behave," Kroft remarks.

"Right," Grant replies.

But it didn't stop ratings agencies, like Standard & Poor's and Moody's, from certifying the dodgy securities investment grade, and it didn't stop Wall Street from making billions of dollars selling them to banks, pension funds, and other institutional investors all over the world. But that was just the beginning of the crisis.

What most people outside of Wall Street and Washington don't know is that a lot of people who bought these risky mortgage securities also went out and bought even more arcane investments that Wall Street was peddling called "credit default swaps." And they have turned out to be a much bigger problem.

They are private and largely undisclosed contracts that mortgage investors entered into to protect themselves against losses if the investments went bad. And they are part of a huge unregulated market that has already helped bring down three of the largest firms on Wall Street, and still threaten the ones that are left.

Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says.

"These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?" Kroft asks.

"Well, it made it easier to sell the terrible investments if you could convince the buyer that not only were they gonna get the investment, but insurance," Greenberger explains.

But when homeowners began defaulting on their mortgages, and Wall Street's high-risk mortgage backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off their obligations.

Bear Stearns was the first to go under, selling itself to J.P. Morgan for pennies on the dollar. Then, Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with an $85 billion rescue.

Asked what role the credit default swaps play in this financial disaster, Frank Partnoy tells Kroft, "They were the centerpiece, really. That's why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages."

How big is the market for credit default swaps?

Says Partnoy, "Well, we really don't know. There's this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It's sort of alarming that, in a market that big, we don't even know how big it is to within, say, $10 trillion."

"Sixty trillion dollars. I know it seems incredible. It's four times the size of the U.S. debt. But that's the size of the market according to these voluntary reports," says Partnoy.

He says this market is almost entirely unregulated.

The result is a huge shadow market that may control our financial destiny, and yet the details of these private insurance contracts are hidden from the public, from stockholders and federal regulators. No one knows what they cover, who owns them, and whether or not they have the money to pay them off.

One of the few sources of information is the International Swaps and Derivatives Association (ISDA), a trade organization made up the largest financial institutions in the world. Many of them are the very same companies that created the vast shadow market, lobbied to keep it unregulated, and are now drowning because of unanticipated risks.

ISDA's CEO, Robert Pickel, says there is nothing wrong with credit default swaps, and that the problem was with underlying mortgage securities.

"Well, there's clearly something wrong with the system if all of these leveraged bets, hidden leveraged bets, caused a collapse in the financial system," Kroft remarks.

"It is something that we all need to look at and learn lessons from. And we all need to work together to understand that and design a structure in the future that works more effectively," Pickel says.

"My point is, the people that made these mistakes are the people you represent in your organization. And many of them sit on the board. I mean, if they didn't get it right, who would?" Kroft asks.

"These people understand the nature of these products. They understand the risks," Pickel replies.

"Well…they didn't or they wouldn't have bought them. They wouldn't have used them," Kroft says.

"These are very useful transactions. And the people do understand the nature of the risk that they're entering into…but I'm not sure that…," Pickel says.

"Useful?" Kroft interrupts. "How come they brought down the financial system?"

"Because, perhaps they didn't understand the underlying risk, and nobody really saw the effects that were going to flow through from the subprime lending situation," Pickel says.

That chapter is not over, and there is much suspense and fear on Wall Street that there are other big losses out there that have yet to be disclosed

They already dwarf what has been lost on those original risky mortgages. As bad as the mortgage crisis has been, 94 percent of all Americans are still paying off their loans. The problem is Wall Street placed its huge bets and side bets with all of those fancy securities on the 6 percent who are not.

"We wouldn't be in any of this trouble right now if we had just had underlying investments in mortgages. We wouldn't be in any trouble right now," says Partnoy.

He says it’s the side bets.

"You got Wall Street firms, Bear Stearns, Lehman Brothers. You got insurance companies like AIG. Merrill lost a ton of money on this," Kroft says. "Everybody's lost a ton of money. They're supposed to be the smartest investors in the world. And they did it themselves."

"They did it all on their own," Partnoy agrees. "That's the most incredible thing about this crisis is that they pushed the button themselves. They blew themselves up."

Asked how much of this was incompetence on the part of Wall Street and the people who ran it, Jim Grant tells Kroft, "The truth is that on Wall Street, a lot of people just weren't very good at their jobs. It's as simple as that."

"These people were being paid $50 to $100 million a year. Some of them, the guys that were running the places," Kroft remarks.

"There is no defending," Grant replies. "A trainee making 45,000 a year would have had the common sense not to bet the firm on mortgage contraptions that no one in the firm actually understood. That is not a deep point to comprehend. Somehow, through, I will call it a criminal neglect and incompetence, the people at the top of these firms chose to look away, to take more risk, to enrich themselves and to put the shareholders and, indeed, the country, itself, ultimately, the country's economy at risk. And it is truly not only a shame, it's a crime."

60 Minutes requested interviews with top executives at Bear Stearns, Lehman Brothers, Merrill Lynch , Morgan Stanley, Goldman Sachs, and AIG. They all declined.
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Unregulated swaps seen as big factor in Wall Street collapse

By John Dunbar
The Associated Press
Sunday, October 12, 2008
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WASHINGTON — It can be a fine line between investing and gambling, but in Las Vegas, you know the odds.

On Wall Street that's not always the case, especially when it comes to the $62 trillion market in arcane financial contracts known as "credit default swaps."

"Moreover," added Michael Greenberger, former director of trading and markets for the Commodity Futures Trading Commission, "Las Vegas is regulated."

These swaps are increasingly being blamed for the near-collapse of insurance giant American International Group Inc., the bankruptcy of investment bank Lehman Brothers, and the downfall of other investment houses and financial institutions.

Members of the House Oversight and Government Reform Committee on Tuesday accused AIG of opening "a casino in London" when it began dealing in these complex derivative contracts. The Federal Reserve came to AIG's rescue three weeks ago with an $85 billion line of credit; so far, the company has tapped it for $61 billion.

The swaps are a form of insurance, but they aren't regulated that way.

Say a big investor buys a bond from a company, but is worried about the company's ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit default swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it.

The issuer doesn't write this insurance for free. It gets a fee, usually a percentage of the value of the bond.

False sense of security

The transactions are made "over the counter," not regulated by any public exchange, and since the contracts are not considered "insurance," Greenberger said, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.

The swaps have given those invested in all manner of debt, including mortgage-backed securities, a false sense of security.

"Everyone walked around saying, We're insured,'" said Greenberger, a law professor at the University of Maryland.

As housing prices rose and more people could get mortgages despite questionable credit records, mortgage-backed securities were an attractive place for pension funds and other investors to park money.

"Were it not for that insurance, it certainly wouldn't have reached this manic state of growth," Greenberger said.

Mortgage-backed securities have turned sour with plummeting home prices and increasing default rates. The securities have clogged the credit market, prompting the Bush administration and Congress to put taxpayers on the hook buying them up.

As the government buys mortgage-backed securities from teetering financial institutions at less than face value prices, issuers of the credit default swaps could be liable for the difference.

That's troublesome enough, but it actually gets worse.

Phantom contracts

Buyers of credit default swap insurance are not required to own the underlying securities they are insuring.

In other words, the investor can buy insurance on a mortgage-backed security without having to buy the security itself. When that security turns sour, whoever is holding the credit default contract — whether they actually own the security or not — can demand payment for the face value of the security.

This has created a market in which speculators actually are betting that mortgage-backed securities will lose their value.

Because the market is unregulated, the size of the credit default market is difficult to estimate.

The International Swaps and Derivatives Association, a trade group, estimates that its "notional value" for year-end 2007 at $62.2 trillion — roughly five times the entire U.S. production of goods and services last year. The total represents how much sellers of the protection would have to pay if every one of the securities were to default, an unlikely scenario to be sure.

But even this is a rough estimate. Participation in the survey was voluntary. What is helping drive the panic in these contracts is that little is known about who owes what to whom.
http://www.venturacountystar.com/news/2008/oct/12/unregulated-swaps-seen-as-big-factor-in-wall/?printer=1/
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The $55 trillion question
The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?
By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter
Last Updated: September 30, 2008: 12:28 PM ET

(Fortune Magazine) -- As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see "Hank's Last Stand").

And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation.

"The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."

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AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.

Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)

You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.

Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.

The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.

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ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

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THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."
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