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The Political Blogosphere Jumps the Shark & The Path Forward

Dave Hoffman

Dave Hoffman is the Murray Shusterman Professor of Transactional and Business Law at Temple Law School. He specializes in law and psychology, contracts, and quantitative analysis of civil procedure. He currently teaches contracts, civil procedure, corporations, and law and economics.

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9 Responses

  1. Bruce Boyden says:

    Dave, maybe you can clear something up for me. I don’t understand why the commercial paper market is freezing, and how buying bad mortgage securities helps that. Aren’t those two different markets? And why would everyone stop making short-term loans? I can understand the price going up. I’m having trouble understanding why loans would just stop.

    As far as I can tell (which is not far), the bailout package failing is a big deal because people think the bailout package failing is a big deal. Hmmm, someone in a time of economic stress had a famous quote similar to that, let me think…

  2. shg says:

    Take your dialogue a step farther:

    Tiahrt: Are you telling me that you operate your business without enough cash on hand to manage regular operations for a period of 30, 60, 90 days? You need a loan just to make it through pay day?

    HT: Well, uh, yeah, I do.

    Tiahrt: So what is wrong with your business that you can’t manage to survive, to perform basic daily functions, except on debt?

    HT: Well, uh, I keep spending and spending, because I always thought I could borrow and borrow and someday I would catch up.

    Tiahrt: So our “national crisis” is really a crisis of your making because you spend wildly and fail to keep funds on hand to meet obligations.

    HT: Well, uh, yeah.

    Tiahrt: And you’re angry with me for not giving away $700 billion in taxpayer money because you can’t manage your own finances?

    HT: Well, uh, yeah.

    Tiahrt: So, maybe, just maybe, it’s time for your business to fold and for someone else to fill your niche who can manage to operate a healthy going concern, conduct business within its means, maintain adequate cash reserves to finance your own operation and be part of a healthy and contributing business economy rather than behave like a junkie in need of a fix.

    HT: But we’re an American business. If we can’t borrow, we’ll die.

    Tiahrt: And that’s now everyone else’s fault, and problem.

    The crisis is one of perception. The commercial paper market will open again as if nothing happened on its own, because it has no other choice. The money has to go somewhere, or it’s useless. Those who can’t survive for 30 days without it probably shouldn’t survive.

    And even if this bailout passed, it would do nothing to cure the disease. It’s only treating a symptom. The patient would remain as sick as before.

  3. Mike says:

    There is a crisis, I guess. But what exactly is it and how would the Bush/Paulson plan resolve it? I have read a lot about this but still do not see how what they want to do will actually solve the liquidity problem. I don’t see why the Fed Reserve lacks the capacity to flood the system with liquidity under its existing authority. Might it be that we need new financial institutions, or those that clearly have not been implicated in all of these bizarre ways to get that liquidity and get customers needing credit? Is that much different than what happened with the savings and loan crisis, an early indicator that unregulated financial markets end up crashing?

    At the other end, why not let the FHA, Freddie and Fannie work their way through all the mortgages that make up these crazy financial instruments doing workouts. That will take time and so won’t resolve the immediate credit crisis. But it will sort out what can be repaid and what can’t within all those “risk spreading”, er, “risk generating” schemes that have blown up the bursting of the housing bubble into a potential bursting of the world economy.

    I think the next step has to be to start all over. Scrap the idea that the Bush/Paulson approach is relevant. Find mechanisms, new or already existing, and put them to work.

  4. A.J. Sutter says:

    According to a report on Bloomberg , commercial paper for financial companies was “freezing,” but not for manufacturing companies, Microsoft, and other non-financials. The spread in basis points was huge. In fact, borrowing costs for industrials are at their lowest point in 4 years, since they are regarded as a safe haven.

    I think the obvious explanation of that would be lack of mutual trust among the financials. In theory, buying up bad loans might improve the balance sheets of financial companies, and thereby restore trust.

    But as Bruce points out, true freezing sounds different from a price increase. Maybe the problem is hyperbolic use of “freezing” instead of “is getting prohibitively expensive”…

  5. dave hoffman says:

    Bruce: The mechanism is as follows. A refusal to extend commercial credit arises from two sources: (1) significant doubt as to counterparties’ ability to repay, based on an inability to value toxic mortgage-related assets, and a leveraging of those assets widely in the economy; and (2) a classic bank run – a lack of confidence. The proposal rejected today would help with #1 by pricing the assets and removing them from institution’s books, leading, we would hope, to an easing of the trust problem.

    Scott: I don’t understand, and to the extent I do, I disagree. The credit crisis isn’t an illusion – it is caused by vaporous assets on the books, and a collapse in the value of homes, and a resulting rise in foreclosures, as individuals who leveraged themselves find themselves unable to pay. The money doesn’t actually have to go anywhere. Given a choice between a highly volatile market that lost 7% on a single day and holding onto cash, investors are obviously choosing cash (that’s why you see such low returns for treasury bills. .25 percent today, I think!) As for your point about funding operations with commercial paper, I probably am missing your point, because I think you are suggesting that we pay for operations with cash. It may be that we get to that kind of world – which would look something like how the economy operated before 1920. But it would look nothing like the world we live in, and we wouldn’t be able to support nearly the population, or lifestyle, we now enjoy.

    AJ: You are right, that *right now* much of the credit rate illiquidity is limited to financial firms. But though if you fish around the net there are many stories about smaller firms – franchisees, distributors, retailers who are being told that there are no loans at all available. Give it a few days, and we’ll see whether the market will continue to see retailers as a safe haven. In my view, there are no ports in this storm. Also, I don’t see a particularly relevant difference between “freezing” and “prohibitively expensive”. Obviously, credit will always be available at some cost. Degenerate gamblers with a history of welching can get credit, from loan sharks. It just depends on what you mean by liquidity.

  6. Bruce Boyden says:

    Thanks Dave. I’m still missing something though, and I’m hoping you can help. I don’t get the connection between the mortgage-backed securities and the wider threat to the national economy/credit market.

    Let’s call the class of all institutions holding a significant amount of unpriceable mortgage-backed securities “X”. The members of X are in dire straits right now because they had to mark down the value of their assets, and those assets are now totally illiquid. And then there is the class of all institutions that offer credit, in the commercial paper market and elsewhere. Let’s call that class “Y”. Finally, let’s call the class of all entities *needing* credit “Z.”

    The classes I’ve identified can be drawn using a Venn diagram with 3 overlapping circles. The part I’m unclear about is the amount of overlap. It’s pretty clear that no one would want to loan money to the Z’s that are also X’s. They’re in danger of going under, and the danger is you’ll never get your money back. It’s also pretty clear that the Y’s that are also X’s may not be in a position to extend any credit right now. How much of the diagram have I just eliminated? If it’s only a small fraction, what’s the problem with all of the remaining Y’s lending to all of the remaining Z’s? And who cares if the X’s go under?

    If it’s a large fraction — well, that just seems sort of implausible. How is it that *everyone* is *heavily* invested in these things? I mean, there are only so many mortgages to go around. How many financial institutions are heavily invested in securities based on accounts receivable? On oil? On corn yields? Why would MBSs be so much more prevalent?

  7. Nate Oman says:

    Bruce: The securitized debt market is roughly $13 trillion, which is also roughly equal to a years GDP for the United States. I think that a lot of people have no sense of how truly huge this market is.

  8. Dave says:

    Bruce – the key is the Y’s don’t have the capital to cover the demand of the Z’s. The X’s have cash that might have been loaned tied up to cover calls against their written down assets. Plus, some X’s are defaulting on loans because their liabilities are exceeding their written-down asstes, and they file for bankruptcy. Thus, the price goes up for credit (because of both constrained supply and increased default risk), and less is available. Less credit means less investment, less investment means the economy starts to recede, and we don’t have one of the main tools employed to get us out of recessions: cheap credit. The result, as Dr. Peter Venkman would put it: human sacrifice, dogs and cats living together… mass hysteria!

    But it doesn’t need to be this way. The problem here is not that the MBS’s are worthless, but that we don’t know how much they are worth, because the market in them has collapsed. But for the most part, most people will keep on paying the mortgages, which is what feeds the securities’ cash flow. Nobody wants to buy them right now because they don’t have a clue what they are. Is security x full of cash flows that will probably be paid off over the next 30 years, or is it on the point of becoming worthless? No one knows, because the cutting and slicing removes the asset from the initial mortgagee, and the actuarial models were based on a time when housing prices did nothing but rise. The result is that until better information is available, there is neither interest nor liquidity in the market, and the market values have dropped to ridiculously low levels.

    The key is getting the market in these things going, so that firms don’t have to write them down so much (because of mark-to-market). Hence the reasoning behind the “bailout”: if the treasury becomes a buyer of the securities, that added demand will trigger an active market, and better approximation of actual values. With higher values, firms don’t have to write them down so much, that frees up cash to be loaned and prevents defaults, and the rest of the credit markets start functioning again, and we can all get back to emulating Wile E. Coyote’s blissfull ignorance, because sometimes there is nothing keeping us from falling into the abyss but a lack of confidence in our ability to keep ourselves afloat in midair.

  9. Eigernorthface says:

    The CEO’s have been asked to return in December with a plan that could become a law and get an appropriation.

    Fair enough, gentlemen are you prepared to lay down your careers to save your companies?

    That’s what it would take — and not just you — the top five layers of management.

    You don’t have to go out of there wearing dunce caps, but if you made that part of the deal, you would get a few more votes.

    Why can’t anybody in America ever accept responsibility for anything. In Japan — well let’s not go there — not our tradition.

    These guys don’t need golden parachutes — they’ve paid themselves so well for so long that they and next 6 generations of their families are set for life.

    If they retire early, and just say OK we blew it, go get some new guys, do a national search, make it a professional recruitment of the highest quality — whoever you get can’t do worse than we did — that would add huge credibility to the proposed bailout that they offer.

    The proposed bailout would be an “us-free plan” — a plan without us in it. We care enough about our companies, that we will lay down out careers if that will help save our firms and the jobs of 10 million people and maybe keep the US from sliding right over the precipice into a full scale Great Depression Revisited.

    Sincerity according to Kung Fu Tze (Confucius) is the source of a man’s power. How better to show sincerity than by self-sacrifice. With the money they have, their retirements wouldn’t be that bad, right? A little more time on the tennis courts, a little less time designing gas guzzling SUVs, Escalades, 3500 Series Trucks for personal use.

    Whoever comes in with the electric cars, the hybrids, the super-efficient cars has got to believe in those things to make it work. If the only thing that we know about the car companies is that the guys who run them now do not believe in those things, then let’s use all the information we have. So what does that info say? It says: “Can these guys. Get some other people!”

    You want a plan that Congress will adopt? You want a Bill they will pass and pay for? Make it one that does not have you in it — that adds a lot of weight to your proposal — less is more you see?

    Eigernorthface approved this message 20 Nov 2008 1600 hrs EST

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