Good reads from the U.K. on the U.S. bailout

"Those whom the gods would destroy, they first make mad," Willem Buiter, Financial Times.

"Unprincipled Madness," Tony Curzon, Open Democracy. An excerpt:

Both [Frank Shostak and Amn Pettifor] have the sense that the financial system has produced an illusion of wealth while actually, in important ways, eating at the core of what makes for a good society.The difference comes in a disagreement about the nature of the good society, and not in the analysis of what has gone wrong with our own bad societies. Pettifor stands for social equity, Shostak for market-faith. Pettifor goes much further in her analysis of the manufacturing of demand for debt through consumerism and her analysis of the distributional consequences of low input price for banks (in the form of cheap money) and high output prices for banks (in the form of expensive consumer debt).

Nevertheless, Shostak and Pettifor are in a strange analytical agreement over the mechanism of the mess we're in. It is therefore slightly less surprising that many Republicans and many Democrats voted against the bail-out: the orthodoxy at the centre of American politics is under attack--under an analytically similar attack--from both left and right. The vocal voter phoning in to their Representative is pretty likely to be able to justify a strong sense of indignation against the bail-out, whether they are free-market mystics or Democratic progressives. Buiter correctly identifies some of the anti-bail-out sentiment as "mad but principled"'. If the shrinking centre-ground means that it is made up of the "unprincipled but sane"', it may be time to abandon the centre and to have the real argument over the shape of the good society.

Tony Curzon's RSS feeds here, which includes the Becker - Posner blog (Chicago), where Judge Posner offers this remarkably clear summary of the current crisis:

Banks (broadly defined to include investment banks and the many other lenders) borrow--bank deposits, for example, are loans to banks--and then lend out what they have borrowed. As a result, their loans are much larger than their capital assets (cash, a building, etc.). If their capital shrinks in value, they have less protection against the possibility that the loans they make will not be repaid in full. If a bank's capital is 10, and it borrows 100 and lends 100, and the persons or firms it lends to return only 90, its net worth will fall to zero (10 [its capital] + 90 [the value of its loans] - 100 [the amount it owes its depositors] = 0.

Banks in recent years have increased the ratio of their loans to their capital because borrowing costs were low and financial experts thought they had discovered ways of reducing the risk of leverage (that is, of borrowing). Many of the loans were mortgage loans, and the value of those loans fell when the housing bubble burst. (Risky, and in some cases deceptive, mortgage practices had contributed to the bubble.) What made the situation worse was that rather than retaining the mortgages that they originated, banks (especially the major ones) sold the mortgages in exchange for securities backed by the mortgages. Those securities became a part of a bank's capital. The value of the securities depended on the value of the mortgages that the entity issuing the securities had bought; those mortgages were the entity's assets. As that value fell, the bank's capital fell.

The mortgage-backed securities achieved geographical diversification of mortgage risk. But the housing bubble, though not geographically uniform, was sufficiently widespread that geographical diversification did not reduce the risk of mortgage defaults sufficiently to avert the fall in the value of mortgage-backed securities.

A complicating factor was that the value of those securities was and is very difficult to determine, because each security represents a share in pieces of many different mortgages. The bank that owns the security cannot readily determine the value of all those different mortgages, since it has no direct relationship with the mortgagor, having sold the mortgage to the entity that issued the mortgage-backed securities.

Because the banking industry (and remember that I am defining "banking" very broadly, basically as all lending) was highly leveraged, and because much of its capital consisted of securities very difficult to value, the bursting of the housing bubble reduced the capital of the banks, but by an unknown amount. The reduction and uncertainty have curtailed lending by reducing the capital cushion that a bank needs to reduce to an acceptable level the risk that some of its loans will not be repaid. That is the "credit crunch," and it is painful because so many individuals and businesses borrow to finance their activities.

Ordinarily one would expect a credit crunch to be self-correcting. As lending dropped because of the fall in bank capital, interest rates would rise and this would attract more capital to the financial markets. We have seen this process at work in Warren Buffett's $5 billion investment in Goldman Sachs. Buffett has capital, Goldman needs it, so Buffett gives it to Goldman in exchange for preferred stock (which is really a type of bond but one that does not have a term--it is never repaid) paying a handsome interest rate.

But Goldman is pretty healthy. Many lenders have so much of their capital tied up in mortgage-backed securities or other novel forms of capital that are difficult to value that they cannot attract new capital at a price that would enable the lender to continue in business. The sale of the securities would just expose their lack of value. . . .

From the "$700+ Billion Bailout - Posner"