By now, most homeowners know that their monthly mortgage payment might go to a pension fund in another state or a bank in another country, thanks to the bundling of home loans into securities.

What they might not realize is that these mortgage-backed securities are only the beginning of the slicing and dicing that has brought the world’s financial markets to the abyss. Companies that purchase these securities also buy something called “credit default swaps,” a product cooked up by Wall Street in an effort to insure against losses.

The explosive growth of these credit derivatives, as they are known, is a tale of hubris, folly and blind devotion to markets. Derivatives now back more than $60 trillion in credit ”” that’s 20 times the annual budget of the United States making them kind of like cluster bombs spread throughout the global economy.

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The banks aren’t lending. And despite what you have heard, they probably won’t start just yet….

Sure, there are some positive signs that the credit market is opening up a bit: Libor rates, the price at which banks lend to each other, have crept down in recent days, greasing the wheels of capitalism, or at least what’s left of it. Some banks, like JPMorgan Chase and Citigroup, actually made loans to banks in Europe on Friday. These are all important steps on the way to a recovery.

But make no mistake, the banks are doing the opposite of what Henry M. Paulson Jr., the Treasury secretary, sought when he virtually demanded that they accept the taxpayers’ money: They are hoarding it. It’s a bit like the government’s sending out tax rebate checks and the consumers’ not immediately running out and spending them.

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Euro: 5.02% vs. prior 5.08%; Dollar: 4.42% vs. prior 4.50%; Sterling: 6.16% vs. prior 6.18%.

The good news is the move is in the right direction, the struggle is the process is painfully slow–KSH.

Since the 1980s, Americans have consumed more than they produced””and they have made up the difference by borrowing.

Two decades of easy money and innovative financial products meant that virtually anyone could borrow any amount of money for any purpose. If we wanted a bigger house, a better TV or a faster car, and we didn’t actually have the money to pay for it, no problem. We put it on a credit card, took out a massive mortgage and financed our fantasies. As the fantasies grew, so did household debt, from $680 billion in 1974 to $14 trillion today. The total has doubled in just the past seven years. The average household owns 13 credit cards, and 40 percent of them carry a balance, up from 6 percent in 1970.

But the average American’s behavior was virtue itself compared with the government’s. Every city, every county and every state has wanted to preserve its many and proliferating operations and yet not raise taxes. How to square this circle? By borrowing, using ever more elaborate financial instruments. Revenue bonds were backed up by the prospect of future income from taxes or lotteries. “A growing trend is to securitize future federal funding for highways, housing and other items,” says Chris Edwards of the Cato Institute. The effect on the projects, he points out, is to make them more expensive, since they incur interest payments. Because they “insulate the taxpayer from the cost”””all that needs to be paid now is the interest””they also tend to produce cost overruns.

Local pols aren’t the only problem. Under Alan Greenspan, the Federal Reserve obstinately refused to inflict any pain.

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Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.

The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.

In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.

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The actions are “not what we ever wanted to do”, Mr Paulson conceded, “but today, there is a lack of confidence in our financial system ”“ a lack of confidence that must be conquered because it poses an enormous threat to our economy.”

In recent weeks, governments around the world have had to respond to the financial crisis with extraordinary measures and dizzying speed. The financial system came close to calamity in the days after the Bush administration, arguing that markets should be allowed to work difficulties through without government help, let the investment bank Lehman Brothers fail last month. Before a week was out, however, the US government had to take over the world’s largest insurance giant, AIG, and promise to guarantee all the money in the $3 trillion money market industry. Last month, it became the country’s largest mortgage lender when it took over the tottering mortgage finance giants Fannie Mae and Freddie Mac in a rescue bid that could cost taxpayers $200bn.

Almost without any thought, the actions usher in a new and unpredictable era in American capitalism.

“It wasn’t just the right move, it was the only move,” Ken Rogoff, Harvard University economist, said of yesterday’s cash injection. “Thank goodness they didn’t dally for another week to finally figure it out.”

Read the whole article.

Similarly, euro three-month Libor, which was down 7.37bp at 5.225 per cent on Tuesday remains high.

“The fact that the boldest banking guarantee in history was not worth more . . . raised some eyebrows,” said Christoph Rieger, analyst at Dresdner Kleinwort.

Dollar three-month Libor is reacting better, down 11.75bp at 4.635 per cent, which was accompanied by a 15bp rise in the yield on three-month Treasury bills to 0.4 per cent.

This leaves the so-called Ted spread, which measures the difference between interbank lending rates and risk-free government lending rates, at a hefty 420bp. “These developments suggest that the market is reducing the odds of imminent financial Armageddon, but that significant year-end funding issues remain,” said TJ Marta, strategist at RBC Capital Markets.

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The government’s plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis.

Many economists believed that the heart of the government’s initial plan to pay $700 billion for toxic assets was aimed at the wrong target. Purchasing mortgage securities from banks wouldn’t do anything to kick-start lending and get credit flowing again, they said. Rather, banks would use the proceeds they got from the Treasury to pay off debtors, and those debtors would use the proceeds to buy safe assets.

They said a wiser course — the one the Treasury now seems to have come around to — was for government to rebuild the badly depleted cash levels on bank balance sheets. That would cushion institutions against future losses, giving them the wherewithal to lend again. Other hitches in the original plan include coming up with a price for mortgage securities that is above the “fire sale” level they would draw on the open market, but not so high that taxpayers end up getting taken for a ride.

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The Wall Street geeks, the quantitative analysts (“quants”) and masters of “algo trading” probably felt the same irresistible lure of “illimitable power” when they discovered “evolutionary algorithms” that allowed them to create vast empires of wealth by deriving the dependence structures of portfolio credit derivatives.

What does that mean? You’ll never know. Over and over again, financial experts and wonkish talking heads endeavor to explain these mysterious, “toxic” financial instruments to us lay folk. Over and over, they ignobly fail, because we all know that no one understands credit default obligations and derivatives, except perhaps Mr. Buffett and the computers who created them.

Somehow the genius quants ”” the best and brightest geeks Wall Street firms could buy ”” fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and ”” poof! ”” created $62 trillion in imaginary wealth. It’s not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers. Or maybe we are lost in space, with Dave the astronaut pleading, “Open the bank vault doors, Hal.”

As the current financial crisis spreads (like a computer virus) on the earth’s nervous system (the Internet), it’s worth asking if we have somehow managed to colossally outsmart ourselves using computers. After all, the Wall Street titans loved swaps and derivatives because they were totally unregulated by humans. That left nobody but the machines in charge.

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Remember the Rule of Holes: When you find yourself in one, the first thing to do is to stop digging.

Right now we’re in one of the deepest economic holes anyone has ever seen. And what we need to do is to stop making things worse by continuing to over-rely on financial markets and financial institutions that have proven to be incapable of performing their core missions: getting capital to where it needs to go and pricing that capital in a way that reflects the risks and underlying economic values. We have to stop digging. Another week like this one, and there won’t be much left to rescue.

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For U.S. Depository Institutions non borrowed reserves have been between $30-50B for the past 65 years.

Two weeks ago the number was -154 Billion

Today? -363 Billion.

–From a friend who is an analytical whiz about the industry. For those interested in the subject, the latest information on this may be found here.

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”

–Alan Greenspan, former Federal Reserve chairman, in 2004

US shares plummeted again last night as fears that further, frantic efforts by governments to halt financial turmoil will fail to stave off global recession triggered another punishing slump in stock markets.

As panic over the danger of financial and economic meltdown swept Wall Street once more, the latest 7 per cent plunge in the value of America’s blue-chip businesses piled pressure on world financial leaders gathering in Washington today to take yet more drastic measures to avert disaster.

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George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives ”” exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street.

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Not a pretty picture at all. (For a longer term perspective, look here, and for further background, please see this earlier thread).

AIG suffered huge losses when its credit rating was cut, thanks largely to complex financial transactions known as “credit default swaps.” AIG was a major seller of the swaps, which are a form of insurance, though they are not regulated that way.

The swap contracts promise payment to investors in mortgage bonds in the event of a default. AIG has been forced to raise billions of dollars in collateral to back up those guarantees. AIG stopped selling credit default swaps in 2005 to limit its exposure, but the damage was done.

Read the whole article.

“The core problem is that the smart people are realizing that the banking system is broken,” said Carl Weinberg, chief economist at High Frequency Economics. “Nobody knows who is holding the tainted assets, how much they have and how it affects their balance sheets. So nobody is willing to believe that anybody else isn’t insolvent, until it’s proven otherwise.”

—From the IHT

U.S. Securities and Exchange Commission Chairman Christopher Cox’s regulators stood by as shrinking capital ratios and growing subprime holdings led to the collapse of Bear Stearns Cos., according to an unedited version of a study by the agency’s inspector general.

The report, by Inspector General H. David Kotz, was requested by Senator Charles Grassley to examine the role of regulators prior to the firm’s collapse in March. Before it was released to the public on Sept. 26, Kotz deleted 136 references, many detailing SEC memos, meetings or comments, at the request of the agency’s Division of Trading and Markets that oversees investment banks.

“People can judge for themselves, but it sure looks like the SEC didn’t want the public to know about the red flags it apparently ignored in allowing Bear Stearns and other investment banks to engage in excessively risky behavior,” the Iowa Republican said in an e-mailed statement.

Read it all. I find this really frustrating. When I hear all the talk of “more regulation” being needed, I worry about the poor record of the current SEC. In some cases, we do need more regulation, as for example the CDS market. But more than anything we need wiser regulation and better regulators–KSH.

Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system, according to government officials.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.

The proposal resembles one announced on Wednesday in Britain. Under that plan, the British government would offer banks like the Royal Bank of Scotland, Barclays and HSBC Holdings up to $87 billion to shore up their capital in exchange for preference shares. It also would provide a guarantee of about $430 billion to help banks refinance debt.

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In addition to the original $85 Billion, now AIG gets a whole lot more.

I just keep thinking of Everett Dirksen:

As I think of this bill, and the fact that the more progress we make the deeper we go into the hole, I am reminded of a group of men who were working on a street. They had dug quite a number of holes. When they got through, they failed to puddle or tamp the earth when it was returned to the hole, and they had a nice little mound, which was quite a traffic hazard.

“Not knowing what to do with it, they sat down on the curb and had a conference. After a while, one of the fellows snapped his fingers and said, ”˜I have it. I know how we will get rid of that overriding earth and remove the hazard. We will just dig the hole deeper.'”

“The U.S. Treasury looks like a triage unit on a daily basis.”

–John Licata of Blue Phoenix on Bloomberg Television today

There are some hints of improvement: Fannie Mae today sold $1 billion of three-month bills at a yield of 1.55%, down from 2.35% at last week’s sale.

Although Fannie Mae has essentially been nationalized, some investors still have been unwilling to buy the company’s debt, preferring Treasury securities instead.

So the sharp decline in Fannie’s three-month bill yields today suggests “a movement toward risk- taking,” says Tony Crescenzi, bond market strategist at Miller, Tabak & Co. in New York.

Read it all.

“The market can remain irrational longer than you can remain solvent.”

— John Maynard Keynes

Taxpayers will be committed today to providing more than £50 billion to bail out high street banks in an attempt to avert a cataclysmic failure of confidence.

Alistair Darling was due to tell the City in an early morning announcement today that the sum will be available for “investment” in banks that have demanded help from the Government. The drastic rescue move is designed to help to reassure savers and to kickstart the paralysed credit markets by encouraging banks to lend to each other again.

After meeting Mervyn King, the Governor of the Bank of England, Downing Street was forced to make the announcement earlier than it had intended because of fears that a second day of hammering for bank shares had made leading institutions vulnerable. HBOS shares slumped by 42 per cent yesterday, Royal Bank of Scotland was down 39 per cent and Lloyds TSB dived 13 per cent in another torrid day for the banks.

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Years ago, don’t ask me why, I was drawn into the moderatorship of a panel starring then-colleague Milton Friedman. His main point, iterated in the face of any criticisms or questions by panelists and audience members, was that markets succeed because, “unfettered,” they are the best expression of perfect freedom. They needed no watching or help from other spheres of life. Challenged: “Do you mean, Dr. Friedman, that there is no place where, say, the governments have a part to play in the market world?” “Roads!” The confident, one-word response sounded rehearsed. Roads have to run through private properties, subject to eminent domain. Anything else involving “others” with the “private” world? No, only “roads.”

Of course, not all advocates of “unfettered” and “unregulated” markets were as sure of themselves as Dr. Friedman, who was as informed and skillful a debater as I’ve ever known. Yet for most, governments were not to play any part in regulating or monitoring markets. Today we are hearing from many who are suddenly “born-again” advocates of some measure of regulating agencies and companies and transactions. The various sectors of society do have different interests and can mess each other up, but the headlines and prime time utterances this week indicate that, to give a secular translation of a “body of Christ” theme, “we are members one of another.” We re-learn it again, too late, during this “Worst Crisis Since 1930s,” and hope for healing.

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The nation’s celebrated rags-to-riches story began in the Nineties when free market reforms, fish quota cash and a stock market based on stable pension funds allowed Icelandic entrepreneurs to go out and sweep up international credit. Britain and Denmark were favourite shopping haunts, and in 2004 alone Icelanders spent £894m on shares in British companies. In just five years, the average Icelandic family saw its wealth increase by 45 per cent.

But, as a result of the international banking crisis, the billionaires who own everything from West Ham United football club to the Somerfield supermarket chain, Hamleys toy shops and the House of Fraser, are in trouble and the country is drowning in debt.

Iceland’s cheap labour force, the Poles and Lithuanians, have left already – there’s little point in sending home such a worthless currency, and the tourist season is over. Iceland is on its own.

Read it all.

As pressure built in the credit markets and stocks spiraled lower around the world on Monday, the Federal Reserve was considering a radical new plan to jump-start the engine of the financial system.

Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.

The plan was being formulated amid cascading losses in global stock markets, as the banking crisis spread across Europe and investors feared dire consequences for the world economy. The Dow Jones industrial average fell as much as 800 points before a late recovery, finishing down 369.88, below 10,000 points for the first time since 2004.

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“I told him, ‘You have to do this,’ ” [Charlie] Rose recalled in an interview on Saturday. ” ‘No one has your credibility, and people want to hear what you have to say.’ ”

Buffett agreed to do it, and Rose flew to San Diego, where Buffett would be on Wednesday. The hourlong interview on Wednesday night was vintage Warren Buffett: calm, plain-spoken and wry.

He called the current crisis an economic Pearl Harbor, requiring immediate action. Its biggest single cause, he explained, was the real estate bubble. “Three hundred million Americans, their lending institutions, their government, their media, all believed that house prices were going to go up consistently,” he said. “Lending was done based on it, and everybody did a lot of foolish things.”

As far back as 2003, Buffett had warned that the complex securities at the center of today’s troubles– once so profitable, but now toxic– were “financial weapons of mass destruction.” These securities were engineered by the math quants on Wall Street, and in the interview Buffett expressed his disdain: “Beware of geeks bearing formulas.”

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What’s occurring now is a frantic effort to prevent a modern financial disintegration that deepens the economic downturn. It’s said that the $700 billion bailout will rescue banks and other financial institutions by having the Treasury buy their suspect mortgage-backed securities. In reality, the Treasury is also bailing out the Fed, which has already — through various actions — lent financial institutions roughly $1 trillion against myriad securities. The increase in federal deposit insurance from $100,000 to $250,000 aims to discourage panicky bank withdrawals. In Europe, governments have taken similar steps; Ireland and Germany have guaranteed their banks’ deposits.

The cause of the Fed’s timidity in the 1930s remains a matter of dispute. Some scholars suggest a futile defense of the gold standard; others blame the flawed “real bills” doctrine that limited Fed lending to besieged banks. Either way, Fed Chairman Ben Bernanke, a scholar of the Depression, understands the error. The Fed’s lending and the bailout aim to avoid a ruinous credit contraction.

The economy will get worse. The housing glut endures. Cautious consumers have curbed spending. Banks and other financial institutions will suffer more losses. But these are all normal symptoms of recession. Our real vulnerability is a highly complex and global financial system that might resist rescue and revival. The Great Depression resulted from the mix of a weak economy and perverse government policies. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.

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Two September shocks will define the presidency of George W. Bush. Stunningly enough, it already seems clear that the second — the financial crisis that has only begun to unfold — may well have far greater and more lasting ramifications than the terrorist attacks of Sept. 11, 2001.

That’s because while 9/11 changed the way we view the world, the current financial crisis has changed the way the world views us. And it will also change, in some very fundamental ways, the way the world works….

The current economic debacle is far more likely to be seen by historians as a true global watershed: the end of one period and the beginning of another. The financial chaos has brought down the curtain on a wide range of basic and enduring tenets also closely linked with the Reagan era, those associated with neoliberal economics, the system that the Nobel Prize-winning economist Joseph Stiglitz has called “that grab-bag of ideas based on the fundamentalist notion that markets are self-correcting, allocate resources efficiently and serve the public interest well.” Already this crisis has seen not just our enemies but even some of our closest allies wondering whether we are at the beginning of the end of both American-style capitalism and of American supremacy.

Read the whole piece.