Tuesday, August 4, 2009

The US government, via the Federal Reserve and US Treasury, caused the financial meltdown in September 2008.

Major premise: The US government, via the Federal Reserve and US Treasury, caused the financial meltdown in September 2008. (Cause-in-fact, not proximate cause).
Minor premise: There was no need for a bailout by the US government. The US stock market crashed and the panic continued after the bailout was reinstated. When the first bailout was rejected, the market actually rallied.

Argument in favor of thesis:
Major premise arguments--
The Ted Spread is a good proxy for panic in the credit market.
The Ted Spread spiked only after September 11, 2008, which was after the US government took over Fannie Mae and Freddie Mac. Reference I(1) below, note the spike upwards.

The stock market did not crash until September 30, which was after Paulson/Bernanke proposed the first bailout, which was formally announced on September 18. However, it is speculated (but not proven) that the plans for the bailout must have been discussed by Treasury and the Federal Reserve at least a few days before September 18. If in fact the plans were formulated on or before September 11, then it can be argued that the credit markets froze up because credit holders thought they would benefit from the bailout rather than trading their toxic debt. This cannot be proven at this time however [but see this thread below on Volcker's proposal in the Wall Street Journal, a few days before the Fed and Treasury bailout plea to Congress]

Minor premise arguments--
The Ted Spread historically has spiked just as dramatically as it did in September 2008, see for example the Ted spread in the late 1970s, in particular 1978 (Reference I(2) below). Yet the economy did not collapse, as per Paulson’s statement on September 18 in support of the first bailout (“"If we don't do this, we may not have an economy on Monday." Reference II below). Similarly, the equivalent of the Ted Spread in Japan has spiked upwards as dramatically as in the US during the 1990s, but it did not cause the end of the Japanese economy (reference: guest on Bloomberg, link unavailable).
Even with the first bailout voted down by the US Congress, on September 29, the market did not crash, in fact the next day it rallied. It crashed beginning after October 1, when the Senate formulated their own bailout plan on October 1, when the U.S. Senate passed HR1424, their version of the $700 billion bailout bill. Thus the bailout being rejected was either neutral or even positive for stabilizing the credit panic.

BTW, we are discussing in this thread the "cause-in-fact" of the Crash, not the "proximate cause". That is, what caused the bubble to pop, not what caused the bubble to inflate in the first place. This is important since a balloon that is overinflated can be gradually allowed to deflate without harm to the balloon, rather than, as was done by the US government, popping the balloon and causing a panic.


I) (1) Ted Spread: http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP:IND
(2) Long term TED spread: http://www.crystalbull.com/stock-market-timing/TED-Spread-chart

II) Timetable of Financial Crisis for September 2008: http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline#September_2008
September 2008
Main article: Global financial crisis in September 2008
September 7: Federal takeover of Fannie Mae and Freddie Mac, which at that point owned or guaranteed about half of the U.S.'s $12 trillion mortgage market, effectively nationalizing them. This causes panic because almost every home mortgage lender and Wall Street bank relied on them to facilitate the mortgage market and investors worldwide owned $5.2 trillion of debt securities backed by them.[137][138]
September 14: Merrill Lynch is sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse[139]
September 15: Lehman Brothers files for bankruptcy protection[140]
September 16: Moody's and Standard and Poor's downgrade ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[141][142]
September 17: The US Federal Reserve lends $85 billion to American International Group (AIG) to avoid bankruptcy.
September 18: Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke meet with key legislators to propose a $700 billion emergency bailout through the purchase of toxic assets. Bernanke tells them: "If we don't do this, we may not have an economy on Monday."[143]
September 19: Paulson financial rescue plan is unveiled after a volatile week in stock and debt markets.
September 23: The FBI discloses that it had been investigating the possibility of fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group, bringing to 26 the number of corporate lenders under investigation.[144]
September 25: Washington Mutual is seized by the Federal Deposit Insurance Corporation, and its banking assets are sold to JP MorganChase for $1.9 billion.
September 29: Emergency Economic Stabilization Act is defeated 228-205 in the United States House of Representatives; Federal Deposit Insurance Corporation announces that Citigroup Inc. would acquire banking operations of Wachovia.[145]
September 30: US Treasury changes tax law to allow a bank acquiring another to write off all of the acquired bank's losses for tax purposes [146]
III) Stock market DJIA: http://www.google.com/finance?q=INDEXDJX:.DJI


  1. Here is an update provided by an astute reader on Google Groups misc.invest.stocks, Ex-government officials Brady, Ludwig and Volcker actually proposed a sort of bailout a few days before Volcker's proposal, in an editorial in the Wall Street Journal, repeated below. Hence this also is evidence that the 'cat was out of the bag' and credit markets seized up in anticipation of a bailout.

    Ray Lopez


    SEPTEMBER 17, 2008

    Resurrect the Resolution Trust Corp.


    We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse.

    Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis.

    Fannie Mae and Freddie Mac, the giants in the mortgage market, are overextended and now under new government protection. They are not in sufficiently robust shape to meet all the market's needs.

    The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments, levered as much as 30 times.

    Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy that so far has held up reasonably well.

    There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.

  2. Here is a op-ed in 2009 by Alan Greenspan that argues since long-term interest rates did not track the short term rates set by the Fed, then the Federal Reserve is not responsible for the housing bubble. Interesting and plausible. Greenspan blames poor understanding of risks.

    go here: http://online.wsj.com/article/SB123672965066989281.html

  3. An excellent journal on the bubble is as follows: Critical Review, A Journal of Politics and Society, Vol. 21, Numbers 2-3, 2009, ISSN 0891-3811. In it, there is a good article by Juliusz Jablecki and Mateusz Machaj, "The Regulated Meltdown of 2008", which has a table, Fig. 15, which shows in 2007-2008 that the panic had two components: a credit risk and a liquidity risk. The credit risk, from 2007, actually predates the liquidity risk. This is further evidence that the panic was caused by some other trigger than the realization that banks had toxic assets and could fail. The trigger was the bailout IMO (though the authors don't say this). Of interest in this journal are the "proximate causes" (the underlying causes of the crash). But this thread is addressing the 'causes-in-fact' (the actual trigger), and again I maintain it was the rash action of the Fed in September 2008 that caused the bubble to pop, rather than gradually deflate.

  4. Here is more evidence of the Fed causing the crash (the immediate cause). This from conservative economist John Taylor, who has wrote " Government actions and interventions, not any inherent failure or instability of the private economy, government actions, caused, prolonged, and worsened the crisis" - John B. Taylor

    Critical Review: A Journal of Politics and Society, Vol. 21, Nos. 2-3, 2009
    Economic Policy and the Financial Crisis: An Emperical Analysis of What Went Wrong – John B. Taylor
    p. 358
    An Event Study
    Many commentators have argued that the reason for the worsening of the crisis was the decision by the U.S. government (more specifically the Treasury and the Federal Reserve) not to intervene to prevent the bankruptcy of Lehman Brothers over the weekend of 13 and 14 September. It is difficult to bring rigorous empirical analysis to this question, but it is important that researchers do so, because future policy actions depend on the answer. Perhaps the best empirical analyses we can hope for at this time are "event studies" that look carefully at reactions in the financial markets to various decisions and events. Such an event study, summarized below, suggests that the answer is more complicated than the decision not to intervene to prevent the Lehman bankruptcy and, in my view, lies elsewhere.
    Figure 13 focuses on a few key events from I September through mid-October 200S-the last few observations in Figure 12.
    Recall that for the year previous to the events represented in Figure 1 3, the spread had been fluctuating in the 50 to 1O0 basis point range, which was where it remained through the first half of September 2008. I t is evident that the spread moved a bit on 15 September, which is the Monday after the weekend decision not to intervene in Lehman Brothers. It then bounced back down a little bit on 16 September, around the time of the A.I.G. (American International Group) intervention While the spread did rise during the week following the Lehman Brothers decision, it was not far out of line with the range of the previous year.
    On Friday of that week, the Treasury announced that it was going propose a large rescue package, though the size and details hadn't been determined. Over the weekend, the package was put together a on Tuesday, 23 September, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson, testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2page draft of legislation with no mention of oversight and few restrictions on the funds' use. They were questioned intensely in this hearing and the reaction was quite negative, judging the large volume of critical mail received by many members of the United States Congress. As shown in Figure 13, it was following this testimony that one really begins to see the crisis deepening, as measured by the relentless upward movement in the LIBOR-OIS spread for the next three weeks. The situation steadily deteriorated, and the spread went through the roof to 3.5 percent.

  5. 2 of 2 John Taylor's comments from his paper:

    The Lack of a Predictable Framework for Intervention
    The main message of Figure 13 is that identifying the decisions over the weekend of 13 and 14 September as the cause of the increased severity of the crisis is questionable. It was not until more than a week later that conditions deteriorated severely. Moreover, it is plausible that events around 23 September actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led 1'0 believe. At a minimum, a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed and thereby had to be factored into investment decisions at that time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere. Some evidence of the uncertainty is found in a survey taken later (5 November) by the Securities Industry and Financial Markets Association; it showed that 94 percent of securities firms and banks found that the TARP lacked clarity about its operations.
    The problem of uncertainty about the procedures or criteria for government intervention to prevent financial institutions from failing had existed since the time of the Bear Stearns intervention in March. The implication of that decision for future interventions was not made clear by policy-makers. This lack of predictability about Treasury-Fed intervention policy and recognition of the harm it could do to markets likely increased in autumn 2008, when the underlying uncertainty was revealed for all to see. What was the rationale for intervening with Bear Stearns, and then not with Lehman, and then again with A.I.G? What would guide the operations of the TARP?
    Concerns about the lack of clarity were raised in many quarters. At the Stanford July 2008 conference on "The Future Role of Central Banking:
    The Urgent and Precedent-Setting Next Steps," held to address the new interventions, I argued [7] that the U.S. Treasury and the Fed urgently ...

  6. http://tinyurl.com/pdljc9

    Click on the above link to take you to the top of this blog where the unsized photo is of Fig. 13 from John Taylor's paper. This figure shows clearly how the crisis of 2008 was caused by the announcement of TARP. In contrast to Alan Meltzer, who claims the failure of Lehman Brothers caused the crash, this figure shows that Lehman's failure was a minor blip, and much more damaging was TARP.

    1. Another good graphic to show bailouts did not stabilize the market is here: http://www.hussmanfunds.com/wmc/wmc150803.htm

      Only if you assume an impossible-to-prove counterfactual like "it would have been worse without the bailouts" can you justify the bailouts.

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  8. A common graph is the one shown in this blog, which shows government action caused Libor-OIS spreads to drop, since the market hates uncertainty (it can be argued that the TED spreads shot up and the market seized up because people were waiting to see what the government would do). But another graph, which I will try and upload here, shows that Credit Default Swaps actually peaked in early 2009, well after the bailouts were passed. This shows that government action did nothing to stop uncertainty over default.

  9. I've updated the blog photos to show that Credit Default Swaps peaked in early 2009, not 2008. Sorry if the graph is hard to read but Google does not support bigger pictures. The graph was taken from Forbes, Oct. 5, 2009, p 32 print edition. This is more evidence that the bailouts were unnecessary. A further piece of evidence is a paper: How the Great Recession Was Brought to an End JULY 27, 2010 Prepared By Alan S. Blinder and Mark Zandi. They programmed a computer simulation to show what would happen in an economy with and without stimulus and government intervention. Though these are liberal economists trying to prove a Keynesian thesis that the stimulus was necessary, you will note that in their tables (e.g., see Table 4), that without any government intervention the GDP would actually grow higher in years to come. What would happen, shorter term, is unemployment would rise. So essentially political fallout is minimized by the government when it employs stimulus: keeping the unemployment rate lower than it would be, at a cost of future growth. Bear in mind however this was just a computer simulation, and in fact growth could be much higher without government meddling, as evidenced by the quick recoveries in the 19th century when government was much lower (and overall growth rates in the late 19th century, as Angus Maddison has show, were nearly the same as now).

  10. The growth in government worldwide is documented by economist Vito Tanzi. It started in the late 1950s and 1960s, worldwide. But it has not resulted in growth rates being any greater than in the days when government was less than 10% of GDP (total spending, including transfer payments which were lower years ago), see for example the graph here: tinyurl.com/32urgja

    Compare the late 19th century with the late 20th century for each country--which is more of an apples to apples comparison than the post WWII era, when economies were rebuilding from the ashes. If anything, the average growth back in 1870-1913 was greater (3.0%/yr) than in the period from 1986-1994 (2.4%) And in the USA, much greater: 4.7% vs. 2.5%.

    Lesson learned: government is bad. Big government is worse. Transfer payments are subject to hysteresis. On the last point, a cartoon in Reason magazine said it best: it showed a patient, the USA being given a blood transfusion by transferring blood from the left arm to the right arm. No matter how well intentioned, such transfer payments do nothing except placate the patent a bit (placebo effect). If we don't want social unrest, I say increase welfare payments to those truly needy (disabled, single mothers with kids, etc) but cut off all other social payments, including mandatory Social Security.

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    1. Lookie here jennifer: LIBOR was RIGGED! Shocking theatre for sure, since rising LIBOR rates were a big reason for the bailouts. This is bigger than Watergate IMO.


      #1 is the biggest story of the year. Wasn’t rising LIBOR rates the basis for the credit crisis bailouts of September / October 2008? And if BOE’s M. King knew that LIBOR was rigged in 2008, as the article states, then so did Treasury Secr. H. Paulson, his US counterpart. Isn’t that fraud of some sort? As I suggested to T. Cowen by email, somebody needs to write a paper on this exposing this to the wider public. Outrageous. Choice excerpts below. RL

      This has been an open secret among bankers and regulators since the start of the credit crunch in 2007. What any outsider would find surprising is that until now, neither the Financial Services Authority (FSA) nor the Bank of England have really made it their business either to replace Libor – or make it more accurately reflect reality. As we keep hearing, that was the situation for large parts of 2007, 2008 and 2009, when some of the “fixing” and attempted manipulation of Libor at Barclays was taking place. But, as Robert Peston often reminds us, it is also true of many banks right now – especially across the Channel.As it happens, the strangeness of this situation was captured very well by Sir Mervyn King in testimony to the Treasury Select Committee in late November 2008, when he had this to say about Libor. “It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing. It is hard to see how it can actually have much of an impact.”We are all understandably interested in what Bank of England deputy governor Paul Tucker and other senior officials may or may not have said about the Libor to Bob Diamond or other bankers, at the height of the credit crunch in 2008.

  12. From the Economist on the LIBOR scandal of July 2012. Rates were not reflective of real world borrowing--and this is a problem when policy makers are assuming the credit market has freezed up (when perhaps it has not, and in fact did not). Further, since LIBOR was rigged for more than a decade, the apparent stability of LIBOR was a mirage--this is even more damaging to policymakers like the US Treasury that panicked when LIBOR started rising in Sept. 2008.


  13. http://marginalrevolution.com/marginalrevolution/2012/07/assorted-links-501.html#comment-157608900

    #5 – LIBOR scandal– biggest story of the year.

    Facts: LIBOR was fixed (too low) during the “Great Moderation”–it was fixed says the Economist for decades. LIBOR therefore was not an accurate measure of interbank risk. Yet after the Lehmann Bro bankruptcy of Sept. 2008, US Treasury Secr Hank Paulson used LIBOR as evidence of the “end of the world” unless a bailout was granted by US Congress over the weekend (it was not, and the world did not end, but ultimately Paulson got what he wanted–a bailout for his friends on Wall Street).

    Question: if in fact the situation in September 2008 was not so bad as to warrant a bailout (in fact, credit default spreads peaked in early 2009, not 2008, see the graphic here: http://raylopez99.blogspot.com/ from Forbes magazine, which argues that the worse was not in Sept 2008 when the bailouts were first proposed in the USA), then ergo it follows the bailouts of 2008 were unnecessary.

  14. More proof that LIBOR was artificially low for years...giving a false signal that made the sudden rise in September 2008 seemingly inexplicable to US Treasury Secretary Hank Paulson (if we are to believe him).

    BUSINESS Updated July 13, 2012, 5:40 p.m. ET
    Fed, BOE Talked of Libor Problems in 2008


    Top U.S. and U.K. officials were aware in early 2008 that large international banks might have intentionally distorted a key global interest rate, but a trove of releases by central banks Friday left unanswered how aggressively authorities pressed banks to address the problem.

    In a transcript of an April 11, 2008, telephone call between Barclays BARC.LN -0.83% PLC and the Federal Reserve Bank of New York, a Barclays employee acknowledged to a New York Fed analyst that the U.K. bank was misreporting interest rate data to avoid "unwanted attention." In October of 2008, after the crisis worsened, a Barclays employee told the New York Fed that the interest rate in question—known as the London interbank offered rate, or Libor—was "rubbish."

    The records were released by the New York Fed and the Bank of England. The Fed was responding to requests by Congress for documents related to the matter and could provide more information as it searches its records.

    The Fed releases showed that Treasury Secretary Timothy Geithner, who was then president of the New York Fed, alerted U.S. Treasury officials, other U.S. regulators and U.K. authorities in 2008 about problems associated with Libor and proposed changes to the way the rate was determined by the British Bankers' Association

    But the documents offered only a partial picture of the internal discussions regulators held about possible Libor problems. It wasn't clear, based on the disclosures, whether U.S. or British regulators pressed the issue beyond Mr. Geithner's efforts for changes in mid-2008. The health of large global banks during this period was crucial, because several months later several of them toppled or were nationalized as the financial crisis intensified.

    Libor is used as a benchmark for trillions of dollars-worth of consumer and business loans and financial-market trading contracts. The rate is a measure of what banks pay each other for short-term loans. On a daily basis, a group of big global banks, including three large U.S. banks, submit their borrowing rates to the British Bankers' Association. The process, as recent investigations have shown, made it possible for banks to submit data that made them appear healthier than they were, and allowed traders to game the submissions to boost revenue.

    During the financial crisis, Libor drew intense attention from regulators because banks' borrowing costs were seen as a sign of their financial health. By understating their own borrowing costs, banks might have given a false view of the risks they truly faced as the crisis worsened.

    One Barclays employee anonymously cited in New York Fed phone transcripts said the bank was just trying to "fit in with the rest of the crowd" and said "we know that we're not posting, um, an honest Libor."

  15. Good post here on the costs of the bailout: zombiefication of the economy.


    Hank Paulson, George W. Bush & Ben Bernanke killed Western capitalism. During the 2008 crash, when the banking system was failing (as is entirely predictable and natural in a hyper-levered house-of-cards economy) they decided to end market-led creative destruction, and institute a system of government-led bailouts, bailouts and bailouts — or, more accurately, uncreative stagnation.