Marginal Revolution

David Murphy makes me weep

He is a loyal MR reader, but that doesn't mean he always carries good news:

My question:

When the Fed backstops the Commercial Paper market by entering it and offering a "risk free" counterparty to companies, is it crowding out private lending?  I also feel like the same could be true of the Treasury.  If the Treasury offers to buy the toxic MBS on the books of private companies, they lose all incentive to deal with private counterparties that are not risk free...

I know that the government is trying to encourage credit to flow. In some way it seems like they are impairing the flow by making markets on risk free capital.

Boo hoo!  The ideal, of course, is that the people who need riskless assets can hold riskless assets and pass their funds along to those who can profitably lend funds out to riskier borrowers.  That's not where we are right now.  To put this more concretely, if the Fed is not buying or backstopping your commercial paper (and they're not touching mine), maybe now it's harder to make your way in the marketplace.

David, by the way, poses the thought experiment of ceasing to issue T-Bills but suggests that might bring Armageddon. 

Russian foreign aid, circa 2008

A E4bn loan from Russia might make financial sense – although Russians might think otherwise given Moscow’s shaky finances. But it would create strategic ructions. Iceland is a NATO member, but Russia would want something in return for a loan equal to almost a third of the tiny state’s GDP. The US would fret this could eventually mean a Russian military presence in the North Atlantic.

Here is the story.  It seems that Iceland may prefer Russia to the IMF, but Russia does not yet seem on board.  I can only wonder what Bobby Fischer would have said...

Reverse auctions: a defense

The US is embarking on the greatest public intervention into financial markets since the Great Depression. The ultimate success or failure of the intervention will depend, in part, on the fine details of the auction design.

The basic auction approach suggested here is neither new nor untested. It has been used successfully in many countries in recent years to auction tens of billions of dollars in electricity and natural gas contracts, as detailed in Section 8. Moreover, it is quite similar to the approach that has been used to auction more than $100 billion in mobile telephone spectrum worldwide. It is a dynamic version of the approach that financial markets use for share repurchases. If implemented correctly, each auction can be completed in less than one day. And the same software used for implementing electricity and gas auctions could be used to initiate these auctions in October.

Here is the whole paper, thanks go to Samson in the comments section.  So far this is the best paper I've seen on the topic.  Tim Harford offers other useful links.  Still, I am inclined to agree with Arnold Kling:

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that--a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later--probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan.

Is there a positive spin to this?

Fed announces commercial paper funding facility.  Here is my post from yesterday.  My best shot at a positive spin, just offered to Alex in my office, is this:

They wouldn't do it unless they had to.  And if they had to do it, that they are doing it is very good news indeed.

I am not sure that Alex was persuaded.  There are some good comments at the first link.

The roots of Chinese pollution

A detailed analysis of powerplants in China by MIT researchers debunks the widespread notion that outmoded energy technology or the utter absence of government regulation is to blame for that country's notorious air-pollution problems. The real issue, the study found, involves complicated interactions between new market forces, new commercial pressures and new types of governmental regulation...

China's power sector has been expanding at a rate roughly equivalent to three to four new coal-fired, 500 megawatt plants coming on line every week...most of the new plants have been built to very high technical standards, using some of the most modern technologies available. The problem has to do with the way that energy infrastructure is being operated and the types of coals being burned.

The good news is that there is a single lever -- coal quality -- that could have an enormous impact on Chinese pollution levels.  Here is the full story.

Why exactly are those mortgage-backed securities so hard to trade?

With emphasis on that word "exactly," here is Gary Gorton's superb paper The Panic of 2007.

Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed.  You are confused because it is confusing.  Then I got to p.45 (!) and I almost split a gut (and cried, simultaneously) when I read the sentence:

Now we come to the first information issue.

It then goes like this:

What is the loss of information?  The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone.  It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined.  But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages.

His examples show this in detail but I do not know a simple way to blog it.  Scroll to pp.23-30, and p.35 for a dose of how these securities were structured.

Gorton is also highly critical of "mark to market" (p.62) and he pinpoints the collapse of certain parts of the REPO market (p.66) as a critical development.  He ties it all in to Hayek and Grossman and Stiglitz and discusses how we ended up having assets with non-transparent, non-backwards-translatable prices and what that means for economic calculation.  He contrasts a private clearinghouse (and monitoring) vs. rules of accountancy and how we ended up relying too much on the latter.

Starting on p.67, there is a sustained and mostly convincing argument that securitization has not been much at fault.

If you are interested in the nuts and bolts of the current financial crisis, and its origin in 2007, this paper is essential reading.