Here is the front page of the leading Canadian daily last weekend. The graphic is very impressive, and the headline, An Economic Crisis Descends into Farce, is more charitable than some other foreign headlines, notably in Asia. The same issue has Eric Helleiner’s Depression book recommendations.

Apropos reading lists, Adam Levitin recommends Maury Klein’s Rainbow’s End.

I tend to the dishy comparative. Here are my top three choices of the week. 

• Paul Blustein’s The Chastening is the best telling of the last time U.S. Treasury personnel graced glossy covers. Chapter 3, which tells of the Thai central bank’s battle with the derivatives markets, is especially racy. Chapter 10 sheds light on crisis policy coordination, and Chapter 11 on LTCM puts the story well-told by Roger Lowenstein in global perspective. I have been assigning The Chastening to my International Finance class for the past few years; I think I will do it again this year despite the new cataclysm. The book’s advantage as a teaching tool is that it covers so many different aspects of the financial industry – banks, securities and currency markets, derivatives, hedge funds, etc. And it makes for great fixins to one tough textbook.
• Gillian Tett’s Saving the Sun is about the demise of Long-Term Credit Bank, but it is really a window on Japan’s crisis of the 1990s. Like Blustein, Tett is a money journalist, which makes for lucid, savvy prose. She is also an anthropologist (biiig plus in my book). Lots of scary déjà vu moments for the current adventure – though Adam Posen’s warning against overwrought Japan comparisons should relieve you some.
• Finally, it may be a sin to put a classic by one of the greatest economic historians ever in the same string as dishy journalism, but I hope Charles P. Kindleberger’s spirit takes it as a compliment. I find his writing in Manias, Panics, and Crashes:  A History of Financial Crises so utterly zany that I cannot resist. I will be sure to reprise this recommendation in a serious academic reading list as I atone next week.

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The SEC revisited its fair value accounting standards today, as Usha predicted.  Here's the SEC statement, and Floyd Norris has insights here and here.  We speculated that the bailout would eventually take a criminal tinge, Doug Berman agrees.

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Why did the market fall 777 points yesterday?

A quote from today’s Business Week captures the prevailing logic:

“Credit is the lubricant for the U.S. economic engine. If loans don't get made, businesses don't expand, orders don't get placed, workers don't get hired. A garden-variety economic slowdown can turn into a deep recession.”

OK, I get that. When the cost of capital goes up, growth becomes more expensive. And if the real cost of capital has shifted upward, valuations will shift downward, and who knows where that all ends? But did the world change so much just because Congress failed to make a one-time injection of $700B into the credit markets (some of which it will inject anyway through other means) that the long-term cost of capital changed? Or are we really worried about something else?

The same article stated: “If companies can't get funding in the commercial paper market, they won't be able to take care of basics, such as meeting their payrolls.” I’ve been hearing statements like this a lot the last few days. The experts seem to be saying that unless the short-term credit markets “unfreeze,” consumers and businesses alike will not be able to meet their day-to-day obligations. I don’t know about you, but I don’t rely on credit to meet my day-to-day obligations. And I’m not aware of many healthy businesses that do either. Sure, longer-term capital projects may be postponed in the current financing environment, but payroll? Are we really worried about consumers and businesses (other than over-leveraged financial institutions) facing bankruptcy because they can’t borrow more money? Were we all playing this kind of financial kiting scheme as part of some mass illusion of prosperity?

Yes, we are facing tough economic times. Yes, we will see real economic growth slow as we digest the excesses of the past few years. Yes, we will need to adjust to a world where spending bears a more prudent relationship to income and home prices are set by the demand of those who can actually afford them. Yes, these adjustments will mean corporate revenues, and thus earnings, will fall. Yes, as growth and earnings fall, so will jobs. But we knew all that before Congress voted yesterday.

So why did the market fall 777 points yesterday? Because we were hoping we would be allowed to ignore a bit longer what we all already knew. As a society, we have been living beyond our means. Being the sensible people we are, Americans told Congress yesterday it was time to stop. Even the stock market seems to understand that now. It’s time to go back to work and build real value. Nothing has changed in our fundamental ability to do that. S&P 500 is up 4% and climbing.

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Since the collapse of Bailout 1.0, I've been wondering when critics would seize on mark-to-market accounting. It turns out that Newt Gingrich and Mark Cuban (never thought I'd use those two names in the same sentence) have been calling for a suspension of the rule. From Newt:

Mark-to-market accounting (also known as "fair value" accounting) means that companies must value the assets on their balance sheets based on the latest market indicators of the price that those assets could be sold for immediately. Under such a rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them is worth less.

Moreover, when a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.

More foreclosures and home auctions continue to depress housing prices, further reducing the value of all mortgage-related securities. As capital values decline, firms must scramble to maintain the capital required by regulation. When they try to sell assets to raise that capital, the market values of those assets are driven down further. Under mark-to-market, the company must then mark down the value of all of its assets even more.

I'm not a tax gal. Anyone care to weigh in on this one? I know mark-to-market was the response to accounting hanky panky at Enron, WorldCom, et al. Was the cure worse than the disease?

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One of the rules of financial crises is that some business executives end up doing time after they happen.  You can ask yourself if the punished executives are chosen through a fair process, whether other executives avoid prosecution for essentially the same conduct, and so on, but:

During the Savings and Loan bailout 20 years ago, federal prosecutors brought more than 600 cases against 1,000 defendants.

and Sorkin:

It is hard to imagine that taxpayers would spend $700 billion (or any amount) to bail out Wall Street and the economy without some big-name executive going to jail. For better or worse, it is the way our society works.

I don't do white collar, but ex-post white collar tends to be part of the bureaucratic response, and I do do bureaucracy.  Who is going to be the villain of this crisis, and who should lawyer up?  It's pure speculation, but I think AIG is more likely to get Enronized than Lehman, and I suspect that Congress, quite hypocritically, will be baying for a little blood from Fannie and Freddie; lawyers for the defense are going to want to paint the relationship between top management and the Washington establishment (i.e., Congress), as extremely close.  I should say that these predictions are almost guaranteed to be inaccurate, and are based only on reading the same stuff you all are reading.  Nonetheless, here's some of the latest on the criminal side:

• The FBI has announced it is investigating Fannie Mae, Freddie Mac, AIG, and Lehman for fraud.
• Who is the Times singling out?  Gretchen Morgenson has gone after Countrywide a lot, and, now, Joseph Cassano at AIG, which, do remember, had its problems with Elliot Spitzer.  The good news for AIG is that the bailout may make it easy to investigate, but possibly harder to prosecute.
• Two weeks ago, Wachovia CEO Robert Steel told CNBC "we have a great future as an independent company."  Then it got sold for a dollar a share.  (Something like this happened at Bear Stearns as well.)  Troubling, but Wachovia wasn't the first to go, and Steel was, until recently, Paulson's crisis undersecretary.  Will the Feds go after one of their own?   
• The Bear Stearns investigations are well underway.  As the CEO of the first bank to go, the bridge-and-golf-playing James Cayne doesn't have good optics, but he did leave before the collapse.
• Don't forget about the state AGs.  Cuomo has to do something (he may go after the shorts), and the AGs in CT, MA, and FL are all active players as well.

After the jump, the Columbia Journalism Review's juicy multiple choice questions about housing/finance market shenanigans.  Some people ought to pay for those sins!  Go to the article for the answers.

Allegation

1. Handed out copies of the movie Boiler Room as a training tape

2. Partnered to sell its “PayOption Arms” with a brokerage owned by a five-time felon, whose convictions included gun-related charges

3. Forbade loan officers to check borrower income on certain loans

4. Ran an “art department” in its Tampa office, where documents were altered

5. Settled allegations of institutionalized marketing deception that covered two million customers

6. Developed “FastQual,” a program designed to approve borrowers in twelve seconds

7. Incentivized brokers and loan officers through “yield spread premiums” and other compensation schemes to put borrowers into more expensive loans

8. Tapped two kegs of beer at weekly staff meetings

Institution

A. Citigroup

B. Countrywide

C. Ameriquest

D. IndyMac

E. Merit Financial

F. New Century

G. All of the above

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Fortis, the failed financial conglomerate jointly rescued on Sunday by the governments of Belgium, the Netherlands, and Luxembourg, has assets several times the size of the Belgian economy.  Each of the three governments took 49% of Fortis’s banking subs in their respective countries; the total price tag was just over $16 billion.  Gives one pause about the prospects of financial regulation at the national level.  At least we have a global lender of last resort, says Brad Setser.

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The folks at the Glom kindly scheduled this guest blog to coincide with the release of the IMF-brokered code of conduct for sovereign wealth funds, due out in early October.  Who knew we would be in the middle of the Greatest Crisis since the Great Depression.  With the Paulson package defeated and oblivion upon us, it seems appropriate to start with a long view on sovereign wealth and crises:

Earlier this month, the FT reported that KAMCO, Korea’s state-owned asset management company, is looking to buy just under a billion dollars’ worth of distressed U.S. assets.  Ten years ago, KAMCO was reorganized in the wake of the Asian Financial Crisis to take bad loans off the books of Korean banks.  At the time, there was huge opposition to selling assets to foreign investors at fire-sale prices.  KAMCO more or less finished cleaning up at home by 2003, and began developing its international asset management and advisory business.  Now it is time to go shopping.  Assuming some version of an AMC will come out of the U.S. Congress before the world ends, at least we have something to look forward to in a few years.  FWIW, Badbank Harmony (KAMCO’s consumer arm) is a fetching name.

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Question.

Answer.

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Anna Gelpern joins us as a guest blogger at an auspicious time. Anna is Associate Professor of Law at Rutgers School of Law - Newark, where she studies the legal and policy implications of international capital flows.  I first became acquainted with Anna through her excellent article (co-authored with Mitu Gulati) entitled Public Symbol in Private Contract: A Case Study," 84 Wash. U. L. Rev. 1627 (2006). Her most recent publication is Domestic Bonds, Credit Derivatives, and the Next Transformation of Sovereign Debt, 83 Chi.-Kent. L. Rev. 147 (2008). We are thrilled that she is joining us, and we look forward to her insights on the financial crisis and other topics that strike her fancy.

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The story being told about the bailout vote is simple: common folk hate the idea of a bailout, so the representatives with tough elections on the near horizon voted against the bailout bill.

If you favored the bailout bill, you might tend to think of votes like this as cowardly. Where is the leadership on this crucial issue?

Anthony Ha uses the data at MapLight.org (a website dedicated to "illuminating the connection" between money and politics) to tell another familiar political story. Looking at this page, Anthony observes:

Overall, bailout supporters received an average of 54 percent more in campaign contributions from banks and securities than bailout opponents over the last five years. The disparity also held true if you look at individual parties. In fact, the 140 Democrats who voted for the bailout received almost twice as much money from banks and securities as the 95 Democrats who voted against it. (The difference was closer to 50 percent for Republicans.)

The usual disclaimers apply, but the data give us an intriguing alternative story.

Of course, there is also the possibility that the "nay" votes were heroic.

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Well, let's look at what else it did today:

• Increase the number of Term Availability Facilities ("By committing to provide a very large quantity of term funding, the Federal Reserve actions should reassure financial market participants that financing will be available against good collateral, lessening concerns about funding and rollover risk.");
• expand the size of foreign exchange swap lines ("The increase in the amount of foreign exchange swap authorization limits will enable many central banks to increase the amount of dollar funding that they can provide in their home markets.  This should help to improve the distribution of dollar liquidity around the globe.");
• support the acquisition of Wachovia's consumer banking services by Citi ("In support of this transition, the Federal Reserve Bank of Richmond stands ready to provide liquidity as needed.").

These efforts come with big dollar values attached ("the total size of outstanding swap lines is $620 billion") ... but liquidity alone will not, apparently, be enough.  The crisis is internationalizing, though, and it is worth noting the Fed has rallied the foreign central banks to pump money into the system - and perhaps they did so as a hedge against Congress deciding not to legislate.

It's worth looking at what the Fed is doing, not least because it would be nice to figure out whether the Fed's discount window powers would be sufficient to bail out the financiers without legislation.  Based on the way that window has been used so far, the answer to that question is yes (or at least the Fed thinks it is yes - I'm not so sure).  The problem, I assumed, was that the Fed didn't have enough money to do to everyone what it did to AIG and Bear.

Anyway, Felix Salmon is thinking along similar lines:

the obvious next step is for the government to do something on its own -- something which doesn't require legislative approval. My best guess is that Treasury and the Fed are now going to try to come up with some kind of debt-for-equity swap: a recapitalization proposal which can be implemented through the Fed's existing powers.

UPDATE: What am I, psychic?

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I don't know about you, but I'm loading up on the S&P 500.  Too much smart money is out there buying assets like Wachovia, Lehman's Neuberger business, Constellation Energy, Goldman Sachs and so on.  These businesses are not good investments if the world is going to economic heck.  So why is Bain Capital doing an all cash deal for an asset management business if the markets are going to crash?  Why is Citi buying a retail banking franchise?  Why is Buffet buying an energy company?  The WSJ reported this morning that the vulture funds have been waiting for the dumb money (that's us taxpayers) to flush through before loading up on mortgage assets.  Doesn't this all suggest that the bailout is another "after the fact" governmental response to the "just do something" instinct of the crowd?  Remember, it is times like these that the most money is made (by a few people).

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That's a sell-off of everything, including stocks that have nothing to do with mortgages (though I guess every public company gets financed).  Political crises have often seemed to be a challenge to the efficient markets hypotheses.  We bomb Libya, the Dow plunges.  Today, traders hit refresh on their House vote screens, the Dow drops 700 points.  I'm sure they're just pricing the political risk into their purchasing decisions - and not panicking at all.

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• The Treasury Secretary got what he wanted in the bailout, Steven Davidoff thinks.  And it is an awesome amount of power.  Which makes you wonder who the next Treasury Secretary will be.  Could Paulson's successor be ... Henry Paulson?
• State Street - which doesn't really do the whole mortgage thing - is a leading candidate to be the next bank to go.
• Bainbridge is for - yes, that's for - the bailout.

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As Eric Posner says, a quick skim offers few surprises:

• As an exercise in the development of legislation, note what has happened to the bill, drafted to be three pages long, with absolutely no attention paid to the fact that the program would have to be implemented (and so maximum discretion given to the Treasury Secretary, who was to decide how to implement it later), to something 110 pages long, with savings clauses, detail, compromises, and many fewer obvious legal problems.  Those interested in parsimony might dub this a triumph of legalese.  But lawyers have always told themselves that they solve problems with their contributions.
• I don't claim that all problems are solved here.  The secretary has the power to hire, fire, contract, issue regulations, "establish vehicles" to hold assets (a new one to me - I suppose it's true what they say, this really is a sovereign wealth fund) and so on - and his powers under this section are only subject to limited judicial review.
• The Secretary is directed, however, to consult with various agencies (a weak constraint), to issue regulations (though that can come after he starts bailing out whomever), and that he "shall take such steps as may be necessary to prevent "unjust enrichment," which is sorta specified as meaning the Secretary can't pay more for the asset than the financial institution did when it bought it.  The bill also says that the Secretary "shall take into consideration" nine worthy factors (serving the underserved, protecting families, saving money, ensuring stability, &c) when implementing the program - it's going to be easy for Paulson to pay lip service to these, and there are just too many of them to have much bite.  Rather than cabining flexibility, sometimes multi-factor tests enhance it.
• Some of the new additions only make sense, and haven't been talked about much - the Secretary probably should set conflict of interest regs, for example, and under the bill, he must.
• Clawbacks and golden parachute bans on executive compensation are in there, and in there in a difficult to ignore way (the Secretary shall promulgate regs, which must do these things).  Lucian Bebchuk must be pleased.
• And the oversight board - though sorta strange - it's Treasury, the SEC, the Fed, an obscure federal housing regulator ... and the Secretary of HUD? -  is free of obvious constitutional problem.  UPDATE:  Andrew Grossman of the Heritage Foundation is pondering the fact that three of these five officials can only be fired for cause ... which does limit the President's ability to oversee the overseers, which is not without constitutional moment.  See this case for more on that. 
• The joint resolution disapproving of the second half for the $700 billion is kept, and fast-tracked (that is, little debate, no amendments) through both houses.
• Judicial review is done APA style, though the statute doesn't direct the review to the courts of appeals (as it does for APA rulemakings - which would be tough).  The powers given the Secretary under section 101 are not subject to injunctive or equitable relief, and yet the statute carefully limits injunctive relief in some cases ... and I can't figure out what Congress is worried about there.  I still think that APA style review is injunctive and equitable relief - at least, it's not damages relief - and a clear statement about whether individual purchasing decisions by the Secretary are subject to judicial review or not might be useful.  Currently:
  • "Actions by the Secretary pursuant to the authority of this Act shall be subject to chapter 7 of title 5, United States Code [that's the APA linked to above], including that such actions shall be held unlawful and set aside if found to be arbitrary, capricious, an abuse of discretion, or not in accordance with law."
  • But "No injunction or other form of equitable relief shall be issued against the Secretary for actions pursuant to section 101 [that's the power granting section] ... other than to remedy a violation of the Constitution."
  • The section by section notes prepared by the drafters say only that the section"[p]rovides standards for judicial review, including injunctive and other relief, to ensure that the actions of the Secretary are not arbitrary, capricious, or not in accordance with law." You tell me, dear reader, whether the Secretary's run of the mill decisions will or will not be subject to arbitrary and capricious judicial review under the statute.

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