Two passages stand out in the statement released late Friday afternoon by Treasury Secretary Henry Paulson, after the conclusion of a meeting between “G-7 Finance Ministers and Central Bank Governors.”

We are developing strategies to use the authority to purchase and insure mortgage assets and to purchase equity in financial institutions, as deemed necessary to promote financial market stability. As we develop plans to purchase equity, as in the approach we are taking to broad mortgage asset purchases, we are working to develop a standardized program that is open to a broad array of financial institutions. Such a program would be designed to encourage the raising of new private capital to complement public capital. Consistent with the legislation, any equity the government purchases through a broadly available equity program would be on a non-voting basis, except with respect to the market standard terms to protect our rights as investors.

I am not entirely sure what merit there is in being a shareholder in Morgan Stanley or Goldman Sachs on a “non-voting” basis. If my tax dollars are going to be used to rescue a Wall Street bank, then, by golly, I want a seat on the board of directors. If we’re going to nationalize the bums that made this mess, let’s not pussy-foot around.

As recent developments have demonstrated, the market turmoil is a global event. Governments around the world have taken actions to address financial market developments, and international cooperation and coordination has been robust. It is critical for governments to continue to take individual and collective actions to provide much-needed liquidity, strengthen financial institutions, enhance market stability, and develop a comprehensive regulatory response. We must continue to closely coordinate our actions and work within a common framework so that the action of one country does not come at the expense of others or the stability of the system as a whole.

Manifesto for a New World Order? Perhaps one of the unexpected consequences of a truly global economy will be actual global governance.

Call it whiplash Friday — a day of stock market extremes to test the nervous system of any trader, no matter how hard-boiled. Immediately after trading commenced, the Dow Jones industrial average plunged 660 points, only to turn around and erase the deficit within minutes. After that heart-attack inducing spasm, share prices fell steadily until mid-afternoon, nearly breaking through the 8000 benchmark. But in the last hour of trading an extraordinary rally brought all the indexes back into positive territory, albeit temporarily.

In the end, after an amazing 1000 point swing, the Dow closed down 128 points, which, by the standards of this week, qualifies as not too shabby. That was Friday, Oct. 10: Despair and exaltation, but ending with a whimper, which is better than a bang.

Some headlines to mull over as we all try to catch a break this weekend. (Note: when I first jotted these down, they they were designed to accompany a Dow drop of 500 points.)

From CNBC:

“I don’t wish to spread alarm on the line people but the big issue confronting the market is I’m afraid the health and sustainability of Morgan Stanley and Goldman Sachs” Hugh Hendry, Partner and CIO at Eclectica, told CNBC early Friday. “It is unimaginable that they can be allowed to go, I suspect that they will be nationalized at some point today or over the weekend,” he added.

Would the nationalization of Goldman-Sachs mean a return engagement as CEO for Treasury Secretary Hank Paulson?

From the Financial Times:

Describing a world in which wholesale money markets were now refusing to lend to banks, even overnight, the UK authorities warned that the world was on the edge of a collapse of the financial system.

At the risk of repeating myself, that’s just not the kind of warning you hear every day.

Also, Germany is considering recapitalizing all its banks, and Iceland is bankrupt.

Are there any encouraging signs? Bloomberg News reports that the interest rate cuts pushed through earlier this week by central banks may be having the desired effect. General Electric and Toyota both lowered their overnight borrowing rates on Friday. Translation: the two companies did not have to offer as high yields on their debt issues as they did yesterday in order to attract buyers.

If that trend continues next week, perhaps calmer waters are ahead. But absent any significant action from Washington this weekend, don’t count on it.

 

Naked Capitalism’s Yves Smith spots a concrete example of how the credit freeze is bringing the real economy grinding to a halt. Shipments of grain are piling up in U.S. and South American ports, unable to move because sellers no longer trust that international buyers have the wherewithal to make good on their debts.

The issue is credit. International trade is greased by “letters of credit” — essentially, a bank statement to the effect that the buyer will pay what is owed once the shipment of goods arrive.

Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don’t trust the financial institution named in the buyer’s letter of credit, analysts said.

“There’s all kinds of stuff stacked up on docks right now that can’t be shipped because people can’t get letters of credit,” said Bill Gary, president of Commodity Information Systems in Oklahoma City. “The problem is not demand, and it’s not supply because we have plenty of supply. It’s finding anyone who can come up with the credit to buy.

There’s been much scoffing from both the right and left about the “scare tactics” allegedly employed by the Bush administration to get the bailout package passed. But this kind of economic paralysis is exactly what Paulson and Bernanke were referring to when they told Congress four weeks ago that immediate action needed to be taken or the economy could “stop.”

And it’s why Paul Krugman is not alone when he demands in his column today that the finance ministers representing the world’s economically advanced nations who are meeting in Washington this weekend quickly come up with a coordinated rescue plan.

…the time to act is now. You may think that things can’t get any worse — but they can, and if nothing is done in the next few days, they will.

 

Finance ministers from the elite G7 group of nations are meeting today in Washington, against the backdrop of an economic crisis that continues to expand. I would like to say that I’ve already read the 38-page booklet getting some buzz in the blogosphere that contains 13 essays by all-star economists with recommendations for how the G7 should address the global panic. But events are moving rather quickly. When the Dow falls 660 points at the start of trading, before rebounding almost all the way back, it is difficult to maintain one’s focus. As I write these words the Dow is down a mere 150 points or so. But more important, credit markets haven’t budged. It’s going to be a long day.

Huge declines in Asian and European stock indexes overnight contributed to the fear and trembling that is currently paralyzing New York. International economic cooperation at the level of the G7 (U.S., Japan, Germany, U.K., France, Canada and Italy) has never been easy, but now’s the time to step it up.

From the Wall Street Journal:

“The interdependence of the major global financial markets has been established beyond the slightest doubt,” said H. Rodgin Cohen, chairman of the law firm Sullivan & Cromwell and a top adviser to Wall Street firms. “As a consequence, it is essential that the major countries act collectively and cooperatively.”

In their introduction to “Rescuing Our Jobs and Savings: What G7/8 Leaders Can Do to Solve the Global Credit Crisis,” economists Barry Eichengreen and Richard Baldwin declare:

We are in the throes of what is almost certainly the most serious economic and financial crisis of our lifetimes. The crisis is no longer a U.S. crisis, or even a U.S. and European crisis; it is a global crisis. It has spread from the financial sector to the real economy. It is not just investment portfolios and retirement accounts at risk, continued turmoil will soon start to destroy jobs.

There is a need for urgent action. The policy response needs to be decisive. It needs to be global.

Eichengreen and Baldwin outline a three-point action plan:

• A quick bank recapitalization with global coordination
• A guarantee of deposits and/or loans with global coordination
• Further, coordinated macroeconomic stimulus.

The Wall Street Journal reports that the U.S. is “weighing” the possibility of “guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits.” Such moves would be, suggests the Journal, “the government’s most extensive intervention yet in the financial system.”

The G7 is expected to release a statement Friday at 6 p.m. EST. If ever there was a time for real global cooperation, it would appear to be now.

 

A lifetime supply of Quaker Instant Oatmeal with Dinosaur Eggs arrived in the mail at my home yesterday. My 10-year-old son, Eli, loves the stuff, but I’ve had a hard time finding it in stores lately. So I ordered a full case online.

Eli goggled at the sight. He joked: “Guess we won’t have to worry about food if we are heading into another Great Depression.”

Yes it’s true, we’ve been talking a lot about economic chaos and disaster in the Leonard household lately, to the point where preteens are cracking wise about financial panics that took place 80 years before their birth.

I think it’s healthy. My stomach has been hurting lately, as I try to make sense of events that have no equal in my own lifetime — Republicans talking about nationalizing banks? — and I wonder, not so idly, how I might be able to keep my kids healthy and well-fed if, say, I lost my job as a result of the current turmoil.

I doubt I’m alone. Unlike the economic distress after 9/11, or the crash in October 1987, the current predicament is dishearteningly open-ended. It is discouraging and alarming and panic-inducing to witness government leaders adopting ever more extreme tactics to tackle the crisis, and all the while the dimensions of the disaster just grow bigger. We’re not wondering whether  we’re in a recession — we’re wondering when this madness is going to stop. One day in which the Dow falls by 500 points is good for a lot of chatter around the water cooler. A steady diet of calamitous drops turns out not to be so good for the digestion. Today’s big fall — 680 points — suggests that anxiety is the King of Wall Street. Since half of American households are plugged into stocks, one way or another, there’s lot of stress to go around.

But when Eli made his joke, I had to laugh, hard, and a good bit of the tension that had been building up inside me over the past month washed away. That’s the attitude, son! Oatmeal for breakfast, lunch and dinner, and we’ll get through this! If you imagine the worst, there’s always the upside that it won’t be as bad as you feared!

Not so long ago, Eli was singing a slightly different tune.

While eating dinner together on Sunday night, three and a half weeks ago, after a weekend in which the news of the Lehman Brothers bankruptcy and the teetering-on-the-brink status of AIG sent the unmistakable signal that the financial crisis had metastasized into a new and perilous stage, I tried to explain to my children why I was acting agitated and hyper. Unprecedented things were happening in the economy, I told them. I didn’t know what was going to happen in the long run, but the odds that it could be pretty bad seemed to have suddenly ticked higher. What’s the worst that could happen, they wondered? My kids are about a zillion TV generations removed from “The Waltons,” but I drew them a little sketch about what widespread bank failures and massive unemployment could look like.

Then I gave them a pep talk — and told them that no matter what, we’d be OK. I suggested that maybe we’d move in with relatives in New Hampshire, and threw in a couple of global warming jokes just for good measure. In southern N.H. we wouldn’t have to worry about rising sea levels, I said, and who knows, maybe we could make farming in the Granite State break even economically if temperatures rose high enough.

My son interrupted my babbling. “I don’t want to have this conversation,” he said. “It’s making me upset.”

I was abashed. I realized that just the fact I deemed matters serious enough to give my kids a pep talk was more destabilizing than my history lesson on the Great Depression. Bad parent. Bad, bad parent.

However, from that point on, we’ve had a more-or-less constant dialogue on the state of national politics and the economy. And I now believe that imagining and contemplating what could go wrong go a long way toward anesthetizing the shock. My children are now giving me lessons in how to keep cool. Eli shrugs off the potential for years of privation, and when I mentioned to my 14-year-old daughter that she might start thinking about staying in state for college, she didn’t flinch.

“I’ll get a scholarship,” she growled.

Why panic? What’s to be gained from that? I wish Wall Street were paying attention. Yes, I believe there are deep structural problems in the global economy that must be addressed, but it’s also plainly evident that we’ve reached a point where fear and panic are feeding on themselves. In the absence of any sense of trust or confidence in the marketplace, investors are acting like frightened toddlers. The more they scramble for safer territory, the more chaos they cause. Now would be a good time for Wall Street to just take a giant chill pill.

I don’t know how to make it stop. Certainly, our current president and Treasury secretary and congressional leaders don’t appear to know how to make it stop. But you know what? We survived the Great Depression. We’ll survive whatever is coming at us right now.

Especially if we’ve stocked up on enough Quaker Instant Oatmeal with Dinosaur Eggs to get us through a long winter!

 

One year ago today, on Oct. 9, 2007, the Dow Jones Industrial Average closed at 14164.53.

On Oct. 9, 2008, the Dow closed under 8,600.

Roughly half of all American households are invested in the stock market, primarily through retirement funds. So the loss of almost 40 percent of the market’s total capitalization — as measured by the 30 stocks that make up the Dow — is, in a very real sense, a tremendous loss of wealth for a vast swath of Americans.

But if you don’t have a 401K or a slice of a mutual fund or a kid’s college fund whose balance statements you are carefully ignoring, the outlook isn’t much better. The Wall Street Journal’s latest survey of economists predicts  that the U.S. economy will contract in the third and fourth quarters of 2008 and the first quarter of 2009.

If those predictions bear out, it would mark the first time U.S. GDP — the total value of goods and services produced — has contracted for three consecutive quarters in more than a half century.

Over the last three weeks or so, a wide spectrum of economists who don’t normally agree on policy measures came to a rough consensus: The best, and perhaps only, way to resolve the financial crisis would be a direct injection of capital into financial institutions, in return for ownership stakes. The resulting de facto partial nationalization of the banking system is anathema to free-market conservatives, but when credit markets freeze and the stock market loses roughly a third of its capitalization, laissez-faire ideologues suddenly learn to keep their mouths shut.

Thus the news on Wednesday that the U.S. Treasury Department is “considering taking ownership stakes in many United States banks to try to restore confidence in the financial system,” as reported by the New York Times.

Paul Krugman, who had predicted exactly such a denouement on “The Rachel Maddow Show” on Monday, applauds,” and points us to a fascinating analysis by Nouriel Roubini, on how this latest twist came to pass.

As first reported by Time’s Justin Fox, Paulson hinted in a press conference on Wednesday that the Emergency Economic Stabilization Act of 2008 gave him the authority “to inject capital into financial institutions.”

Readers may recall that the original Paulson plan included no provision whatsoever for taking equity stakes in financial institutions. It was a bailout, pure and simple, designed to take “toxic” assets off the balance sheets of participating institutions by paying more than their current market value. But to get his plan past the the Democratically controlled Senate and House, Paulson had to give in on several key points — one of which was that there should be a way for the U.S. government to get equity in companies that it was rescuing.

There is a bit of a difference, however, between getting some equity in return for buying toxic mortgage-backed securities, and directly injecting capital in order to keep a bank solvent. According to Roubini, some deft maneuvering by House Democrats made it clear that the latter possibility would be authorized by the bailout, even if not explicitly contained in the language of the plan.

Roubini:

In other terms it was necessary to explicitly clarify that the definition of “assets” or “any other financial instrument” in the legislation did allow for such public injection of capital so as to ensure that the regulations following the legislation would allow for such interpretation and actual practice. Since it was too late — by Wednesday last week — to explicitly modify the legislation to allow for explicit wording on this matter and since Treasury was resisting such late explicit changes (that would have jolted the banking industry) the tool that was used (in full agreement with the House and Senate leadership) to allow for such interpretation was to have Representative Jim Moran use the October 3rd House floor debate right before the final vote to put on the legislative record such interpretation. See the following important exchange between Jim Moran and Barney Frank that is now on the legislative record of the House:

Mr. MORAN of Virginia. Thank you, Madam Speaker. I won’t take that much time. I do want to thank the chairman for his masterful leadership on this bill, and I do want to clarify that the intent of this legislation is to authorize the Treasury Department to strengthen credit markets by infusing capital into weak institutions in two ways: By buying their stock, debt, or other capital instruments; and, two, by purchasing bad assets from the institutions, in coordination with existing regulatory agencies and their responsibilities under this legislation, as well as under already existing authorization for prompt, corrective action and least cost resolution.

Mr. FRANK of Massachusetts. Will the gentleman yield?

Mr. MORAN of Virginia. I’d be happy to yield.

Mr. FRANK of Massachusetts. I can affirm that. As the gentleman knows, the Treasury Department is in agreement with this, and we should be clear, this is one of the things that this House and the Senate added to the bill, the authority to buy equity. It is not simply buying up the assets, it is to buy equity, and to buy equity in a way that the Federal Government will able to benefit if there is an appreciation.

Roubini finishes with a flourish:

It is a sorry reflection of the state of the U.S. democracy that hundreds of Senators and Congressfolks did vote for the biggest bailout ever in U.S. history ($700 billion) without even knowing exactly what they were voting for.

So there you go — Barney Frank and Chris Dodd took Paulson’s bailout plan and transformed it into an authorization for the partial nationalization of the U.S. banking system. I find it extraordinary just to write that sentence.

On Monday I briefly discussed the “Long Depression” set off by the great financial panic of 1873. This morning, I stumbled across a fascinating article in the Chronicle of Higher Education by 19th century historian Scott Reynolds Nelson discussing the parallels between the Long Depression and the current financial crisis.

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral …

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad … Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates.

I know, I know, what goes around, comes around. But that’s just kind of freakish.

The McCain mortgage bailout mystery thickens. Even though a good case can be made that the plan is a repackaging of earlier Democratic efforts to get aid to homeowners, the Obama campaign is opposing it:

John McCain wants the government to massively overpay for mortgages in a plan that would guarantee taxpayers lose money, and put them at risk of losing even more if home values don’t recover. The biggest beneficiaries of this plan will be the same financial institutions that got us into this mess, some of whom even committed fraud.

The Obama campaign response tacks very closely to a denunciation of the plan delivered by economist Brad DeLong who says that “McCain’s plan is for the government to buy up $300 billion of distressed mortgages not at current market value but at full face value,” which, he says, would amount to a $100 billion handout to the bankers who made the original loans.

DeLong’s interpretation is based on an explanation of the plan provided by McCain economic advisor Douglas Holtz-Eakin during a conference call Wednesday morning. I e-mailed a copy of the transcript to Alan Levitin, the Georgetown University bankruptcy and commercial expert whose views on the plan I wrote about earlier today.

Levitin had originally assumed that McCain’s plan involved some sort of write-down of the value of the mortgage loans to reflect depressed home values. But after reviewing Holtz-Eakin’s comments, Levitin told me that it sounded as if the plan did indeed involve the government paying “face value” to the lenders for the mortgages. While this would allow the government to get around the securitization problem he had warned about, there’s a big catch — “if someone is underwater, where they have negative equity in their home, and you refinance them at a 100 cents on a dollar, you are way overpaying.”

The McCain mortgage plan — perhaps not unworkable, but definitely high-priced, with taxpayers taking the hit, while lenders get off easy.

John McCain’s campaign has entered strange territory. On the stump, he and his ticket-mate launch blast after blast of character assassination, summoning up the last dregs of the culture wars of eons past in a desperate attempt to rein in the surging Obama campaign. But in Tuesday night’s debate, he pulled a remarkably liberal rabbit out of his hat. His “American Homeownership Resurgence Plan” is a straight-out government bailout of homeowners stuck with mortgages that they can no longer afford. The base is not amused.

McCain’s plan to buy up mortgages and refinance them at the current value of homes represents a dramatic shift from his position in March, when he said in a speech that “it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers,” and that “any assistance must be temporary and must not reward people who were irresponsible at the expense of those who weren’t.” Democrats were also quick to note that the proposal is not new: In fact, there is a provision in the Emergency Economic Stabilization Act of 2008 that expressly allows the government to restructure the mortgages that it purchases.

In theory, the plan addresses the right problem. Until the wave of foreclosures that is continuing to depress home prices is halted, the fundamentals of the American economy have no chance of being strong. But McCain’s own flip-flops and Democratic assertions aside, the major drawback to the Resurgence is that, because of how mortgages are routinely repackaged into securities, any scheme to restructure them runs into serious obstacles. In recent weeks I’ve mentioned the work of Georgetown law professor Adam Levitin, a specialist in bankruptcy and commercial law who has been examining exactly this issue. Levitin’s position is that the repackaging of mortgages into residential mortgage-backed securities (RMBS), and their further slicing and dicing into collateralized debt obligations (CDOS), have fractured the ownership of the original mortgages and redistributed them so widely that the government’s hands are tied. To be able to modify the underlying mortgages, the government would need to own a substantial, possibly two-thirds majority, of the securitization pools into which the mortgages have been transformed. That will be difficult to achieve and exorbitantly expensive.

I e-mailed Levitin this morning for his opinion. His answer was blunt.

The McCain plan cannot work. The vast majority (80 percent+) of residential mortgages are securitized. The government cannot purchase mortgages directly out of securitization pools. There are a limited number of ways to actually get around the securitization problem:

1. Refi the mortgages directly, which would involve paying 100 percent of face value.

2. Buy up ALL the RMBS and CDOs and CDO2s, which will be prohibitively expensive and will result in paying close to face value.

3. Take the mortgages from the securitization trusts via eminent domain — and pay fair value.

4. Permit modification of the mortgages in bankruptcy, or

5. Pass Gold Clause type legislation that changes MBS holders’ rights in a way that will allow modification of the mortgages. There are several ways to do this. It might not ultimately be Constitutional, but I doubt any judge would issue an injunction, so by the time there was a final ruling, the matter would be over and done and the worst case is that the government would have to pay out some (maybe a lot) of money.

Because the McCain plan doesn’t recognize the (admittedly complex) problems created by securitization it is simply unworkable. At best it will help a few homeowners, but Treasury is already authorized to do that.

The McCain plan does not get into the specifics that Levitin outlines above. Of course, neither does the bailout plan, nor do any of the Democrats who are saying that the bailout plan already allows the government to restructure mortgages.

But the easiest and quickest way to get real help to homeowners is Point 4 — permitting bankruptcy judges to make modifications of mortgages. But that proposal is being resisted so fiercely by the banking and securities industry that it was the first thing that Democrats dropped from their version of the bailout, in the face of strong Republican resistance.