Friday, October 24, 2008

Greenspan, Krugman - the Dimensions of the Problem

After listening to Greenspan today and to Krugman tonight, on Charlie Rose, I continue to be struck by the amount to which the categories and scope of the problems *may* yet be ... under estimated.

Part of the problem seems to be a lack of understanding, at the highest levels, of the types of products that Wall Street has generated, coupled with a lack of knowledge of who owns what inside 'the system'.

Greenspan was right to point out that the explosion in lowest quality sub-prime lending occurred after 2005 and was coincident with a rise in securitization. He tied it to foreign capital. Yet, in another part of testimony, the key purchasers of SIVs (structured vehicles), on one estimate, is north of 70% done by hedge funds. Is that 'foreign capital'?

What worse, we also know that there was an explosion in the creation of synthetic CDOs, perhaps because physical issuance couldn't keep pace with the 'demand creation' done by Wall Street in search of riskless yield pickups.

As for Krugman, it would be a logical, conceptual extension for him to go past "capital" as a way to rescue banks, and actually think in detail about the various types of instruments that are threatening the capital base and what to do about it, directly (bottom up). Put plainly, "more capital" and a broad-spray fiscal stimulus *may* not be targeted enough, given the unknown size of the problems and the limited budgetary resources. There may be solutions that actually target assets and instruments, in ways that change the risk-characteristics of assets, making the need for capital injections less urgent and all of it less of a caustic "unkown".

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