Author: Daniel Indiviglio

The mortgage modification conundrum continues to confound policy wonks. The Treasury’s difficulty achieving success with its Home Affordable Modification Program (HAMP) demonstrates this fact well. Lowering interest rates and increasing terms don’t appear to be doing the trick. So the obvious alternative is to rework mortgages so to lower their principal. The FDIC is considering this approach. Unfortunately, it’s not easily done in practice. I have a few ideas to make it work.

The Conflict

How much you love or hate principal reductions depends on your perspective:

Underwater Borrowers

If you’re the distressed homeowner, then you absolutely adore the idea of a principal reduction. It’s like you’re getting the same house, but for less money. Many borrowers who are very underwater are walking away from homes because they can’t comprehend modifying a mortgage with a principal amount higher than what the home is now worth. Why do that when you can just foreclose and buy a similar home for less?

There’s another nice added bonus for the homeowner through a principal reduction: if the market rebounds, and your home appreciates, you get to keep any excess funds when you sell the home again.

Lenders

Banks and finance companies hate — hate — the idea of principal reductions. First, they have to declare a loss on the mortgage immediately for that amount. Since many banks are still in a very fragile state, the last thing they want is widespread losses on their delinquent mortgages to all hit at once. That could result in a devastating market shock. At least if they slowly foreclose on homes, those losses will be more spread out and easier to bear.

They must also worry about precisely what I explained as the bonus to a homeowner above: if the market rebounds and the price appreciates, it doesn’t seem fair that the borrower gets those excess funds. After all, the bank took a loss to keep the borrower there — shouldn’t it get that extra cash?

Everyone Else

In general, all of those homeowners who aren’t having trouble paying their mortgage are quite resentful of the idea that underwater borrowers would get a principal reduction, and for good reason. Their homes have generally declined in value too, but their mortgage principal remains the same. How is it fair that those borrowers get a reduction just because they can’t pay what they agreed to?

Of course, in the long run, these homeowners would probably be better off if there are fewer foreclosures. A smaller housing inventory will result in home prices rising again sooner than if the market remains unstable for several years.

The Reconciliation

So how do we get all of these parties on the same page? We need a compromise. What if lenders offered conditional principal reductions? Here’s how they could work.

The bank first determines the amount the borrower can afford to pay. Then, it appraises the home. Next, it backs into an interest rate. And this is the subtlety: that interest rate might not always be terribly low, given how much the home has depreciated.

I ran a few models so to give an example. If you had a $300,000 home with a 7% interest rate, then your monthly payment was nearly $2,000. But let’s say you can only afford about $1,430. One option would be to decrease your interest rate to 4%. That would do the trick. But then your mortgage principal would exceed the value of the home, which is now only worth $215,000 after declining in value by about 28%.

Instead, you’d rather walk away. But what if the bank agreed to lower your principal to its new value, while leaving your interest rate at 7%? You’d end up with approximately the same monthly payment of $1,430. But the psychological barrier of having a mortgage for more than your home is worth would be gone.

From the bank’s perspective, it’s getting exactly the same payment, so if the loan is paid to term, then it would be indifferent to either modification approach. The problem, of course, is that the loan may not be paid to term.

Why does that matter? Because if the homeowner refinances, then the bank losses that future income it expected from the higher interest rate. If the homeowner sells, the same result occurs. So it needs to put some conditions in place.

No Refinance Clause

The refinance problem is easy enough — the bank could just demand that the homeowner not refinance for the life of the loan. Alternatively, it could demand she not refinance for some given time period, say, 10 years. That would still probably ensure that the bank would end up ahead of the game versus foreclosure.

Profit Sharing With Sale

The bank can’t really require that the borrower not sell the property. In order to safeguard this problem, it can further demand that if the homeowner does sell, then any amount paid exceeding the new mortgage amount, up to the original mortgage amount, go to the bank. Again, this is the most extreme version. You could create some variations on this, including the bank getting a portion of the excess or fazing out the bank’s right to the excess after a certain number of years.

Amortization Of Principal Loss

In the modification scenarios from the example I created, the future value of the bank’s revenue from the mortgage will remain unchanged. But if it does have to declare a principal loss, regulators should allow the loss to amortize over some time period, like five years. That would have the same effect as if foreclosures were spaced out, so the bank would be more indifferent to principal reductions and foreclosure insofar as its balance sheet implications are concerned.

The Result

A conditional principal reduction won’t prevent all foreclosures — there are still situations under which a borrower won’t be able to afford a home even if the principal is reduced to market value, like if he’s unemployed. There will also be some borrowers who can afford a modification that will still choose not to agree to the conditions and walk away instead.

But I think it could help to break that psychological barrier for homeowners who can’t imagine paying a mortgage with a principal balance much greater than what the home is now worth. And banks won’t have to worry as much about the income impairment that will result from a principal modification if it has some safeguards against the sudden, drastic loss associated. With moral hazard also lessened through the conditions put in place, even the non-distressed homeowners might not be so angry.

(Image Credit: edkohler / Flickr)

Over on this New York Times blog, economist Paul Krugman has a really nice explanation of why so-called “core” inflation matters. A few weeks ago, I mentioned that the slight rise in January’s consumer price index shouldn’t be alarming, since core inflation actually declined. While I largely agree with Krugman’s explanation, I have a quibble.

First, for anyone who needs a refresher, core inflation is a measure that excludes goods with very volatile prices, generally food and energy. As for those prices that are included in the core measure, Krugman says:

The key thing about these less flexible prices — the insight that got Ned Phelps his Nobel — is that because they aren’t revised very often, they’re set with future inflation in mind. Suppose that I’m setting my price for the next year, and that I expect the overall level of prices — including things like the average price of competing goods — to rise 10 percent over the course of the year. Then I’m probably going to set my price about 5 percent higher than I would if I were only taking current conditions into account.

And that’s not the whole story: because temporarily fixed prices are only revised at intervals, their resets often involve catchup. Again, suppose that I set my prices once a year, and there’s an overall inflation rate of 10 percent. Then at the time I reset my prices, they’ll probably be about 5 percent lower than they “should” be; add that effect to the anticipation of future inflation, and I’ll probably mark up my price by 10 percent — even if supply and demand are more or less balanced right now.

Now imagine an economy in which everyone is doing this. What this tells us is that inflation tends to be self-perpetuating, unless there’s a big excess of either supply or demand. In particular, once expectations of, say, persistent 10 percent inflation have become “embedded” in the economy, it will take a major period of slack — years of high unemployment — to get that rate down. Case in point: the extremely expensive disinflation of the early 1980s.

In short, since the goods in the basket for core inflation have very sticky prices. So when they do move, it really maters, since it’s a strong indication that inflation expectations are changing. And when it comes to inflation, expectations are very important — a dollar is only worth what the market dictates.

I think this logic makes a great deal of sense, but I’m not completely convinced that food and energy prices are easily ignored. Energy, in particular, matters along every step of the way in the supply chain. Producers need energy for making a good; their shipper burns energy getting it to retailers; stores need power to stay open. If energy prices are increasing, then costs increase. The wholesale prices, shipping and retail prices should all reflect that.

When costs increase, firms must either raise their prices or cut their other costs in order to maintain their profit margins. It’s true that these prices will are sticky, but if costs have already been deeply cut (like they have been over the past few years), then firms might be more likely to feel forced to raise their prices. And that’s not so much going to affect inflation expectation as much as the “catchup” necessary to get the price level right.

Don’t get me wrong: this kind of has to do with expectations too. Firms will care more about those energy price increases if they don’t believe they’re temporary. So expectations still play a part. But if energy prices rise and remain high for a prolonged period, then price level increases for core goods would be unavoidable, no matter what expectations were.

That doesn’t mean core isn’t the most important measure for inflation — it is. But I think the inflation trend of those goods with less stable prices, like energy, is also important for the reason I explained. If a systematic increase in energy prices prevails, then I don’t see how greater core inflation is ultimately avoided.

(Image Credit: Stewart/flickr)

Over the past year, I’ve covered Florida’s deep foreclosure problem on multiple occasions. To attempt to cope with the growing foreclosure inventory, the state government has turned to an eBay-like online foreclosure auction system. While utilizing the Internet may be a smart means for making the auction process easier, it also opens up these auctions to a much wider, less experienced pool of potential buyers — anyone with an Internet connection. But some of those new users who think they’re getting an incredible deal on a foreclosed property are actually getting ripped off instead.

Some Background

Florida’s housing market was one of the most brutalized by the housing bubble’s pop. The state’s economy was very dependent on its real estate industry. In 2009 alone it recorded over a half-million foreclosures, according to RealtyTrac. In Florida 26% of all mortgages are at least one payment past due, reports the Mortgage Bankers Association. So you can see why the state needs to do something to whittle down its growing inventory of foreclosed properties.

The state government is trying to do just that through its new online auction system, administered through realauction.com. First rolled out late last year, counties across the state are slowly adopting these online auction systems accessed through their Clerk of Court’s webites. Miami-Dade’s site went live in January.

The Problem: Confused Consumers

Sounds great, right? Now you don’t have to be a seasoned professional investor to capitalize on all the great real estate deals out there. You just need an Internet connection and a bank account to wire funds to your auction account for the required 5% deposit. This means lots of novices are getting involved, but that’s a problem. Even though disclosures exist to warn bidders that they should thoroughly research the properties they’re bidding on, confused consumers who think they’re getting a great deal are sometimes bidding on what might as well be toxic waste.

In fact, the auction websites contain listings for all kinds of foreclosed property. That means not all the listings are first mortgages: some are second liens. In some cases, bidders think they’re getting an ownership interest on a condominium, when they’re actually getting a worthless second lien that the condo association has levied on the foreclosed occupant for unpaid maintenance fees.

An Example

The best way to understand what’s going on is through considering an actual example. Last Thursday, February 18th, a bidding war went on for a listing on the auction web site for Miami-Dade’s Clerk of Court. Here’s a screen shot of the listing (click for larger image):

As you can see, it shows the assessed value of this property as $213,969. Yet, the judgment amount is only $5,210. To an unsuspecting consumer, it sounds like you could get a great deal. Bidding started at $8,600 at 10:28am. The auction ended at 1:24pm with the winning bid of $20,500.

But this winner was actually a loser. If you perform a records search, you find out that the defendant (foreclosed occupant) has another foreclosure lawsuit pending on the same property by Chase Home Finance, LLC. Yet, the plaintiff in the lawsuit for the auction listing above is Walnut Park Homeowners Assn Inc — not Chase Home Finance. And you can find that separate lawsuit pending through the records search too.

This implies that a title search will almost certainly show that Chase Home Finance has the 1st mortgage on the property, while Walnut Park Homeowners Assn has a 2nd lien for $5,210 on the occupant’s unpaid maintenance fees. Remember, when someone stops paying his mortgage on a condo, he often also stops paying his fees.

The Consequences

So what happens to the “winner” of a second lien? Well, they’ve purchased garbage. Now, they may be able to move into that condo for a few days, weeks or months. But the bank that holds the mortgage will still ultimately foreclose, wiping out that second lien. She never had an authentic ownership interest. Then, the winner must then vacate the premises, unless she wants to pay whatever the bank demands to wipe out its first mortgage, often hundreds of thousands of dollars.

Think about the insanity of what’s going on here. Bidders are paying a premium for a second lien. And it’s worthless: a first lien foreclosure will automatically extinguish that second lien anyway. In the example above, the bidder agreed to pay approximately four times the debt incurred by the former occupant’s unpaid maintenance fees. Why? Obviously because she thought she was getting an ownership interest in the condo for a steal. Unfortunately, she didn’t do her homework.

And now what happens? Well, the best-case scenario is that she only forfeits her 5% deposit fee of about $1,000. But if she pays in full before she realizes the mistake she’s made, then she’ll be in for a very unpleasant surprise: she will likely lose most or all of her money.

I spoke to a few Florida lawyers about what happens to the bidder’s money. Once she’s paid the balance, the condo association will get the amount it’s owed, possibly more if it can argue that it deserves the premium. Any excess cash will then go to whoever qualifies according to the lien priority. After paying, the bidder has no claim on that excess. Her only hope is a very sympathetic judge.

Buyer Beware

The clear solution to this problem would be for buyers to be better informed about what they’re bidding on. But it’s easy to see from the screenshot above how someone could be easily led astray. The listing shows a sizable assessed value for the property. It includes links to the property appraisal, Google satellite and street views, and Zillow.com’s value analysis. All indications imply that this listing exists to auction a property that’s valued at around $200,000. Yet, it doesn’t.

One such burned bidder, Erika Ginsberg-Klemmt, has chosen to do what she can to help create awareness surrounding this problem and contact unsuspecting winning bidders before they’ve paid-in-full. She says she’s seen this happen to dozens of people statewide, some of whom she got to in time to prevent some of their losses. Some of the people she has contacted aren’t completely ignorant about real estate and investing either: they include a foreclosure attorney and an investor from Morgan Stanley. She says that, often, those she contacts are initially paranoid she’s trying to steal their mega-deal, but ultimately they end up thanking her.

Solution #1: Differentiate Between First and Second Liens

But clearly, the efforts of Ginsberg-Klemmt and other concerned consumers aren’t enough to prevent this problem from continuing to occur. Shouldn’t the Clerks of Court do more to provide bidders better information about listings? After all, they do facilitate the process. For example, bidders would find it extremely helpful if listings explained whether or not the property in question is a first or second lien. Then, anything listed as a second lien would be ignored by anyone with even an utterly basic knowledge of real estate.

I spoke to Esther Jones from the Miami-Dade County Clerk of Court about this problem. She informed me that the Clerk doesn’t actually have any knowledge of whether a listing is a first or second lien. They just take all foreclosed properties and schedule them for auction on the website. They do, however, have a disclaimer in place warning bidders to be sure to understand what they’re buying.

That may technically absolve them of liability, but doesn’t the government have an ethical obligation to offer a little additional consumer protection? The state’s websites have opened up these auctions to a wide population without real estate expertise and made it very easy to participate. Shouldn’t the state also provide additional basic information about the property for sale, so to protect consumers that are new to the process and could be misled?

Solution #2: Disallow the Second Liens

Another possible solution might be for the Clerks of Court to forbid second liens from being listed on the website. This should be completely uncontroversial. There’s no legitimate reason that anyone (other than maybe a professional collections agency) would ever want to purchase a second lien. It’s always wiped out when the first lien holder forecloses.

Solution #3: Legislation

Unfortunately, neither of these solutions is likely to happen, because the Clerk of Court appears relatively content with the disclosure language and doesn’t appear to be very concerned with the minority of consumers who get ripped off by purchasing second liens. It doesn’t even know whether these properties are first or second liens. It just puts them up for auction and hopes for the best.

As a result, perhaps the only solution is for state lawmakers to take notice. Currently, Florida statute XL-718.116, section (6)(a) allows condo associations to foreclose their maintenance fee liens “in the manner a mortgage of real property is foreclosed.” New legislation could forbid second liens from being posted on these web sites or force greater disclosure of lien priority for online listings.

Do Your Research

Anyone who plans to use this website should exercise prudence. It goes back to the old adage: if a deal seems too good to be true, then it probably is. One dead giveaway that a listing might be a second lien for unpaid maintenance fees is if a condo association is the plaintiff. But a completing a title search is the best way to make sure that you’re getting a legitimate ownership interest. Purchasing real estate is an investment decision that should not be taken lightly. It’s well-worth taking the time to do the research.

(Image: respres/flickr)

Earlier this week, I noted that the Conference Board’s consumer confidence measure for February fell to its lowest level in about 27 years. Today, another source indicates that consumers were feeling worse this month. Thomson Reuters/University of Michigan’s Surveys of Consumers reports that its index declined in February as well, to 73.6 from 74.4 in January. While this appears a less extreme drop than the Confidence Board’s measure, it’s still pretty discouraging news.

First, just how bad this index value is remains unclear — Reuters/Michigan provides little data to nonsubscribers; and sadly, I don’t have a subscription. So I can’t talk about it in much context. But their index’s decline does confirm that the Conference Board’s drop isn’t an outlandish finding. This reinforces the news that consumers are more pessimistic.

And greater detail also shows bad news for economic expectations. Reuters says:

The survey’s barometer of consumer expectations weakened to 68.4 in February from 70.1 in January.

Compare that to what the Conference Board said about expectations:

The Expectations Index declined to 63.8 from 77.3 last month.

Their indices are likely on different scales, but again, their results are in the same direction. Americans are not only pessimistic about the present, but particularly discouraged with the economy’s direction.

The Reuters/U Michigan survey explains what has consumers so down:

“Consumers have been getting more impatient with the slow progress of the stimulus program, and confidence in the Obama administration’s economic policies has begun to wane,” Richard Curtin, director of the surveys, said in a statement.

Americans aren’t pleased with their lawmakers. Anyone who follows U.S. politics probably finds this statement utterly unsurprising. But consumers’ poor view of politics is also shaping their view of economic health and prospects. Since it’s unlikely that Washington will undergo any meaningful change in the near-term, this revelation probably doesn’t bode well for consumer sentiment. So let’s hope something else can overshadow the trouble in politics to create some optimism.

(Image: thegreatgonzo/flickr)

In its second estimate, U.S. GDP was revised to 5.9% by the Bureau of Economic Analysis. That’s higher than the first estimate of 5.7% last month. Clearly, an upward revision is generally interpreted as positive news. But looking a little deeper into the numbers might not make the change as hopeful as it appears for the condition of the economy in the fourth quarter.

First, it’s worth noting that a positive revision is a drastic change from what we saw with third quarter GDP. In that case, there were two revisions significantly downward. Not only was the forth quarter’s revision positive, but it was small. That probably indicates that the original revision wasn’t that far off to begin with. At this point, the prospect of seeing next month’s final revision much lower than the first isn’t very likely.

I went ahead and dug into the numbers. Most of the change comes from a better result in gross private domestic investment. Almost all of its components were better than the first estimate indicated. That makes clear businesses continue to lead recovery. But the biggest upward revision within this category was from the change in private inventories. The first estimate already indicated that this item was the biggest reason for the fourth quarter’s rise in GDP. Now it accounts for even more. It was revised to make up 3.9% of the 5.9% GDP growth. It was previously thought to account for only 3.4%. Generally, economists are less impressed with this factor as a sign of present economic health. Instead, it indicates firms believe that a recovery is imminent.

That’s pretty much all the good news we’ve got. The worst news in the report is that personal consumption was even weaker than we thought. We already knew it was worse in Q4 than in Q3. But its contribution to GDP was lowered even further to make up just 1.2%, instead of 1.4%, of the 5.9% GDP growth.

Net exports provided mixed, but ultimately bad, news. In fact, the contribution of exports increased from 1.9% to 2.3%. That’s good. But imports were revised up even more, from 1.4% to 2.0%. That resulted in net exports providing an overall smaller contribution to GDP than thought.

Interestingly government consumption was also less than the initial estimate indicated. That was mostly due to state and local consumption in Q4 bringing GDP down by 0.3%, instead of remaining flat — as the original estimate indicated. Federal spending was essentially unchanged for the quarter and had no revision.

So it’s always nice to the GDP number revised up, but the reasons why are less than impressive in this case. Although businesses do appear to be helping the recovery effort through more private investment, most of their contribution came from firms building inventories. Other measures, especially consumption, were quite weak — and even worse than we thought in the first estimate.

(Image: Wikimedia Commons)

These days, Americans are increasingly heard complaining about Wall Street compensation. John Mack, chairman of investment bank Morgan Stanley, is too. Unfortunately, he doesn’t see the industry changing compensation levels anytime soon, since competition is only driving pay higher. So what can be done to fix the problem?

Here’s Bloomberg reporting on Mack’s comments:

“I still don’t think the industry gets it,” Mack said yesterday during an appearance in Charlotte, North Carolina. “The issue is not structure, it is amount.”

He gives an example of why it’s so hard to control compensation on Wall Street:

Mack, who retired as CEO of the world’s biggest brokerage in December, cited a 28-year-old Morgan Stanley trader whose unit had earned $300 million to $400 million for the firm. After Morgan Stanley offered $11 million in compensation, the trader jumped to a hedge fund that paid him $25 million, Mack said.

If you think that $11 million is already too much for a trader to make, then presumably you think $25 million is bordering on insanity. You could try to diagnose what went wrong here, but it’s pretty hard to identify where the buck should stop.

First, Morgan Stanley’s motivation for paying him $11 million makes sense: he made the firm hundreds of millions of dollars. He should be paid accordingly. Second, the hedge fund can’t really be blamed for upping that offer. If the trader can replicate his previous success, then at $25 million he’d still only be paid a small fraction of what he’d earn the fund. Third, you can’t really blame the trader. Obviously if you’re doing the same work as a hedge fund as a bank, then why not more than double your compensation?

The problem I see here is that it’s consistently possible for a trader to bring in $300 million to $400 million in a year. If this was a sort of one-off payout resulting for some particularly lucky bet, that might be okay. But if it’s possible to do this year-after-year, then something’s wrong.

Where do the enormous piles of money come from that settle on Wall Street? Some consist of fees for transactions or advisory. Investment profit also plays a part. What has caused these quantities to grow so high over the past few decades? I think credit is mostly to blame.

Think about all of the outstanding debt right now. If all suddenly came due, do you think there’s any chance that the world, as we know it, wouldn’t crumble? Credit is way overextended. Businesses, banks, consumers and the government are so highly leveraged that it’s hardly comprehensible.

As credit continues to grow, Wall Street capitalizes every step of the way. Businesses do debt deals: bankers get a fee; bond traders enjoy transaction costs; bond investors get interest; equity investors get a higher return because the credit brings growth to those firms. Consumers incur debt through a mortgage or credit card: bankers securitize it and take a fee; traders sell the resulting bonds and get a transaction fee; bond investors get interest; equity investors see broad returns because consumer spending increases. Similar logic applies to municipal and sovereign debt. The derivatives market then grows to facilitate all of that credit activity. Credit is the life-blood of Wall Street.

The way you lower profits, and consequently compensation, on Wall Street is by lowering leverage levels. And I don’t mean only for banks. I mean for insurance companies, manufacturing firms, consumers — you name it. If you shrink credit, then you have less intangible credit-based money providing real money to bankers and traders.

I really thought that the credit crisis would be a reckoning for economy. But it looks like the credit markets will shortly be returning to business as usual — unless we make a choice to rely less on borrowing going forward. That could be regulatory, but it must also be done on an individual level. If consumers live within their means, then they’ll utilize less credit. If businesses shift their capital structure to be less reliant on debt, then they will pay less to lenders. And finally, if banks are forced to rely less on borrowed money, then their profits won’t be as outlandish. Credit isn’t inherently bad, but too much can create dangerous imbalances.

Easy credit makes for high Wall Street profits. Credit got a little harder following the crisis, but only a little. Using less credit is a difficult choice to make, because using money you’ve actually earned, instead of borrowed, takes will power. It humbles us. Growth would be more restrained, but less volatile. More reasonable credit levels will result in a healthier, more balanced economy in the long-run.

A Gallup poll released this week shows that underemployed Americans in the U.S. are extremely discouraged about finding full-time employment. That underemployed population makes up about 20% of the workforce, according to another recent Gallup poll. They’re defined as those who are “either unemployed or work part time but want to work full time.” Here’s what the pollster found:

Sixty-one percent is a pretty big portion. This might not be surprising if you think about how the number of discouraged Americans has increased in recent months according to the official unemployment report. Here’s the chart I used to show this earlier in the month:

So the Gallup poll reinforces the idea that discouragement is a problem. Since some of its respondents are likely still trying to find work, despite being discouraged, I wouldn’t imagine that this number is going to decline significantly in monthly unemployment reports to come.

But it’s sort of hard to tell how alarming we should find this data. Unfortunately, as far as I can tell, this is the first time Gallup has conducted a poll tracking discouraged underemployed Americans. So we can’t really identify if 61% is better or worse than it was, say, six months or a year ago. But it sure sounds bad. And logic dictates that the portion of discouraged job seekers has probably increased since the start of the recession: as people remain unemployed for longer, discouragement will generally follow.

Also interesting to note from the report: the more educated were even more pessimistic than the less educated. The survey also found that nearly two-thirds of those with a college or graduate degree were not hopeful. That could partially have to do with expectations. It probably seems easier to find an unskilled job, since jobs that require skills will only be open to those with certain backgrounds. If you can apply to more jobs openings, then you are probably less discouraged.

Amusingly, the poll also tracked how respondents felt about President Obama’s performance. As you might expect, those who are more hopeful were more likely to embrace the President. He did, after all, run a campaign based on hope and change. Here are those results:

According to the World Trade Organization, global trade plummeted by 12% last year. The Guardian says this is the fastest pace of trade contraction since World War II. The fallout of the financial crisis has thrown world trade off course. It might not be easy get back to the previous level of trade either.

Global trade is good for everyone involved. For developing nations, it’s especially important because they can often produce goods more cheaply than more developed countries and experience significant growth through exports. The more advanced economies enjoy cheaper goods thanks to those developing nations. When trade suffers, everybody is worse off.

How did the financial crisis cause such a big problem for trade? The major source of the trouble comes from the demand side. Firms and individuals aren’t spending the way they were prior to the crisis. Unemployment is higher than usual in some countries, especially the U.S., and that constrains consumer spending. Shaken firms are hoarding cash and buying less.

On the supply side, it might not seem too bad: interest rates are relatively low. But as just mentioned, many businesses aren’t spending, so they have no need to borrow. Some of those who might be willing to spend more aren’t finding credit as easy as it used to be, with lenders having stricter underwriting requirements than before the crisis.

The Guardian reports that WTO head Pascal Lamy suggests more progress in the latest Doha round:

Completing the Doha round, which has already lasted more than eight years, could help to open up new sources of revenue for recession-hit countries, and kick-start a world recovery, he said.

Making trade easier would certainly help, practically by definition. But I see its effect as potentially minor: until consumers and businesses decide to start spending again, demand won’t rise. And without greater demand, more abundant supply can only do so much.

Unfortunately, it might just take time. Once the battered economies improve, demand will as well, and trade should recover. Until then, it will remain weak.

Slate’s The Big Money suggests that schools should be psyched about Apple’s do-everything iPad device. Apple has traditionally done pretty well in the education market. TBM suggests the company’s latest innovation could add an new dimension to learning. I’m less convinced.

Here’s what TBM says:

Academic life is really one of media production. Professors create lectures in presentation format, they assemble syllabi from mixed-media sources, and they generate a slew of exams and research projects that all bear the fundamental kinship of being media.

Really? Maybe I studied the wrong subjects or went to the wrong schools, but my professors rarely utilized media or assembled syllabi from mixed-media sources. I just don’t see the value added to education by the iPad.

Won’t Enrich Learning

First, I’d argue that for most subjects, media isn’t very important to learning. Take math, for example. What can multimedia really do that a chalk and blackboard can’t? I guess equations may be prettier on an iPad’s screen, but that’s about it. How about for English/literature? Now you can read a book on the iPad, but you don’t learn more by doing so. And even then, any old e-reader will do. With history, I guess you can view video clips or pictures on an iPad. But you could do the same with a film projector and an e-mail from the professor with the slides/clips attached for studying. Science may sort of blend all of the other three: there may be visuals and equations. But the iPad won’t help you execute the scientific method in the lab.

Makes Education More Expensive

But let’s say I’m missing something, and the iPad’s capabilities can be very useful for the learning experience. Is it worth paying for? I doubt it: school is already expensive enough. And I’m not asserting this based on the iPad’s current high price tag. Even if the price comes down substantially, I don’t understand the need for a device that has fewer capabilities than a laptop with slightly better portability. And an iPad won’t eliminate the need for a computer.

Professors Won’t Bother

Finally, even if iPads were practically free and enhanced the educational experience, I don’t see many professors taking the time to create presentations specifically geared towards the iPad’s capabilities. It’s actually really difficult to create multimedia presentations. Think about the time professors (or more likely unlucky graduate students) would have to take each week creating these snazzy new presentations for three to five lectures. Maybe I just had the wrong professors, but most of them liked to put as little effort as possible into their lectures. While, in time, canned multimedia presentations could be created, subject matter changes and so do the courses professors are responsible for. I just can’t see them embracing the back-end time commitment necessary to utilize the iPad’s innovative capabilities.

The truth is that most learning doesn’t need multimedia. Students also generally don’t have extra money to spend on another new technology. Finally, professors’ time would be better spent doing research or working one-on-one with students than developing pretty multimedia-driven lectures. While the iPad might be a fun toy for its owners to play with, I just can’t see it having a major role in education.

Hummer is officially dead. Probably. General Motors announced that it would begin winding down the firm yesterday once the news came that Chinese regulators would not approve Sichuan Tengzhong Heavy Industrial Machines Co.’s acquisition of the company. But is Hummer really finished?

Here’s what GM says, according to the Associated Press:

GM said it will continue to honor existing Hummer warranties.

“We are disappointed that the deal with Tengzhong could not be completed,” said John Smith, GM vice president of corporate planning and alliances. “GM will now work closely with Hummer employees, dealers and suppliers to wind down the business in an orderly and responsible manner.”

Well that sure sounds final. But remember what happened with Saab? There, GM’s initial sale failed and it looked like Saab would be wound down. At that time, I quoted this passage from a Bloomberg article:

GM has a contingency plan for Saab similar to a process being used to wind down Saturn, the person said. Saab owners would continue to be covered by GM warranties and be assigned to a new dealership for service, the person said.

Sound familiar? But two months later, GM managed to complete a deal with another firm to ensure Saab’s survival after all. Could that happen here?

Maybe, but it might be harder this time. Sichuan Tengzhong was only going to pay a measly $150 million for Hummer in the first place. Saab’s original deal was for $600 million. How much less would GM accept? It’s pretty clear that no one is willing to pay much for a company that’s business focuses on stamping out big fuel hogging SUVs. After all, Chinese regulators clearly didn’t want one of their companies taking it on. With the auto industry running in the opposite direction of such vehicles, it’s hard to blame them.

But who knows. Maybe GM will find some random dark horse buyer yet, like it managed to for Saab. But at this point, Hummer lovers should probably prepare for the worst.

Before the House Budget Committee today, Treasury Secretary Timothy Geithner testified that the Obama administration won’t reveal its plans for the future of the government sponsored entities (GSEs) Fannie Mae and Freddie Mac until 2011. Given that these two companies were the largest of all bailout recipients, played a major part in the financial crisis and continue to incur massive losses, I’m shocked that there’s no sense of urgency for their reform. The news gets worse.

First, how is the Obama administration so detached from the real problems facing the economy that the GSEs won’t even hit its radar screen until 2011? Today, Freddie just announced yet another multi-billion dollar quarterly loss, this time $6.5 billion. The GSEs may not have been the only cause of the financial crisis, but they were certainly a central cause. That’s part of the reason why I’ve argued that these institutions should just be wound down. House Financial Services Chairman Barney Frank (D-MA) also wants them abolished.

Yet, today Geithner also implied that the administration has no intention of winding down the entities. The Wall Street Journal reports him saying:

“It’s very important that we make it clear to investors around the world that we will make sure…that those two important government-sponsored enterprises can continue the role they need to play,” Mr. Geithner said.

In other words, they’re not going anywhere. The administration will just make them work better. Good luck with that. Whenever you’ve got organizations with the kind of deep inside-Washington connections that Fannie and Freddie have, they’re beyond reform.

I’m in the middle of reading former Treasury Secretary Hank Paulson’s book about the financial crisis, “On The Brink,” where he makes clear that the only way the Bush administration managed to take the GSEs under government control and fire their management was by a very secretive, difficult process that included a lot of regulator arm twisting. Once Paulson realized the problem they posed, he essentially used his signature brute force to make it happen. But he’s gone now. And if the GSEs get their way, then it will be back to business as usual before long.

In fact, I’ll make a bold prediction right now: we won’t get meaningful reform for Fannie and Freddie during President Obama’s first term. If the administration is waiting until 2011 to reveal its plans, that means it doesn’t intend for them to matter. Republicans will likely have a majority in the House by then and more power in the Senate. 2011-2012 will be a time of profound gridlock. And when it comes to Fannie and Freddie, Republicans are generally pretty outspoken in their criticism of the firms. I find it highly unlikely that their ideas for reform will match up with the Obama administration’s plans. That translates to nothing — or nothing meaningful — getting done.

Earlier, Cult of Mac reported that Apple added an “explicit” category for application developers to use when submitting their programs. The new category has since disappeared, but it’s fairly unlikely this was just a glitch. How do you accidentally create an “explicit” category? Its temporary presence could indicate that Apple is preparing to allow overly sexual apps for its iPhone and iPod Touches after all. If that’s the case, then it speaks directly to what I wrote this morning, when I pondered why the company would just ban explicit content, instead of developing a system for allowing parental controls. It may be doing exactly that.

Cult of Mac received this information from an app developer who provided them with the following screenshot:

It’s worth noting, however, that there are currently no applications with this category designation in the app store.

Despite the fact the category has since disappeared, its earlier presence may show that Apple actually does intend to allow users of its devices to download adult-oriented apps eventually — just not yet. As I mentioned earlier, it really has to if it wants to maintain its app market position. As other mobile phone platforms allow developers more freedom, Apple will risk its dominance if it’s overly restrictive.

If Apple does allow explicit content, I’d be shocked if it did so without creating parental controls. Otherwise, why ban it in the first place? So the company may also be working on giving parents the ability to forbid their child’s iPhone from downloading “explicit” apps. That would give Apple an edge if its parental controls are more powerful than what other mobile platforms offer. Those controls would also allow that the company to capitalize on all apps — no matter how explicit — without angering parents.

New home sales in January fell by 11.2% to a seasonally-adjusted annualized rate of 309,000, according to the Commerce Department (.pdf). Reuters reports that as the lowest level since the government began keeping records in 1963. Separately, the Mortgage Bankers Association says that mortgage applications declined by a seasonally-adjusted rate of 8.5% last week. These indicators might have people wondering: what housing recovery? But this data should be taken in context.

There’s an important factor at play in both of these statistics: the weather. It’s has been unusually awful for much of the U.S. throughout 2010. People tend not to buy as many houses when the weather is bad. The MBA report argues this:

“As many East Coast markets were digging out from the blizzard last week, purchase applications fell, another indication that housing demand remains relatively weak,” said Michael Fratantoni, MBA’s Vice President of Research and Economics.

That makes sense for the MBA data, for sure. But was the weather really that bad for all of January? After all, the lowest level of new home sales since at least 1963 is pretty terrible. This statistic was also seasonally adjusted so it sort of already takes winter weather into account. In fact, the new home sales data has been getting worse rather steadily since August:

So there must be other factors at play. In general, the demand for new homes is very weak. The U.S. is still dealing with a huge supply of existing homes, many of which offer great deals through short sales and foreclosure auctions. Why pay a premium for a new home if you can get a deep discount on an existing one?

But what about the home buyers credit extended by Congress in November? Shouldn’t that be helping demand for both new home sales and mortgage applications? Maybe. I’ve argued that recent data all appears to indicate that the U.S. might be experiencing some home buying fatigue. Congress already brought a great deal of demand forward in 2009 when it originally put the credit in place for first time buyers. Compound that spent demand with the facts that banks have adopted stricter mortgage standards and that many Americans’ financial struggles take them out of the equation for purchasing a home. Then, you can quickly see that the credit’s extension should have a muted effect.

Still, I think over the next few months, particularly March and April, we’ll see a little pickup — the credit’s extension ends on April 30th. The urgency of wanting to capitalize on the credit before it ends, along with better weather, should help. But after April, I would expect demand to decline again to return closer to the levels we’re seeing now. That won’t necessarily kill a housing rebound, but it should prevent it from being a steep one.

Last week, Apple decided to remove any applications it viewed as overtly sexual from its iPhone app store. This is not the first time Apple has denied developers’ apps purely at its discretion. In fact, it’s exercised its right to do so on numerous occasions. Some developers are getting frustrated. But luckily, there’s another mobile phone platform willing to welcome most of them with open arms: Google’s Android.

The Wall Street Journal reports that Apple’s latest wave of app removals could encourage developers to begin spending more time focusing on creating applications for Google’s Android operating system instead. I think that makes sense — especially given Google’s apparent willingness to embrace those who Apple has shunned. From WSJ:

In a statement, Google made it clear it wants to position itself as an alternative to Apple, although it stopped short of naming its competitor. “We want to reduce friction and remove barriers that make it difficult for developers to make apps available to users,” the company said.

But perhaps this latest move by Apple to rid the iPhone of risqué apps is specific: unless you’re planning on producing an app with scantily clad men or women, you should be fine, right? Maybe, maybe not. The logic behind Apple’s decision to remove these apps is a little unclear — at least to me.

I mean the motivation is clear: Apple doesn’t want to expose children to sexual content. Fair enough. But then, why hasn’t it also removed its Safari Internet application or created a filter that doesn’t allow users to visit web sites that can offer even more objectionable content? Is it really any more difficult for a minor to type “sex” in the application store search field than in the Google search field in Safari?

And that’s why developers might be right to worry — the move just doesn’t make much sense. Apple seems more content to just limit its app availability than to meaningfully tackle a problem. Why not, instead, create a software update that includes a parental control function to forbid an iPhone user from downloading overtly sexual applications?

The iPhone is successful for a multitude of reasons, but as an iPhone user myself, I can say that its app store is easily my favorite feature. The diversity and innovation that developers provide to the iPhone’s capabilities set it apart from its competitors. That advantage will remain distinct in the short-term, but eventually other mobile platforms will catch up. Does Apple really want to speed up that process by continuing to frustrate developers?

There’s one very important aspect is missing from the sweeping financial reform proposals currently being mulled over in Washington: to fix or wind down the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. But yesterday, I learned of one piece of legislation sponsored by Rep. Scott Garrett (R-NJ) which seeks to force Washington to face the GSE problem. He’s sponsoring a bill that calls for transparency and accountability for the cost that the GSEs impose on taxpayers. How does he hope to do that? Make the GSEs a part of the budget. While only a start, I think this legislation makes a lot of sense.

Garrett appeared on CNBC this morning to explain his bill, called the Accurate Accounting for Fannie Mae And Freddie Mac Act (clip at end of the post). The idea is simply to have the cost of the GSEs included as a part of the President’s budget. Then, they’ll be impossible to ignore. Garrett says:

We should treat this just like any other expense and other money we’re spending put it on budget “a).” And “b),” all the debt that’s out there for Fannie and Freddie, that’s $1.6 trillion, that should apply to our debt limit as well. Two simple facts. CBO suggests it; we think that it’s a good idea.

And since the U.S. now fully owns and explicitly guarantees these companies, I don’t see how you could dispute the sense in doing exactly what this bill would dictate. The GSEs impose a very real cost on taxpayers. Of course, this would also require Congress to raise the U.S. debt ceiling by a whopping $1.6 trillion. But since the government is on the hook for all of the GSEs’ obligations, then their debt becomes government debt.

On his web site, Garrett explains just what kind of an obligation we’re talking about (his emphasis):

$21 billion estimated taxpayer subsidy cost for 2010 according to CBO

$64 billion estimated taxpayer subsidy cost for 2011-2020 according to CBO

$291 billion added to federal debt in 2009 to support GSEs according to CBO

$8.1 trillion GSE securities outstanding according to data released by the Federal Reserve on December 10, 2009 (Neither CBO nor OMB incorporates debt securities or mortgage-backed securities issued by Fannie Mae and Freddie Mac in estimates of federal debt held by the public.)

UNLIMITED Treasury assistance to the GSEs through 2012

The hope is that, by recognizing that the U.S. government is now responsible for this massive mortgage market exposure, more sweeping reform for the GSEs would follow more quickly, or at least follow eventually. As long as policymakers pretend that this isn’t a problem, they will continue to ignore Fannie and Freddie.

Unfortunately, I’m not convinced that even this basic measure that I view as relatively uncontroversial will get anywhere. In the interview, Garrett indicated that Democrats weren’t yet on board. Until they are, there’s little Congress will do. However, about a month ago I noted that House Financial Services Chairman Barney Frank (D-MA) believes that the GSEs do need reform. Let’s hope he leads Democrats to consider this and more significant measures to fix the very serious problem that the GSEs pose to taxpayers going forward.

The FDIC released its Quarterly Banking Profile Report (.pdf). While it contains a lot of information, one pretty startling statistic that the Washington Post picks up on is that it implies a huge drop in lending in 2009 — $587 billion or 7.5%. The Post says this is the largest decline since the 1940s. That sounds pretty awful, especially considering that Washington has been trying to get banks to lend more. But let’s think a little more deeply about what’s really going on here.

Not Necessarily (But Probably) Less Lending

I dug into the spreadsheet provided by the FDIC that contains the aggregate balance sheet data for the banks it tracks. The line that shows a $587 billion decline is “Total Loans and Leases.” In other words, at the end of 2008, banks had $587 billion more loans and leases on their books than at the end of 2009.

This statistic doesn’t necessarily spell a decrease in lending, and almost certainly doesn’t indicate as large a decline as it implies. The FDIC report doesn’t contain statistics for actual new lending. In order to figure out if banks were lending more or less, you should compare the volume of loans originated in 2008 versus in 2009. The number the report (and Washington Post) cites to show that lending has declined doesn’t necessarily mean that banks decreased their lending during the year — just that they have less loan exposure.

Where Did The Debt Go?

So where did it these loans go? Digging into the report and spreadsheet, you find a few things. First, as you probably expect, banks incurred lots of losses during 2009. The report indicates that banks endured $186 billion in net charge-offs during the year. That wiped out 2.4% of their loan exposure.

Second, banks ramped up their capital levels. The report also says that banks’ equity capital increased by $177 billion in 2009. They also increased their loan reserves by $54 billion, which is more money they set aside to cover future losses. It’s pretty hard to criticize banks for raising their capital levels, given this is another explicit demand of most policymakers in Washington and is likely to be a part of whatever financial reform we end up with. Combined, that would prevent another 2.9% of new lending.

If you sum up all those numbers, you find where $417 billion of that $587 billion decline in loan exposure comes from. This implies that the decline lending that you might choose to hold banks blameworthy for was just $170 billion, or a 2.2% decrease, which is much less alarming.

Another important note: the FDIC spreadsheet shows that the loan exposure of banks at the end of 2009 was $7.29 trillion, more than the $7.23 trillion at the end of 2006. Yet, pretty much anyone who has been paying attention to the trouble the credit bubble caused should agree that banks did too much lending through 2006. But as it turns out, 2009 levels still exceed that.

Less Loan Demand

Still, it’s almost certainly true that banks did curb their lending in 2009, even if to a less significant extent than what’s superficially reported. Was this just banks being thrifty? That was certainly a part of it. And it’s hard to blame them: it’s a wholly rational response to develop stricter loan underwriting requirements after you experience a massive market correction caused by too easy lending.

But that’s not the whole story. Businesses and individuals are almost certainly exhibiting less demand for loans than they did over the past few years. Their savings levels serve as evidence of this. I noted a few weeks back that companies are hoarding cash. If that’s the case, then there’s less reason for them to want to borrow.

Back in December, I also wrote that personal savings and borrowing indicate that Americans who are in a position to do are paying down their debt and saving more. Again, if you’re saving, then you’re almost certainly not borrowing more. And evidence indicates that Americans are actually paying down their loans, which reduces banks’ loan exposure.

Through all of this, I find it a little hard to be too angry at banks for shrinking their loan balances. Given their recent loss experience for lending too much, it’s completely rational. We’re also asking them to hold more capital, which makes it pretty hard to simultaneously lend more. Finally, it’s very likely that businesses and individuals are actually exhibiting weaker demand for lending than they did over the past several years.

Today, S&P’s Case-Shiller Home Prices Indices for December were released. If you adjust for seasonality, then home prices increased by 0.3% in December, according to its 20-city composite index. If you don’t adjust for seasonality, then home prices declined by 0.2%. Prices fell by 3.1% year-over-year. While this news isn’t exactly earth-shaking, it does show stability.

There are a few things to note about this December data. First, Case-Shiller specifically pays attention to metropolitan areas. So it isn’t the broadest measure of what’s happening to home prices in the U.S. It also serves as a broader indication of home value, instead of what homes are actually selling for, which can be vastly different in a market with lots of short sales and foreclosures. All of that should lead it painting a rosier picture than some other broader measures.

There’s a disparity between seasonally adjusted and unadjusted data this month. Here’s the adjusted data, which indicates a price increase for December:

And here’s the same chart, unadjusted, showing a price decline:

So which is more accurate? Since home prices tend to decline in the winter months, the unadjusted decrease in prices is to be expected. Indeed, seasonality would dictate an even larger expected drop, which is why seasonal adjustment led to a gain.

While it’s hard to know which is more accurate a measure of what really happened with home prices, I think it’s more valuable to consider the trends. Both measures don’t deviate much from zero at 0.3% and -0.2%. That indicates that there wasn’t much change over the month, no matter which type of data you trust. The same can be said for the data over the past several months — really since September. I interpret that as stability.

As always, the question is: where will the market go from here? If this apparent stability is real, then you should see home prices stop falling this year. But that doesn’t necessarily mean we’ll see them rising significantly going forward either. I haven’t seen any data to suggest we’ll have a steep recovery in housing. Given how bad the market has been over the past few years, even if 2010 merely establishes firm price stability, I think that’s a great start on the road to recovery.

Banker bonuses flourished in 2009. Wall Street paid $20.3 billion in bonuses last year, according to New York State Comptroller Thomas DiNapoli. Those banks themselves are doing pretty well too. Their 2009 profits could exceed $55 billion — nearly triple their previous record year, according to Reuters. I’ve got a few observations.

First, Reuters also reports that this bonus tally is 17% higher than in 2008. My response to that is — really? Is that all? Remember 2008 — that was the year that the entire financial industry had to be bailed out. And Wall Street has a momentous record year in 2009, yet bonuses have only increased by 17%? Not to say that those sums aren’t lofty enough, but this, more to the point, shows the ludicrousness of the bonus levels in 2008.

As for Wall Street making such lofty profits, I guess I find that altogether unsurprising. Early 2009 was a historically delightful time to employ the simple buy-for-cheap strategy. Asset prices improved steadily over the year and there was a great deal of trading. All of that means Wall Street profits. But more importantly, all of the rescue efforts (through the Treasury and Federal Reserve) created an environment where it was very cheap for banks to borrow money, which leads to even higher profits.

In 2010, those rescue efforts will mostly disappear. That will make it a little more difficult for banks to make as outlandish profits. We might even manage to get a little bit of financial regulation, which I desperately hope will include higher capital requirements and more reasonable leverage limits. If that happens, then we may not see a repeat performance of profit growth on Wall Street once the legislation takes effect. But those bankers and traders do have an uncanny talent for extracting profit no matter what the obscale, so they could very well manage to find ways to escape much of the regulatory effort that would otherwise limit their profits.

Lastly, it’s always good to note who must find this news pleasant. Obviously, anyone who works on Wall Street doesn’t mind. New York City and state also probably walked outside and did a little celebratory dance when no one was looking — those profits mean more tax revenue. Finally, luxury retailers aren’t complaining. They’re polishing up those Ferraris, yachts and private jets to get their showrooms ready.

This news will likely have some angry taxpayers wielding their pitchforks once again. But should it? No. Yes. Maybe.

Wall Street’s success also means that 401k’s and pensions should be better off now than a year ago. The bailouts are also mostly paid back — with interest — from Wall Street, unless you include AIG in that category. These guys pay federal taxes too, so that’s good news.

But where populists might experience more legitimate anger is regarding the fact that these banks are making lending more expensive while reaping incredible record profits. In a vacuum, those new underwriting standards might seem prudent, given banks’ experience over the past few years. Yet, with profits like this, it’s harder to justify increasing interest rates and fees.

Consumer confidence fell off a cliff in February, according to the Conference Board. The index fell 10.5 points to 46 — the lowest level since February 1983. The Present Situation Index and Expectations Index also experienced huge drops. This is extremely bad news.

First, here’s the hilariously small chart, provided by the Conference Board:

So much for that gain last month. As you can see, confidence had been increasing since October through January. But all that progress, and more, was immediately eliminated in February. Lynn Franco, Director of the Conference Board Consumer Research Center says:

Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years (Feb. 1983, 17.5). Consumers’ short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects. This combination of earnings and job anxieties is likely to continue to curb spending.

It’s hard to fathom that consumers felt worse in February than they had throughout the entire recession — or at any time in the past 27 years! At the very least, I would have thought that future expectations would be better. They’re worse.

What happened in February that has Americans so down? I can’t think of any prevailing market shock that occurred over this time period. As a result, I suspect it’s just the fact that Main Street and average Americans don’t feel like things are getting better. And the longer things aren’t getting better, the worse people feel. Those who have been unemployed for an extended period may have thought 2010 would be different, but two months in it’s still proving difficult to get a job.

As Franco mentions, this is extremely discouraging data for anyone who hoped that consumer spending might pick up. I noted that a recent Gallup poll showed that it was flat in January. This data indicates that it might have declined this month. If consumers continue to feel this awful, they’ll continue to spend as little as possible, which is a grim prospect for an economy with a 70% reliance on consumer spending.

Bloomberg breaks more news today about the ongoing fiasco involving Collateralized Debt Obligations (CDOs), Goldman Sachs, AIG, the New York Fed and Rep. Darrell Issa (R-CA). Documents finally released from the NY Fed after about a year indicate that Goldman Sachs created more of the toxic CDOs insured by AIG than any other bank, which played a part in AIG’s troubles and eventual bailout. Those securities were so bad that they sometimes had losses exceeding 75% of their notional value, according to Bloomberg. If Goldman and other banks knew these securities were garbage, should they explain why they asked AIG to insure them? Not necessarily.

First, let me summarize the situation, for those who haven’t been following along. During the financial crisis AIG got an enormous bailout, to the tune of $180 billion. Several months later, it was learned that AIG’s bailout led to a sort of backdoor bailout for some big investment banks like Goldman. Those banks received tens of billions of dollars in cash based on swaps and other obligations that they had with AIG. This angered many, especially in Washington, who believed that this fact was hidden when they approved the bailout.

More recently, in January, the NY Fed finally released some more documents about this debacle at the request of Rep. Issa. They appeared to indicate that the NY Fed was well aware of the fact that there would be a substantial backdoor bailout for banks when AIG got its government cash, but purposely hid that fact until after Congress provided the funding. At that time Treasury Secretary Timothy Geithner was the president of the NY Fed. Yet, he says he knew nothing about the AIG bailout, because he was already recused. But that didn’t prevent Congress from ripping into him during a hearing on the matter last month.

The news today provides a little bit more detail on those CDOs that AIG insured. We learned that Goldman originated a huge number of them — more than any other investment bank at $17.2 billion. Merrill Lynch (aka Bank of America) underwrote the second most at $13.2 billion. Germany’s Deutsche Bank created the third most at $9.5 billion. We also learn that they were incredibly ugly, incurring enormous losses. That means AIG had to pay up to these banks, since the firm made the mistake of agreeing to insure the bonds.

The NY Fed hid this detail for a long time, and many are critical of that decision. They believe that it misled Congress and the public. While conspiracy theorists might believe that they were in cahoots with these banks. I suspect the answer is simpler: the NY Fed was trying to stabilize the financial industry, and this detail going public sooner would certainly not have helped its cause. This doesn’t necessary absolve the Fed’s actions, but it does explain them.

Next, there’s the question of whether or not the banks should get in trouble for seeking insurance on what they may have known were poisonous securities. One Bloomberg source says:

The banks should have to explain how they managed to buy protection from AIG primarily on securities that fell so sharply in value, says Daniel Calacci, a former swaps trader and marketer who’s now a structured-finance consultant in Warren, New Jersey. In some cases, banks also owned mortgage lenders, and they should be challenged to explain whether they gained any insider knowledge about the quality of the loans bundled into the CDOs, he says.

Not really. Assuming that AIG was not misled by the banks, then I’m not sure how the banks could be held blameworthy. These guys at AIG who decided to insure the bonds were not folding shirts at their local mall’s GAP for a living, so knew little about CDOs: they were financial professionals who should have understood what they were getting their firm into. If the banks provided accurate and complete information for what they requested to perform their analysis, then AIG must be held responsible for its decision to insure the securities.

Of course, if it turns out that these banks did misrepresent the CDOs, then that’s an entirely different matter. That’s fraud. Sue away and ready the orange jumpsuits.

You could look at this like a situation sort of like where one financial professional sells another financial professional a security. In that case, the buyer can’t blame the seller if it doesn’t live up to the expectations of the buyer. If he could, then there wouldn’t be much of a financial market. At its very heart is the spirit of transactions where one party believes a security is worth more than another party so a trade takes place. Whoever had a better prediction of the ultimate value of that security makes a profit; whoever misjudged the security probably wishes the transaction never occurred. This fiasco involving AIG is just an extreme example of a variation on that tune.

But don’t get me wrong: knowingly selling very bad securities to other financial professionals is not an advisable practice. Surely, if AIG survives, it should think twice about buying securities so easily from those banks that sold them the worst junk. That’s why there’s a good reason not to take advantage of those you trade with. But if a bank is willing to jeopardize its reputational risk by selling trash to unsuspecting financial firms, then it can do so if those firms are dumb enough to buy that junk after obtaining accurate information about it.