Christopher Whalen

For those of you with the good sense to ignore the financial markets and enjoy the waning days of summer, below are some of the books — new and old — sitting on my table:

1. “Reckless Endangerment: How outsized ambition, greed, and corruption led to economic Armageddon”
This excellent volume by Gretchen Morgenson and Josh Rosner tells the back story of the housing crisis and its sponsors in Washington, many of whom remain in positions of power today.

2. “Chairman of the Fed: William McChesney Martin Jr., and the Creation of the Modern American Financial System”
This book by Robert P. Bremner is a fascinating look at the man who guided the US central bank in the years after WWII. Chairman Martin spanned the terms of Presidents Truman through Nixon, a story Bremner tells well and with great attention to detail. We described the book in a recent Reuters.com post, “Are U.S. regulators worsening E.U. credit squeeze?”

3. “Inside the Nixon Administration: The Secret Diary of Arthur Burns, 1969-1974
When I ordered the Bremner book, another volume by Arthur F. Burns and Robert H. Ferrell caught my eye. For Americans to understand the origins of the current economic malaise, a study of the Nixon years, when growth slowed and housing became the national obsession, is critical.

This gem of a memoir covers the years 1969 through 1974 and provides a very thoughtful and human account of the Burns era at the Fed. Henry Kissinger, John Connally and many other key political figures of the day are scattered throughout its pages. Burns tells the insider story of Washington in a way you don’t see or hear today.

The Burns memoir also shows how different the concerns and priorities in Washington were four decades ago, but also how little has changed. “My efforts to prevent the closing of the gold window,” Burns wrote, “working through Connally, [Paul] Volcker, and [George] Schultz — do not seem to have succeeded. The gold window may have to be closed tomorrow because we now have a government that seems incapable, not only of constructive leadership, but of any action at all. What a tragedy for mankind.”

Sound familiar?

4. “The Modern Corporation and Private Property”
This is probably the most important book ever written on the behavior of large corporations. The authors, Adolph Berle and Gardiner Means, document the anti-democratic, anti-capitalist bias of large enterprises and describe why big banks and companies eventually seek to subvert the rule of law and democracy itself. Reading this classic 1932 book is essential to understanding the socialist tendencies of the managers of large corporations and how American corporate law has deprived shareholders of their most basic property rights. The authors write:

The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital… [Such owners] have surrendered the right that the corporation should be operated in their sole interest …

Indeed, the last 70 pages of this book could have been written yesterday.

5. “The Debt-Deflation Theory of Great Depressions”
Finally, a key piece of reading for all people interested in economics and finance is this essay by the great American economist Irving Fisher. His writing was published by the journal Econometrica in 1933 and is available from the Federal Reserve Bank of St Louis. Fisher’s essay is something I like to talk about because he understood the role of money and credit in the American system.

As we noted this week in The Institutional Risk Analyst:

The prospective deal by Barack Obama and his counterparts in the fascist states of Europe to float the western economies on a sea of new monopoly money issued by the IMF is the final betrayal of American values. In place of the fiat dollar, Washington will instead worship the golden calf of the SDR and declare the jubilee. But no such expedients will change the basic fact that the problem facing BAC, EU banks and the G-20 nations is the same, namely debt deflation and a lack of demand that stems from it. Irving Fisher was right in 1933 and he is only reaffirmed by today’s events. Until we restructure insolvent banks and markets, and thereby create the conditions for credit expansion, there will be no economic growth in the US or EU.

For the past several years, my firm has been arguing that restructuring is the only way to solve the problems facing the largest US banks — the top four institutions that exercise a de facto cartel over the US housing market. After years of earning what seemed to be supra normal returns from the “gain on sale” world of US mortgage originations, the large service banks are now drowning in the same sea of risk that once made them seem so profitable.

As investors have slowly become aware of the concentration of housing risk that surrounds these large banks, they have increasingly shunned them. First with Bear Stearns, then Lehman Brothers, and then the housing GSEs Fannie Mae and Freddie Mac, markets stopped facing these names in the interbank credit markets, then accelerated into a crisis which compelled government intervention.

Now the Obama Administration faces the same threat with Bank of America (“BAC”), an institution that is one of the largest lenders and also servicer of loans in the US.  Millions of payroll deductions, property tax payments and remittances flow through BAC daily. But losses from acquisitions such as Countrywide, Merrill Lynch, as well as hundreds of other operating entities, threaten to bring the bank down. Yet herein is an opportunity for national salvation.

BAC is a too big to fail zombie created by the Obama Administration and the Fed to protect US financial markets, but is now so vast and unstable that it threatens the global economy. But more corrosive and dangerous than the torrents of red ink inside BAC is the steady erosion of public confidence. Uncertainty is the enemy now, both with respect to BAC and to its large bank peers.

The only way to end the uncertainty and also accelerate the economic recovery is to put BAC through a restructuring using the powers under the Dodd-Frank legislation. While a restructuring by the FDIC may seem to be a horrible prospect, in fact it offers the first real hope of definiteness in the housing crisis, the multi-trillion dollar millstone around our collective necks. Indeed, the BAC situation illustrates why the Founders of the US embedded bankruptcy in the Constitution, namely the need for finality.

In mechanical terms, here is how it works. Let’s start the narrative with a last, Hail Mary move by BAC CEO Brian Moynihan, who put the shell corporation that is the legal successor to the Countrywide business into bankruptcy after settlement efforts fail. This engraved message from Moynihan to BAC’s creditors, litigants and even Treasury Secretary Timothy Geithner — “foxtrot oscar” — begins the real endgame.

Hopefully Secretary Geithner will know about the BAC filing before it occurs and will have begun the process under Dodd-Frank to give regulators and especially the FDIC the power to move immediately to protect BAC and its subsidiary banks. In our narrative, FDIC enters the bankruptcy litigation for Countrywide and asserts control of the entire BAC group. BAC becomes effectively a subsidiary of the FDIC, with the full capital and assets of the entire industry behind it.

Once the FDIC is in control of BAC, the process will then proceed like a typical bankruptcy, with the operating units continuing to do business in the normal course. For consumers and business customers, the situation at BAC will be mostly the same. But for investors and especially creditors, the situation will be far from normal.

In a Dodd-Frank resolution, the creditors of BAC will have an opportunity to file claims, much as with any failed bank. Unlike a bankruptcy, however, the FDIC will make all depositors of the subsidiary banks whole before considering claims of creditors of the parent, a significant difference investors ought to consider. Most important, however, will be the process of converting debt to equity in the restructured BAC, providing the resources to absorb losses, fund continuing operations and restructure.

The beauty of a restructuring is that it forces all parties with a claim on the failed company to speak now or forever hold their peace. It also requires the conversion of debt to equity, which increases capital dramatically and also lowers the operating expenses of the enterprise. A super-capitalized BAC with 2-3% asset returns, 30% tangible equity and gobs of cash flow will then be ready to sell assets, modify mortgages and do whatever it takes to restore the ability of the bank to support new leverage. That is why restructuring is the key to US economic revival.

Economists from Irving Fisher to Henry Kaufman have noted that without credit expansion, the US economy cannot grow. In fact, credit is contracting with public confidence in America’s banks. The solution to the financial crisis affecting BAC and the US economic malaise are the same, namely an orderly, immediate public process of restructuring for the top banks and housing agencies. Think of a BAC restructuring as a working model for the rest of the US and EU to emulate.

The good news is that a growing number of observers see what needs to be done, much to the delight of this lonely herald of woe. The bad news is that the Obama White House is clueless, but such is life in a democracy. We can only hope that some of the Americans I now hear talking about the need for restructuring will speak to President Obama and Secretary Geithner sooner rather than later. And if they need help, they know where to find me.

The decision by Standard & Poor’s to downgrade the U.S. credit rating illustrates a number of areas of weakness in the world of ratings.  While S&P,  Moody’s and the other mainstream ratings agencies have done a pretty good job on corporate and municipal debt ratings over the past century and more, when it comes to sovereigns and other highly politicized situations, their records are rather poor, if you’ll forgive the pun.

Most observers now know that S&P, Moody’s and other ratings agencies prostituted themselves and their special position of trust with respect to mortgage-backed securities and exotic derivatives on same.  But in the world of sovereign debt, S&P is forced to evaluate many more subjective facts than are involved in a simple analysis of the probability of default of, say, General Electric or IBM.

Recall the financial and economic crises in Europe following WWII, the era when the U.S. was proclaimed the new Rome and the dollar was equated with gold at the Bretton Woods conference.  The broken nations of Europe and Asia were rebuilt with American credit and prosperity reigned, but most credit ratings for European nations remained unchanged under “Pax Americana.”

By the 1970s and 1980s, oil shocks and trade deficit combined to send many Latin American nations into default.  And in almost every case, the major ratings agencies were late in downgrading these obligors because of political pressure from Washington and the creditor banks in New York.  In the world of S&P and Moody’s, people decide when to issue or change a rating — usually for consideration.  This entirely subjective, conflicted process is very exposed to political manipulation.

Roll the film forward to the late 1990s, when the collapse of Enron was delayed for weeks as rating agencies like S&P delayed their decision to downgrade the fraudulent Ponzi scheme created by Ken Lay.  Robert Rubin, who resigned as treasury secretary in July 1999 and several months later became chairman of Citigroup’s executive committee, called Peter R. Fisher, the Under Secretary of the Treasury for Domestic Finance, on Nov. 8, 2001, after learning that Enron was close to losing its investment-grade rating.  A political uproar followed.

While Rubin was later cleared of any criminal wrong doing, the effort by Washington to delay the change in Enron’s credit rating prevented many investors from fleeing Enron exposures and thus caused them billions in losses.  Likewise in the case of WorldCom, another highly political corporate bankruptcy, the visible probability of default for the obligor was headed toward junk status more than a year before S&P actually downgraded the company’s debt rating.

The experience with past debt crises us several things about the decision last week by S&P to drop the US credit rating.  First, the decision to change a rating on a sovereign borrower is usually months late.  In the case of the downgrade of the US, S&P and other agencies arguably should have acted many years ago.

As I wrote for Reuters last week, “Basel III in the age of sovereign default,” that if credit default swaps (CDS) for the U.S. are trading over 50bp per year, then it sure looks like the marketplace is voting for a “BBB” bond ratings equivalent for Uncle Sam. A bond equivalent “AAA” rating equals 1bp of default probability, by comparison.  Like WorldCom, the US has been trading over 50bp in five-year CDS for many months now.

The second aspect of the S&P action Friday is that the actual decision of the timing of a ratings change remains entirely opaque.  Based on the criteria in the S&P report, the agency arguably should have downgraded the U.S. when the central bank began “quantitative easing” several years ago.  The uproar regarding the S&P decision is due in large part to the fact that nobody understands the timing of the decision.

But the most striking aspect of the S&P decision, especially speaking as the owner of a bank ratings firm, is the lack of a mechanistic framework to help investors and political leaders understand the rules of the ratings game.  Whereas at my firm we use computers to rate all U.S. banks and publish a new rating for every banks at the same time each quarter, the process used by S&P — if you can call it that — has virtually no hard debt service or economic benchmarks to tell when a rating must change.

At the end of the day, the challenge facing S&P and the other traditional providers of ratings is to migrate their decision-making process to a more transparent and less easily manipulated model.  Needless to say, we at IRA are feeling pretty good about our decision of almost a decade ago to allow machines to determine ratings changes using hard rules defined by mathematics, the underlying data and the calendar — not the whim and caprice of humans.

Delay in changing a rating means a delay in a change in valuation and adjusting asset allocation, with big ramifications for investors and markets.  As my friend Sylvain Raynes, who formerly worked for Moody’s rating structure products, said at a meeting of PRMIA in 2007:

Valuation is not the most important problem in finance; valuation is not the most interesting problem in finance; valuation is the only problem for finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If you do not recognize the difference, the fundamental difference between price and value, then you are doomed.

“Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing.” -William McChesney Martin Jr., Chairman, Board of Governors of the Federal Reserve System

During his tenure as Chairman of the Fed from 1951 through 1970, William McChesney Martin Jr. saw the transition from America at war, with the government controlling much of the economy, to a peace time economy where wider financial ebbs and flows were possible.  His experience in confronting both inflation and deflation during his term is instructive today.

The carefully managed, low-interest rate policy which the Fed maintained during WWII ended under Martin’s predecessors, Mariner Eccles and Thomas McCabe.  These two Fed Chairmen defied President Harry Truman and raised interest rates to forestall inflation.  Even when the Chinese Red Army attacked American military forces in Korea, the Fed under Chairman McCabe stood its ground and eventually won its independence from the Treasury in 1951.

Martin was picked by Truman to replace McCabe and thereby bring the Fed to heel.  Instead Martin proved to be an independent man who helped make the central bank independent as well.  Martin, for example, defied President Lyndon Johnson and raised interest rates in the 1960s.  See Robert Bremmer’s 2004 book, “Chairman of the Fed: William McChesney Martin Jr., and the Creation of the Modern American Financial System.”

But Martin recognized that the Fed ultimately could not prevent Congress from funding spending with debt and thereby fueling inflation, Alan Meltzer wrote in his classic “A History of the Federal Reserve.” That judgment has been proven correct in today’s market volatility, which is driven by the excessive accumulation of both public and private debt.  But withdrawing liquidity from solvent borrowers risks a repeat of the Bear Stearns and Lehman Brothers failures.

Were he alive today, Martin would probably argue that the Fed should continue to encourage lending to solvent banks and thereby keep the financial system liquid and functional.  I suspect that his successors, like Arthur Burns and Paul Volcker, would agree.  But instead U.S. regulators are apparently encouraging American lenders to reduce credit risk exposure to E.U. banks and corporations, effectively exacerbating the liquidity crisis that has been hitting European markets in recent days.

The head of the credit risk book at one of the largest French banks told me yesterday that his institution has seen a one-third reduction in the volume of credit available from U.S. counterparties.  He directly attributes this change to advice to U.S. banks from American regulators.  The market veteran notes that long-term credit is unavailable for most E.U. banks, increasing pressure on short-term funding pressures in the dollar/euro market.

American officials apparently want to avoid another “AIG situation,” in the words of one well placed banker, thus reducing credit lines to E.U. banks is seen as a way to reduce systemic risk.  But in fact just the opposite may be the case.  The regulators may be fomenting a systemic risk event by going against the advice of Chairman Martin and most of his contemporaries.

Another market observer points to U.S. derivatives dealer banks reducing exposure to E.U.  banks because of continued worries about the PIIGS implosion.  But one wonders how much these particular data points weigh on the credit markets compared with the impact of low or no interest rates on risk taking.  When Bank of New York announces that it will charge large customers for deposits, it begs the question about current Fed rate policy.

I believe that the Fed needs to let the cost of funds rise to restore yield and risk taking to dollar assets, but at the same time make clear to the markets that the volume of credit available to solvent borrowers is unaffected or even increased.  The contraction of money and credit on both side of the Atlantic is the key issue that should have the attention of policy makers.  As Carl Weinberg of High Frequency Economics said on Bloomberg Radio this morning, nothing good comes from contracting credit and money markets.  But low interest rates is driving deflation, in my view.

To the extent that regulators at the Fed, OCC and FDIC are encouraging U.S. banks to arbitrarily reduce credit lines to their E.U. counterparts, that behavior needs to end now.  The chief threat to the global markets remains deflation as debt levels are reduced to practical levels.  Next week, Fed Chairman Ben Bernanke and his colleagues at other agencies needs to make clear in a very public way that the U.S. central bank is not taking steps to make things in the money markets a lot worse than they need to be.

Last week I described what the prospective default by the US does to the bond markets in terms of spread relationships with supposed “risk free” rate of return represented by government bonds in a research note, “Black Friday and the end of risk free returns”:

The benchmark treasury curve has been been loosed from the bounds of earth and is now a relative benchmark, where “superior” corporate credits can and will be priced through Treasury and agency yields on a regular basis. If this sounds a little too much like the world of quantum physics and Steven Hawking, all we can do is borrow a line from Joan McCullough at East Short Partners: ‘Get used to it.’

Another friend and mentor, Alex Pollock of the American Enterprise Institute, noted in a letter of the Financial Times that there is no such thing as a risk free rate of return. To that point, 100 years ago the United States had no international credit rating — or credit — and was forced to operate through the great New York banks when it came to international payments. How quickly we forget.

By the end of WWII, the US discarded the proposal of J.M. Keynes for a competitive, multilateral currency system and instead took a page from the Roman Empire and equated the dollar with gold. This symbolically and functionally associated the dollar with risk-free assets, at least for a few decades, but now the size of the US federal debt and commitments makes this implication indefensible as a practical matter.

From Nixon’s closure of the gold window in 1972 through to the present day, the US has been on a steady financial course toward default — even if investors do not want to believe it. Now we are “thinking about the unthinkable,” to borrow the title of Herman Kahn’s seminal 1968 book about the reality of nuclear war, only now with respect to financial default in the US as well as in the EU.

For bankers attempting to model forward loss rates and capital requirements, as is now required by federal regulators, how to model sovereign risk raises some thorny issues. Since it is now possible for a nation like the US to ponder default for purely political reasons instead of because of an incapacity to pay, should banks still carry such risk exposures at zero weighting for Basel III capital purposes?

At present, the Basel III framework does not require any capital or reserves for sovereign debt of a certain credit rating. “Lending to AA-rated sovereigns still carries a risk-weight of zero,” the Economist noted last September in a prescient article. So even if the US was downgraded as a result of the childish manner in which fiscal issues are being mismanaged in Washington, banks would still not need to put any capital behind Treasury bonds.

But the fact is, that downgraded or not, investors have looked at the US as a weakening credit for many years. The spread to purchase five-year protection in the market for credit default swaps is now 68 basis points or 0.68% per year. If you compare the ratings scale used by Moody’s and S&P to describe probability of default, a 68bp spread in CDS is roughly equivalent to a “BBB” bond rating. It seems that in the minds of foreign investors, at least, the US is already a lower tier investment grade credit — as much for the ability to pay as for the willingness to enforce reasonable standards of national governance.

At the end of the day, investors looking out over the five year horizon of a CDS contract must ask whether they think the US fiscal situation and the purchasing power of the greenback are likely to improve in half a decade’s time. The answer regrettably is no, if the latest “budget deal” from Washington is any measure. It might be better for Congress to miss the debt ceiling vote, at the end of the day, if it makes the subsequent discussions more purposeful and serious.

For bankers and regulators seeking to enhance the safety and soundness of financial institutions, the new revelations about the possibility of default in the US and EU raise the possibility that top-quality corporations will be trading at tighter spreads and superior credit ratings than sovereign states. Perhaps far from being a surprise, the relatively better management and governance of the best global enterprises may augur the demise of the 19th century nation state. Should Basel III be adjusted to recognize the reality in the marketplace? Heaven forbid.

I must politely disagree with Felix Salmon of Reuters, Ben White at Politico and others who wring their hands and fret about the undoing of the world in the prospective debt default by the US. The damage is done, Felix declared on Reuters.com. I have heard similar views from many friends and colleagues, but I must disagree.

First the debate over the budget, pathetic as it may seem, represents an increase in the intensity of the public discourse over the nature of the American economy. Debate is good. It is the essence of checks and balances, the key feature that separates American democracy from the authoritarian states of Europe and Asia.

For too long Americans have been on auto pilot, relying upon elected representatives and various flavors of hired agents in Washington and on Wall Street to manage our money and our nation. It’s time to start paying attention again.

Second and more important, the debate over federal spending and the tradeoff between higher taxes and greater fiscal discipline begins a larger discussion about the nature of the American political system. After 80 years of borrow, spend and inflate to finance the Cold War, Housing Bubbles and the rest of the world’s growth needs, the US economy has reached an endpoint. The experiment in corporate statism begun by FDR in the 1930s and extended through and after WWII has brought us to the brink of insolvency.

Political gridlock in Washington means not only an end to growth in government spending, but also that we are no longer willing to serve as the overdraft account for the world in terms of demand for imported goods and services. As I noted in my 2010 book Inflated, the US has bailed out the no growth states of Europe three times since WWI. Each time our allies in western Europe have defaulted on their debts. Bring the US troops in Europe home, I say, right now.

Asia, likewise, has grown at the expense of American jobs, the bitter legacy of owning the world’s reserve currency. As the US reins in spending and the monetary excesses that created the illusion of economic growth since the 1980s, an illusion funded with inflation and vast amounts of public debt, our ability to bail out the EU will fade. Remember George Washington’s warning about “European entanglements.”

But the third and most important side effect of the fiscal crisis in Washington is that people around the world will start to diversify both commerce and financial transactions out of dollars and into other currencies. Far from being a threat, I welcome such an evolution. The less of world trade and finance that flows through dollars, the less easy it will be for the Treasury to issue debt or for the Fed to monetize this borrowing on the backs of US consumers and businesses via steady, unrelenting inflation.

Of course Nobel Prize winning economist Paul Krugman rightly notes that a reduction in federal spending will result in pain for many Americans. But what he fails to tell these Americans, especially low income working people he pretends to love, is that the cost of the borrow and spend policies advocated by second generation New Dealers is persistent inflation, a diminution of purchasing power that is just as surely killing the hopes and dreams of all Americans.

I have long argued that a low growth, low inflation environment is better for the working people that the manic, boom and bust cycles caused by big federal deficits and following accommodative Fed policies to make this all seem to work in a nominal sense. Alan Greenspan, after all, was at best a tool; a cog in the machine.

Americans need to understand that we face not a mid-cycle slowdown, to paraphrase the economist Richard Alford, but a post-stimulus adjustment to economic reality. Think post WWII in fact. If this crisis helps to break the cycle of debt and inflation, that is a big plus for America’s long term prospects.

The right choice for Americans is to say no to ever more debt and to instead embrace debt reduction and restructuring of insolvent banks and markets to restore economic solidity. Both in the EU and the US, debt levels by governments and consumers must be reduced to restore national and personal solvency, and thereby start the great growth game all over again.

Do Americans have the courage to make the tough choices, cut spending and also generate more revenue, and thereby set an example for the world? I think the answer is yes, but it may take some time. That is why I am in no hurry to pass the new debt ceiling. A few days or weeks of pain will raise the political temperature in Washington even further and bring all Americans into the proverbial kitchen for a long overdue family discussion about money. And that is a very good thing.

Readers of this blog know that I am a long-time reader of The New York Review of Books. Sadly this love is not because of that great publication’s coverage of finance and economics, which I think is skewed to the neo-Keynesian, socialist end of the intellectual spectrum. George Soros does not count.

No, I read the NYRB because of contributors like physicist and author Freeman Dyson, who teach us about other ideas, people and worlds, both real and imagined. “Dyson has spent most of his life as a professor of physics at the Institute for Advanced Study in Princeton, taking time off to advise the US government and write books for the general public,” notes his bio on the NYRB web site.

This literate and considerate man of science has told the human history of the world of physics in his contributions to the New York Review, most recently through an essay on two new books about his teacher and Nobel Prize winner Richard Feynman: “Quantum Man: Richard Feynman’s Life in Science” by Lawrence M. Krauss and  “Feynman” by Jim Ottaviani.

Dyson’s essay on Feynman, “The ‘Dramatic Picture’ of Richard Feynman,” is important on many levels. It is a personal tribute and a professional history of a man Dyson argues is now a superstar of physics on a par with the likes of Albert Einstein and Stephen Hawking. It is also an important discussion of Feynman’s insights into the nature of organizations and society, particularly how we differentiate between reality and speculation when it comes to public policy.

Following the 1986 space shuttle Challenger disaster, Dyson reminds us, a fatally ill Feynman gave his final months of life to serving the people of the United States by participating in the official investigation and fighting political efforts to conceal the institutional causes of the accident:

Feynman wrote an account of the cultural situation as he saw it, with the fatal division of the NASA administration into two noncommunicating cultures, engineers and managers. The political dogma of the managers, declaring risks to be a thousand times smaller than the technical facts would indicate, was the cultural cause of the disaster. The political dogma arose from a long history of public statements by political leaders that the Shuttle was safe and reliable. Feynman ended his account with the famous declaration: “For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”

Sound familiar? The same statement could be made about Washington’s complicity in creating the housing bubble and the shameful evasion of responsibility for the subsequent financial collapse. In terms of the world of ratings and analytics in which my firm operates, the same juxtaposition could be described as the difference between guessing about the future performance of a bank or company versus focusing on the visible facts of today’s financial and operational results.

But the sacrifice of Feynman at the end of his life to argue the perspective of science in the aftermath of the Challenger tragedy was not his greatest legacy, particularly to the layman who cannot fully appreciate many scientific achievements. Dyson describes how Feynman used pictures to describe the laws of physics, eschewing the mathematical equations used by his peers for more simple conceptual descriptions that are accessible to the average person. “Feynman,” to that end, is laid out as a comic book. Buy this book for your children, but read it yourself.

Even more important, Dyson reminds us of the distinction between the classical layer of human experience — the things we can see, touch and measure — and the quantum layer of reality, that which is impossible to measure with complete accuracy and therefore remains speculative. “The primary difference between the classical layer and the quantum layer is that the classical layer deals with facts and the quantum layer deals with probabilities,” Dyson writes. For Feynman, he concludes, “the road to understanding is not to argue about philosophy but to continue exploring the facts of nature.”

This distinction between the world of observable facts and the speculative worlds of quantum physics — and also unscientific realms such as politics and economics — is an important concept for all of us to ponder. So much of our public discourse about financial markets and fiscal issues like raising the debt ceiling is really just speculation, obscured by the pronouncements of supposed experts and their political sponsors. The beautiful vignette of Richard Feynman which is the latest addition to the literary legacy of Freeman Dyson gives all of us living in the “real” world of finance and public policy much food for thought.

News reports at the end of last week informed the financial markets that the European Banking Authority (“EBA”) failed only eight of the 90 banks examined in the most recent round of stress tests. These eight unfortunates “fell short of the required amount of capital under the tests’ simulations of a deep, two-year economic downturn,” the Wall Street Journal reports. “Those banks faced a total shortage of €2.5 billion ($3.54 billion) of capital, which banks rely on to soak up potential losses.”

Most analysts dismissed the EU stress test results out of hand because of the small number of banks identified as problematic. But investors need to understand that the stress test process in the EU, ridiculous as it may be, is only an indication of deeper problems beneath the surface regarding public disclosure and basic question of governance in the EU. Click here to read the latest report on Reuters.

The first point to be made is that the EBA banking authority does not really exist as a bank supervision agency. The EBA has no power to compel financial reporting from banks located in the 25 member nations, rendering the ability to supervise capital adequacy, much less stress testing, completely moot. The Telegraph in London ran a report today detailing the difficulty that the EBA had in obtaining information for the stress tests.

The second more important point, however, is that the culture of secrecy and a complete absence of public disclosure in the EU has doomed the process to failure. Richard Field, an expert on the mortgage sector who has been pushing for improved disclosure by the EBA and other agencies, says that EU officials are “directly contributing to financial market instability by not making the data available so that the risk of the banks they are supervising could be analyzed.”

The third point is that we do not need stress tests to understand that many of the banks of the EU are insolvent. An inspection of the data published by the International Monetary Fund suggests that many of the banking markets in the EU are badly decapitalized. Even Deutsche Bank, arguably the most important bank in Western Europe, has just €50 billion in capital supporting €1.7 trillion in total assets. Only by ignoring the sovereign and off-balance sheet footings of Deutsche and other major EU banks can anyone even for a moment pretend that these banks are solvent.

When you move from the relatively blissful climes of Germany down to Southern Europe, however, the situation becomes even more ridiculous. While many investors are still concerned by the prospect of sovereign default in Greece, Ireland or Italy, Spain arguably is the most problematic nation in the EU — and the least discussed.

The banks in Spain were run like little imitations of Countrywide Financial, the doomed US mortgage lending that was acquired by Bank of America in 2008, only with worse credit underwriting and record keeping. Indeed, to compare the largest banks in Spain to Countrywide does serious injustice to the American lender. Bad as some of the Countrywide loan production may have been, my view is that the poor credit underwriting and fraud seen in the Spanish real estate boom makes the American experience seem sublime by comparison.

The notion advanced by the EBA that any of the major Spanish banks are actually solvent is a fantasy, in my view, an opinion verified by the high levels of over-collateralization required by Spanish authorities. The excesses in the Spanish real estate sector rival the levels of idiocy seen in Ireland, but on a far larger scale. Some of the covered bonds issued by Spanish banks were so poorly underwritten that financial regulators in that country demanded as much as 80 percent over-collateralization (“OC”). This means that the bank had to pledge $1.80 in mortgages to raise $1.00 in new funding. This is more that 2x the highest level of over-collateralization required by the US Federal Home Loan Banks.

With such high levels of OC,  no surprise then that Spanish banks are feeling increased liquidity pressure in the markets, pressure driven by truly hideous asset quality, not by exposure to sovereign default. But, again, there is little meaningful public disclosure by Spanish banks regarding asset quality.

Last week, I was contacted by a major insurance group in the US who wanted me to travel to their offices and give them a presentation on the state of the EU banking system. I told them to save their money, that most EU banks are insolvent and that, for the purposes of analysis, they should treat all EU banks as sovereign credits, not as private concerns — at least until the EU takes a different approach to public disclosure for banks.

Some disclosures: I review the new book, “Reckless Endangerment: How outsized ambition, greed, and corruption led to economic Armageddon”, by Gretchen Morgenson and Josh Rosner, not because both authors are my friends. They are.  Nor do I review this book because it concisely summarizes the confluence of public policy and private avarice we all know as the subprime mortgage crisis. It does, and more.

No, I review this book because it names names. Names and more names, one after another, in that prosecutorial serial fashion readers of Morgenson know very well. The kind of relentless recitation of the facts and names meant to allow readers to follow the logical chain of a criminal act to an indictment.

With Rosner as the ferret of public and not so public data and Morgenson as the journalistic filter and wordsmith par excellence, the book delivers a readable yet detailed account of the people behind the mortgage debacle. When the show trials begin, the judges will have a copy of “Reckless Endangerment” close at hand.

The tale of how Washington played a crucial enabling role in the mortgage mess is a topic I have discussed with Rosner over many years. Morgenson and her fellow scribes at the New York Times have chronicled the debacle on a national scale, though Morgenson does so with a tenacity and sense of public indignation that probably irks some of her more pro-Wall Street peers on the Times’ business page.

This book soundly repudiates the notion that Wall Street led the subprime parade. Instead, it confirms that government intervention going back to FDR and the New Deal set the stage for a public-private orgy decades later. The book describes how government sponsored entities such as Fannie Mae, banks such as PNC Financial, corporations such as Sears Mortgage and private mortgage insurers  such as MGIC, led the way in the fall of 1993 to redefine the government-backed mortgage market, a market that has been backed by the government since the 1930s.

Recall in the early 1990s, when Citibank started to experiment in private mortgage securities coming out of the S&L crisis. Citi, Chase Manhattan and other large banks nearly failed just years earlier. Thus the move by Fannie Mae and the other members of the affordable housing coalition in 1993 to eventually broaden the definition of “conforming loans” to include loans with inferior credit quality and loans with private mortgage insurance is a key political event in the subprime crisis timeline, and also a sop for the big banks. Think of today’s real estate crisis starting in the 1980s, but delayed and made larger by the affordable housing coalition and Alan Greenspan’s Fed. This book tells that story.

Reckless highlights the relationship between former Fannie Mae CEO James Johnson, a Washington player who was a top adviser to Vice President Walter Mondale and former Countrywide CEO Angelo Mozilo. That fateful pairing of Johnson and Mozilo helped take the changes made in Washington to the legal framework of the government mortgage market and catapult them to the stratosphere on Wall Street.

The authors nicely describe how Johnson was the architect of “the disastrous home ownership strategy promulgated by William Jefferson Clinton in 1994. Johnson, after becoming chief executive of Fannie Mae in 1991 and under the auspices of promoting home ownership, partnered with home builders, lenders, consumer groups, and friends in Congress to transform Fannie Mae into the largest and most influential financial institution in the world.” Today, Fannie Mae is under government control again, after decades of being highjacked by various private agendas set by the affordable housing mafia.

The larger banks on Wall Street were not just copying and perverting the government market for mortgages. They also took example from Countrywide, Bear Stearns and the smaller, more aggressive mortgage firms. Countrywide, a firm that was an insurgent real estate company a decade before, grew to the point where by the end of 2005 it was a $250 billion asset national bank that was turning over its balance sheet three times a year.

Countrywide was selling most of that vast flow of new loan origination to Fannie Mae and Freddie Mac, but also sold a large chunk to private investors. Now Bank of America, which acquired Countrywide in 2008 for just $4 billion, faces tens of billions of dollars in legal claims arising from the Countrywide mortgage securitization franchise. Even today, years after the financial crisis began, Bank of America still faces the possibility of a restructuring because of the legal claims against Countrywide.

This fast moving book follows Johnson and Washington contemporaries such as former Treasury Secretary Robert Rubin through the Clinton years and into the mortgage boom years of 2004 and beyond. By then Johnson was sitting on the board of Goldman Sachs, the authors note, and setting the salary for then-Goldman CEO and later Treasury Secretary Hank Paulson. “Reckless” illustrates that people like Johnson, Rubin and Paulson, even when they reach the limit of their incompetence and fail miserably in positions of public trust, still seem to rise in power and private wealth.

“It is indeed one of the most frustrating aspects of this story — the rise of subprime, the dereliction of duty by so many who participated in the mortgage mess,” the authors note in a harmony that reflects both voices. “The cast of characters that helped create the mess continues to hold high positions or are holding jobs of even greater power.”

Hopefully with books such as “Reckless”, the frustrating fact of the impunity of money and power, graphically illustrated in this book, will change, and public officials will again start to act in the public interest — instead of their own.

“The dollar is our currency, but your problem.”

–Former Treasury Secretary John Connally

As the deadline nears for raising the US debt ceiling, the advocates of extend and pretend are attacking anyone and everyone who says that the federal debt ceiling should not be extended without extracting serious spending cuts. The Democrats in Congress see the proverbial writing on the wall, namely that 80 years of borrow and spend as the national ethic is about to end. Unfortunately neither the Democrats nor Republicans in Washington can see little else.

The fight over the budget is more than a fiscal debate, but also suggests the death knell of the two-party system in America. The socialist tendency we know as the Democratic Party is, to paraphrase President Ronald Reagan, the party of government. Prior to 1932, the Democratic Party was only marginally competitive in national politics. From FDR on through to today, the Democrats built their political fortunes on ever-increasing public spending and a corrupt relationship with the private and public sector unions.

Many Democratic political careers and institutions are now under attack in Washington as the Treasury is nearing the ends of its ability to borrow. Consider that current tax revenues just about cover transfer payments, where Washington taxes one American and subsidizes another. This leaves all of the other operations of government funded by debt. The reason for the conflict over the debt ceiling is obvious — except for members of the Democratic party and their surrogates in the big media.

“Bill Clinton was an Eisenhower Republican, but Obama is a more of a Nixon Republican, betraying core liberal beliefs on many issues,” notes economics writer and former Treasury official Bruce Bartlett, who sees President Barack Obama eventually cutting a spending deal with Republicans with less “smoke and mirrors” than President Clinton would never have accepted.

Back in April, we talked about why a delay in raising the debt ceiling is not the end of the world (see “Default, debt ceilings and democracy”). If it takes a financial crisis to change the fiscal behavior of the US, then so be it. You need courage to say no to more debt, but it is easy to borrow. The people of the US have the right and even the obligation to withhold approval of further debt issuance unless real changes are made in federal spending.

The Democratic party headed by Obama is making common cause with the large banks and corporations in the US to raise the debt ceiling without making significant cuts in federal spending. Big companies hate spending cuts, but don’t really worry about things like inflation. This quarter’s earnings is all that matters.

Ironically enough, the pro-democracy movement in American politics is now defended by the Republican Party, which finds itself almost forced to become more populist with each passing day. This is an uncomfortable position for established members of the GOP, many of whom are functionally indistinguishable from their Democratic peers on fiscal issues. With each election, though, the fiscally conservative tendency among conservatives is coming to dominate the Republican leadership. Even mainstream conservatives such as John Boehner cannot hold back more radical fiscal and social agendas of the GOP.

As the two institutional political parties wrestle over national spending, and paying attention only to each other, the US economy is entering a new and potentially dangerous period of deflation. The continued process of de-leveraging in the financial sector is causing banks to shrink and credit availability to dry up. And the government is about to make things a lot worse by allowing the conforming limit for loans sold by banks to federal housing agencies like Freddie Mac and Fannie Mae to fall dramatically.

After September 30, 2011, the maximum loan limit for single family homes in San Diego, CA, will fall from  $729,000 to $483,000 or to the pre-July 2007 levels. What this means is that the amount of mortgage financing available to markets all over the US is going to drop dramatically. While there are many markets where there will be little or no change, the markets most affected are also the areas where banks have the most exposure to future credit losses, the east and west coasts in particular.

“These housing markets are going to get clubbed to death like baby seals,” said one mortgage market veteran who assembled a list of the counties where the conforming loan limit is likely to drop the most.  The impact of this change is already being felt in real estate markets around the nation, especially in markets such as Washington, DC, New York, Los Angeles and Southern California. The maximum loan limit for Fairfax County, VA, dropped from $729,000 to just over $600,000.

The impending decrease in the conforming loan limit will accelerate the drop in home prices this year, adding fuel to the fires of deflation. Even as President Obama and the Democrats draw a line in the sand against spending cuts, the inattention of the White House to accelerating deflation in the housing market is creating a new crisis.

The Republicans welcome crisis as a means to destroy the Democrats as a national political force, but at what price?  The Democrats are resisting budget cuts, and in doing so only give the GOP the crisis that they seek. By the time the 2012 election cycle begins in earnest, for President Obama and both political parties, raising the debt ceiling will be the least of our problems.