Bailout smoke and mirrors; JwJ calls for protest today

Chris Lowe

National Public Radio is reporting this morning that the Senate is scheduled to vote tonight on a financial bailout bill that will be at the core the same as the bill defeated in the House on Monday, with a new element making a bad bill worse: the new version would loosen accounting requirements on bank reporting of their assets.

To a substantial extent the financial crisis has been caused by banks being allowed to disguise overvalued or worthless mortgages with the smoke and mirrors of complex "mortgage-backed securities" that created the illusion of hedging against non-performance of mortgage loans without actually doing so. Such securities form part of the "bad paper" so often mentioned in the media, together with mortgages that were unsustainable from the get-go -- in some cases created fraudulently, in others the result of imprudent borrowing -- and with mortgages that were legitimate at the time they were made, but which have been rendered problematic by falling real estate values.

The smoke and mirrors practices were worsened by "bundling" such securities into even more complex "instruments" together with solid or marginal but potentially real-value mortgages, whose value was dragged down by being bundled with the bad paper.

Now the revised Senate bill is proposing a change in bank accounting practices that amount to giving the banks new smoke machines and distorting mirror factories.

The proposal to relax accounting rules appears to be the same as one unfortunately included in the alternative "No BAILOUT Act" (never trust cutesy capitalized acronym titled bills) being proposed in the House by progressives led by Oregon's Peter DeFazio among others. David Sirota describes the provision this way:

Right now, federal law mandates that banks assess their assets on a "mark-to-market" basis - that is, what their assets could be sold for right now, rather than what they could be sold for in the future. The theory is that during a housing and financial crisis, the "mark to market" value of mortgages is artificially low, even though those mortgages represent houses with actual value (for instance, because no one wants to buy mortgages right now, many mortgages are valued at zero on a mark-to-market basis, even though they represent homes that could ultimately be sold for value). Because what a bank can lend out is a multiple of the assets they own, proponents of the accounting change argue that the mark-to-market system is forcing banks to devalue their assets and therefore contract credit. They say that changing the accounting rule to allow banks to list their assets at an "economic value standard" (ie. higher than mark-to-market) will therefore loosen up credit.

The problem with this accounting change is that it would allow banks to leverage even more against assets whose value is still unknown. That, says some opponents, could simply push off - and potentially make more intense - an inevitable day of collapse in the banking system.

(Hat tip to torridjoe in comments at the thread on the DeFazio proposal).

Christopher Hayes at The Nation offers a more favorable interpretation which at least makes comprehensible why progressive lawmakers might support such a move:

1. Require the Securities and Exchange Commission (SEC) to require an economic value standard to measure the capital of financial institutions.

This bill will require SEC to implement a rule to suspend the application of fair value accounting standards to financial institutions, which marks assets to the market value, no matter the conditions of the market. When no meaningful market exists, as is the current market for mortgage backed securities, this standard requires institutions to value assets at fire-sale prices. This creates a capital shortfall on paper. Using the economic value standard as bank examine[r]s have traditionally done will immediately correct the capital shortfalls experienced by many institutions.

However, the reason "no meaningful market exists" is that the previous smoke and mirrors practices rendered the economic value of most of the assets in question opaque and unknown. In those circumstances, it appears that this proposal would allow banks to assign arbitrary nominal values that would shore up the overall appearance of their books, and stave off bankruptcy. But it would not make the real value of the specific "illiquid assets" any clearer, and banks still would not be able to sell them or borrow against them because potential buyers or lenders don't buy or lend against the overall appearance of the books, they buy or lend against the value of specific assets. Thus it will not relieve the credit liquidity crisis.

It is also at the level of the real economic value of property that the related foreclosure crisis rests. A great many of the homeowners facing foreclosure do so because of sharp declines in the real economic value of the properties they bought, such that they no longer provide security for the amount of money they borrowed to buy the property. The foreclosures in turn further lower the economic value of surrounding properties, depressing the economies of entire municipalities and local regions, likewise affecting the value of residential rental and commercial properties, in a cascading vicious cycle that accounting tricks will do nothing to change.

A progressive approach to the conjoined crises needs to begin with the principle of stabilizing the value of real estate and keeping people in their homes. The liquidity crisis should be addressed by rendering the value of mortgages and a more limited, better regulated set of mortgage-backed securities transparent again, re-forming the market by allowing market actors to once again negotiate and agree prices and loans based on assessable values.

Secretary Paulson's proposal could more or less be made the basis of such an approach. It would require very steep discounts in the purchase of the "distressed assets," so that the likelihood that the actual economic value of properties hidden amid the worthless "bad paper" to which it is tied would cover a substantial portion of the public funds used, if not all of it. That risk could be further covered by a securities transaction tax like that included in the proposal by DeFazio et al.

However, at present the Paulson proposal as embodied in the failed and apparently to be resurrected legislation is merely permissive of steps to safeguard public money put into a bailout, and says nothing about the crucial issue of the terms on which illiquid assets would be purchased or how prices would be determined, leaving those matters in the hands of a Treasury Department itself run by Wall Street financiers.

Assets bought under any Paulson-like plan should not be controlled by the Treasury Department, which is too corrupted by conflicts of interest to be trusted. Rather they should be controlled by a newly created entity specifically charged to triage and restructure them into actual mortgages, securities that may prove to have value when the situation is stabilized, and really worthless securities, and to renegotiate mortgages with homeowners based on current property values and affordable payments. That entity should have an explicit preference for such renegotiated mortgages over foreclosure as way for real marketable value to be re-established.

Personally I would favor in addition that the government get an equity stake in financial institutions bailed out in this manner as a further guarantee of the public risk.

There are several ancillary issues that probably would need to be addressed. In some cases current mortgage holders simply will not be able to afford the houses they tried to buy, even with revaluation. In those cases affordable rents should be established to allow people to stay in their homes until the property is sold, if they wish, rather than foreclosing and leaving properties empty to hurt entire neighborhoods and localities. For the sake of equitability, a medium-term temporary program should be established to aid mortgage-holders who have not quite been driven to the point of default and whose mortgages thus would not be taken over by the government, but who are hard-pressed and close to the margin. And steps should be taken to ensure that the administration of the new agency is not simply contracted out to private financial entities for excessively lucrative fees that would reward the same persons and entities who created the crisis.

The exact mechanisms to do these things might need to be worked out over a longer period of time, but the principles should be put in a binding way into any immediate legislation.

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Jobs with Justice, the solidarity program of the AFL-CIO *, has called for protests today against any bailout that protects big financial capital at the public expense, or that fails to help ordinary Americans and addressing the foreclosure crisis at the bottom of the wider problems. Their call has been backed by the United for Peace and Justice anti-war coalition and other progressive organizations.

In Portland Jobs with Justice has called a "No Blank Check for Wall Street" demonstration at 5 pm today, Weds. Oct 1, at the Federal Building, SW 3rd and Madison, Downtown Portland.

* Correction: I am reliably informed that Jobs with Justice is not in fact a program of the AFL-CIO, either nationally or locally, although my informant says "we are pals." I apologize for the error.

Comments

  • (Show?)

    The reason the relaxation of mark to market is bad in Paulson's plan but good in DeFazio's is that in the latter, the whole point is to extract actual value from otherwise bad paper--that is, an estimated real value of a mortgage based on the physical structure it represents--and establish a level of equity, that banks would then use to once more begin offering credit. In the Paulson version, we'd leave that job to...Henry Paulson. No thank you. In the DeFazio version, the FDIC would carry out that task, and issue "net worth certificates."

    This exact thing was done in the S&L crisis, and created $200bil of equity at a cost of about $2bil.

    Easing the credit crunch would then buy time to address the rest of the problem, without simply handing $700bil to the Master of the Universe at Treasury.

    I don't think it's fair to conflate the two plans on this basis. DeFazio's makes sense, as something that could be done RIGHT NOW to ease the credit crunch, without handing over a bunch of taxpayer dollars in the process.

    Thanks for the hat tip.

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    BY the way, the Sirota link takes you right back here. The real link is: http://www.ourfuture.org/blog-entry/2008094030/strategy-memo-turning-wall-street-giveaway-economic-rescue-all-americans

    It's an excellent piece.

  • Bill Bodden (unverified)
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    Call Senator Wyden (202-224-5244) and Gordon Smith (202-224-3753) to let them know you don't want the Senate to sell out to Wall Street?

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    One thing that is becoming clear is that the longer this deadlock persists, the risk grows that this bill will get worse.

    The FDIC insurance limit increase is good and, if the bill is successful, shouldn't really cost anything. The "mark to market" provision was already in the bill that was voted down, although it was permissive, not mandatory.

    I don't like Congress prescribing accounting methods, but this should be relatively harmless, since it is my understanding that the relief relates to assets for which there is no ready market anyway.

    The tax stuff bothers me only because it clutters the bill, isn't really relevant to the issue at hand and risks polarizing votes, i.e., for every vote it gains on one side, it risks losing one on the other.

    I'm one of those who believes this needs to get settled and the sooner the better--not because of the stock market (although that helps focus Congress's attention) but because of the impact the credit crunch is already having on businesses large and small, and by direct implication on their workers and customers.

    After the dust settles, there will be plenty of opportunity to look at more fundamental changes in the structure and regulatory regime of the financial markets. Now is the time to unblock the flow of credit and keep the economy, adn the people in it, working.

  • (Show?)

    After the dust settles, there will be plenty of opportunity to look at more fundamental changes in the structure and regulatory regime of the financial markets.

    The time to press for regulations that will keep us from falling off of this cliff a second time is right now, when these very large creditors are asking the American people for an additional $700 billion on top of the nearly $1 trillion that we have already paid out.

    After American taxpayers have given these people what they want, there will be no need for them to agree to concessions.

    Congress would be better off taking a few weeks to pass the right bill, than to pass the wrong bill just because people are feeling panicked right now.

  • (Show?)

    The total value of the bad mortgages is around $1 trillion. Fully discounted, it's probably a $200-$300 billion problem, tops. None of this would be happening if we just had bad mortgages. We'd just be in the doldrums, with falling housing values and anemic growth in income.

    The problem is the $62 trillion in credit derivatives. Originally designed as insurance on loans, the investment banks turned these into a printing press. As designed, a lender might pay $10,000 for insurance on a $100,000 risky loan. The insurance is called a credit default swap. If the loan goes bad, the issuer of the swap owes the lender for the whole value of the loan. Makes sense.

    The problem is the investment banks saw this as a profit center, and started issuing multiple swaps on the same loan. Side bets, essentially. So, a $100,000 loan might have $5 million in insurance policies on it. The effects of the subprime loans going bad are magnified by something like a factor of 50.

    The investment banks violated some cardinal rules. They assumed these mortgages wouldn't go bad. And they didn't hedge. They saw the value of these swaps increasing, and rather than balance their positions by buying as many of the swaps as they sold, they started holding massive amounts of these swaps themselves. Like a bookie who just collects bets from people who say the team will win, when the team loses, he's toast.

    $62 trillion is close to the total value of every material thing in the world. There is no way this should have been allowed to happen. Any financial company who took these positions deserves what they get. They knew what they were doing. They were bringing in record profits and earning fat bonuses. The responsible people couldn't compete.

  • (Show?)

    TJ, thanks, I seem to have forgotten to paste the link in, it's fixed now.

    David Sirota seems to see real questions about the version in the DeFazio, Kaptur et al. bill. As you know, that's what the article was addressing.

    Jack, unless NPR is seriously misreporting something, whatever's in the Senate bill scheduled for vote tonight must be different from what was in the House version that failed. One thing that concerns me is that the ability to keep "assets" on the books as such when there is no market for them is that it may increase the bargaining power of their holders on the price the government pays for them, & thus the risk to the public fisc.

    I think there is an area of middle terms between "ASAP by any means for the banks," and "more fundamental changes in the structure and regulatory regime of the financial markets."

    One part of that territory is "who will carry the burden of a short-term bailout in the longer run?" That question is affected by the terms of asset purchase, including both price of assets and the possibility of government equity stakes, and other mechanisms to offset the public risk / long term addition to the national debt, e.g. the transfer tax proposal, or what William Greider of The Nation calls "due bills," which if I understand him correctly would seem to change the nature of the transaction from a simple purchase to something like giving a no-interest, open-ended line of credit under which the asset holder would have to repay any difference between whatever the government eventually realized from the assets and the money paid for them, once the markets were functioning again and the institution returned to profitability.

    I think securing the public against indebtedness for a transfer of wealth to the banks created by the unknowability of the value of the mess of "assets" they've created is a legitimate part of the process of short term solution-finding. Possibly this could be done in a less detailed way to move quickly but I think making it definite that the public is to be so secured should be a minimum requirement.

    Relatedly, I think it should be built into whatever is done that the underlying foreclosure crisis will be handled in a way that keeps as many people in their homes as possible. This is not about the long term structure of regulation but about a dimension of remediating the whole mess that is comparable to remediating the problems of the asset holders, and connected to it.

    Underlying my view on both of these dimensions are views about what all this means for our social contract, and a view that the "moral hazard" problem is much more important at the level of the big institutions than at the level of individual borrowers, and the imperative not to reward the bad behavior of the big players that much greater.

  • Bill Bodden (unverified)
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    Congress would be better off taking a few weeks to pass the right bill, than to pass the wrong bill just because people are feeling panicked right now.

    More than likely the right bill, or close to it, could have been passed in a few days if the involved senate and house committees had been open and honest by inviting impartial authorities - Joseph Stiglitz, William Greider, Paul Krugaman come readily to mind - and considered a variety of opinions. Instead, the leaders of these committees and their members did what their campaign donors from Wall Street wanted them to do; that is, bailout the culprits.

  • Tom Civiletti (unverified)
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    I agree with Sal. The power of campaign contributions and our nation's proclivity for institutional amnesia suggest that nothing significant will get done later. The time to reform the Ponzi scheme that is our economy is now.

    Also, the incessant repetition of the idea there will be plenty of time to assign blame at a later date serves to divert attention from outrageous gamble of the Paulson plan: that those who have bungled stewardship of the economy through ineptness, wrongheaded ideology, and malfeasance should be given carte blanche control of $750 billion of public funds. We can assign blame after the money is given away, presumably.

  • (Show?)

    More than likely the right bill, or close to it, could have been passed in a few days if the involved senate and house committees had been open and honest by inviting impartial authorities - Joseph Stiglitz, William Greider, Paul Krugaman come readily to mind - and considered a variety of opinions.

    That you would describe Stiglitz, Greider and Krugman as "impartial authorities" is revealing. Maybe they should be paired with "impartial journalists" like Rush Limbaugh, Sean Hannity and Bill O'Reilly.

  • (Show?)

    Jack Roberts: I'm one of those who believes this needs to get settled and the sooner the better--not because of the stock market (although that helps focus Congress's attention) but because of the impact the credit crunch is already having on businesses large and small, and by direct implication on their workers and customers.

    I have zero doubt that you said that in good faith and with good intentions. It's a sentiment being expressed widely by financial experts and politicians alike.

    But... isn't appealing to our jobs tantamount to economic blackmail?

    I had no hand in creating this mess. I don't own a home, and in fact have never owned a home - and thus, never a mortgage. My 401-K (the closest I've ever come to playing any kind of economic market) amounts to chump change in the grand scheme of things and I've always tended to be moderate in the level of risk I was willing to move funds into.

    The threat to my livelihood may be real, but it's blackmail nevertheless.

  • Jack Roberts (unverified)
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    But... isn't appealing to our jobs tantamount to economic blackmail? . . . The threat to my livelihood may be real, but it's blackmail nevertheless.

    Kevin, is a doctor telling you that unless you have surgery to remove a malignant tumor you'll die guilty of medical blackmail?

    If scientists tell us that unless we reduce carbon emissions the plant will suffer immeasurable hardships are they guilty of environmental blackmail?

    No one is saying, "If you don't support this, you're fired!" What we're saying is that if the economy implodes, a lot of people will lose their jobs--not as retaliation but as a fact of economic reality.

    If banks don't have enough money to lend, a lot of businesses that need credit to survive will fail and a lot more will have to cut back, spend less, and lay-off workers. This isn't a threat, it is a prediction of foreseeable economic consequences.

  • Tom Civiletti (unverified)
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    Read it:

    Not One Dime!

  • Tom Civiletti (unverified)
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    Also read this:

    Bailing Out The Oil Market

  • (Show?)

    Jack,

    I don't have a malignant tumor, Wall Street does. Thus the doctor would be lying - at best - if she tried to convince me that I have the tumor.

    I have owned a series of internal combustion vehicles and still do. Thus it's entirely appropriate for scientists to appeal to me to help mitigate global warming by mitigating how much I personally contribute(d) to it.

    Do you really think this stuff through or is this coming from some talking points email?

    What we're saying is that if the economy implodes, a lot of people will lose their jobs--not as retaliation but as a fact of economic reality.

    I understood it perfectly the first time, but please feel free to rephrase as needed to assist your own understanding.

    It's still economic blackmail. The potential for dire consequences don't alter that reality, as we all found out during the Lebanon Hostage Crisis of the 1980s.

  • (Show?)

    No, Kevin, I don't repeat anyone's talking points. And it is obvious you don't either.

    Let me try another analogy. Your neighbor, who lets trash pile up around jis house, burns candles everywhere and smokes in bed, finally sets his house on fire. It is burning like crazy and the volunteer fire department shows up and say, "Quick, help us put out this fire!"

    So you say, "No sir, I'm a responsible homeowner. It's my neighbor's own fault his house is on fire and I'm not going to help."

    So the fireman says, "But you don't understand. If we don't put this out soon, it will spread to your house and it will burn down, too."

    So we're to believe your answer would be, "I won't be blackmailed! Let it burn!"

  • Tom Civiletti (unverified)
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    Bad analogy, Jack. These folks are not neighbors, they are predators for whom the bailout is just another kill.

  • Kumar (unverified)
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    Chris,

    Greetings from Moloy, your old thesis student!

    Thanks for this analysis and explanation. It's good to see/hear your commentary. So much of this reminds me of the build-up to the Iraq War. Back then, according to the Administration, we were facing a grave threat, Congress needed to act quickly, we were assured that we had the best people in charge, and this was the only alternative to avoiding Armageddon.

    Unlike back then, though, I'm about as worried about nothing getting done as I am worried about the wrong thing getting done.

    Sadly, I don't see the Dem leadership coalescing behind something like DeFazio's bill, and overall I don't see veto-proof numbers coming behind it, D or R.

  • (Show?)

    So the fireman says, "But you don't understand. If we don't put this out soon, it will spread to your house and it will burn down, too."

    Will it, though? I could assert that the Moon is made of Green Cheese and that wouldn't necessarily make it so. N'est pas?

    Let's say that it would burn my landlord's house down too - since I'm not a homeowner. So we put out the neighbors housefire by dumping enough cash - which we've mortgaged our own homes to get - on it to smother the worst of the flames until his own well water can handle the rest? And then what? The irresponsible neighbor takes what's left of the cash we dumped on his fire, rebuilds and proceeds to pile trash around, leave burning candles sitting around and smokes in bed just like before? No? Why not? Because he learned from the massive conflagration in the early 20th Century? Except that no, he obviously hadn't learned from history or he wouldn't have caused the fire. Either that or he's so confident that we'll just keep bailing him out and underwriting his rebuilt home that he just doesn't care whether he starts another fire or not.

    How many mortgages do you expect my landlord to take out on her property until she says "Enough with the blackmail!!"?

  • (Show?)

    Okay, Kevin, I give up. Keep sleeping through the fire. I'm sure you'll be just fine.

  • Bill Bodden (unverified)
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    That you would describe Stiglitz, Greider and Krugman as "impartial authorities" is revealing. Maybe they should be paired with "impartial journalists" like Rush Limbaugh, Sean Hannity and Bill O'Reilly.

    I should have said "relatively impartial." No one is totally impartial, but I submit Stiglitz, Greider and Krugman are slightly to the left of center; whereas, Limpbag, Hannity and O'LIElly are 'way out in right field. I was listening to William Greider on a replay of his discussion of his book "The Soul of Capitalism" at the weekend. The original occurred in 2003 or 2005. A number of his opinions at that time are now in the process of becoming tragic reality.

    Joseph Stiglitz won a Nobel Prize for economics. If Limpbag, Hannity and O'LIElly ever get such an honor you'll know the world is in greater trouble than it is now.

  • (Show?)

    I submit Stiglitz, Greider and Krugman are slightly to the left of center

    Joseph Stiglitz is certainly a distinguished economist, but defnitely a liberal economist. Paul Krugman was a once promising young economist who was enticed by the fame and fortune of becoming a very partisan political pundit and in the process has undermined his credibility as an economist. William Greider is a left-wing journalist, not an economist, and would not meet anyone's definition of even a "relatively impartial" authority on anything.

  • trishka (unverified)
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    it absolutely gobsmacks me that there are people who believe that if they don't own a stock portfolio, this won't affect them.

  • (Show?)

    The total in bad mortgages is 1 trillion? I thought the total amount of ALL mortgages was 3 trillion--and there's no way that 33% of all mortgages are bad. (Or is the total number higher, and I just misremember?)

    "If banks don't have enough money to lend, a lot of businesses that need credit to survive will fail and a lot more will have to cut back, spend less, and lay-off workers. This isn't a threat, it is a prediction of foreseeable economic consequences."

    ...which IMO is why the DeFazio plan, which addresses immediately the credit crunch by providing those banks the equity to begin lending again, makes so much sense to me. It's the credit crunch and lack of confidence that makes this an imminent crisis. Fix that, then let's talk about structural solutions.

  • Tom Civiletti (unverified)
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    I don't think that is true, trishka. I believe the American people are concerned with who will pay and whom will be paid to straighten out the mess.

  • (Show?)

    I'm not sleeping through the fire, Jack. I just don't understand why a bunch of volunteer firefighters are refusing to answer the alarm until a smorgasboard of unrelated BULLSHIT is agreed to before they'll even consider responding to the fire. The whole process being complicated by the fact that the Fire Chief has almost no credibility with either volunteers members or citizens and was slept through a couple years worth of warnings that the neighbor's house is a tinderbox of flammables.

    At the same time most of the rest of the volunteer firefighters are still back at the station trying to find creative ways to put the stationhouse and most of the equipment into hawk so they can bribe the holdouts to respond to the fire.

    Meanwhile, the borrow-and-spend holdout firefighters look very suspiciously more like pyromaniacs than firefighters. A perception which is just underscored by the ongoing wrangling back at the station house over tax cuts and how not to pay for them.

    I think my skepticism is more than justified.

    If the crisis is as grave as you make it out to be, why are members of your own party petulently insisting on unfunded tax cuts for utterly unrelated things before they'll fight the fire?

    I trust you've heard the parable about taking care of the log in your own eye before worrying about the splinter in my eye...

  • (Show?)

    Torridjoe, the $700 billion figure was based on a belief that 5% of mortgages may be bad. There are approximately $14 trillion in mortgages outstanding, hence the $700 billion figure.

    Despite my original preference for a clean bill, the Senate bill that just passed added county timber payments and mental health parity, two things Gordon Smith has been working on for a long time.

    Smith voted yes but Wyden voted no. Go figure.

    Can't wait to hear where Merkley is on this.

  • (Show?)

    Smith voted yes but Wyden voted no. Go figure.

    Imagine that. A borrow-and-spend Republican backed it and a pay-as-you-go Democrat didn't.

    Remind us again why this bailout is needed?

  • (Show?)

    Jack,

    You're a smart guy. Are you ignoring the role of the derivatives on purpose? It's convenient to blame the mortgages, but the real problem is the credit default swaps, which dwarf the actual mortgages.

    Do you have a source on the tying the $700 billion to the idea that 5% of mortgages are bad?

  • Bill Bodden (unverified)
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    I think my skepticism is more than justified.

    Skepticism is always called for when politicians are involved.

  • Tom Civiletti (unverified)
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    Jack Roberts wrote:

    Paul Krugman was a once promising young economist who was enticed by the fame and fortune of becoming a very partisan political pundit and in the process has undermined his credibility as an economist.

    The Committee for the Prize in Economic Sciences in Memory of Alfred Nobel thought otherwise, evidently.

  • (Show?)

    Damn you, Tom! I had the exact same idea... Nice!

  • Tom Civiletti (unverified)
    (Show?)
    <h2>Great minds..., Kari</h2>

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