Stephen’s Posterous

There is a budget deficit when the government spends more than its revenue. These deficits are paid for by the U.S. government selling interest bearing Treasury securities. If the government were ever to default on making interest payments, the U.S. economy would plunge into a level of chaos.

Lawrence Kadish, a real estate investor, and a trustee of the Claremont and Hudson institutes, says that the interest on the national debt makes the future of the U.S. unstable. In addition to devaluing the dollar, increased inflation and taxation, there is no way to ever pay this massive bill.

As of Sept. 30, 2009, the national debt was almost $12 trillion and interest on that debt was $383 billion for the year, according to the Treasury Department's Bureau of the Public Debt. The Congressional Budget Office on Oct. 7 estimated the 2009 budget deficit to be almost $1.4 trillion, about 10% of GDP.

In August 2009, the White House Office of Management and Budget (OMB) estimated total government revenues at about $2 trillion. The revenue estimate included $904 billion from individual income taxes. This means the cost of interest on the debt represented more than 40 cents of every dollar that came in from individual income taxes.

Except for a few years in the late 1990s, the U.S. government has spent more than it has taken in each year and borrowed the rest.

The OMB projects deficits of about $9 trillion over the next 10 years. If that occurs, the national debt will be almost $21 trillion by 2019.

Unless Americans demand accountability, the U.S. economy will be destroyed. Interest rates and interest costs will soar and government revenues will be devoured by interest on the national debt. One example would be to look at the country of Iceland.

And now the U.S. government is debating whether to create social programs it can't afford. Mr. Kadish says that Americans need to take notice, stand up, and remind our elected officials that in a democracy the people can change bad leaders.

View the U.S. National Debt Clock.

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The government’s capital infusion into banks aimed at getting them lending again has achieved only part of its goal, according to a monthly bank lending survey released by the Treasury Department today.

While the banks gave out more home mortgages in February than in January in 2009, they extended less credit to businesses for such purposes as capital expenditure and acquisitions, the survey shows.

The survey reviewed data reported by 21 banks including Bank of America, JPMorgan Chase & Co., Citigroup Inc., Goldman Sachs Group and Morgan Stanley & Co. It found that the median increase in home mortgage lending from January to February was 35% among the banks, showing that lower mortgage rates had spurred demand for such loans.

But commercial and industrial lending saw a median decrease of 13% for new commitments and a 14% decline for renewal of existing accounts.

“Uncertain economic conditions have resulted in borrowers reducing expenses, paying down debt, and delaying capital expenditure,” the Treasury said in a report. “Also contributing to the lower demand was lower overall merger and acquisition activity.” The survey didn’t break down business lending for different purposes.

Bank of America leads the banks with highest amount of both loan renewal and new commitments, lending $11.7 billion and $10.2 billion, respectively in February. JPMorgan comes in second, with $10.7 billion in loan renewal and $8.9 billion in new lending. Wells Fargo is a solid third, with $9 billion in loan renewal and $4.8 billion in new lending.

By comparison, three other large banks lent much less in February, with $2 billion in new loans for Morgan Stanley, $422 million for Goldman Sachs, and $416 million for Citigroup.

“New loan origination has been substantially limited as the current economic environment makes very few deals viable,” Citigroup said in a report to the Treasury.

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Just when venture capitalists think they’ve safely avoided the crosshairs of regulators, they find themselves lumped together again with hedge funds and the scrutiny that comes with it.

In his testimony today about regulating risk (read the transcript here), U.S. Treasury Secretary Timothy Geithner proposed that hedge funds, private equity firms and venture capital firms should be required to register with the Securities and Exchange Commission.

No further details were provided, but it’s implied that Geithner is aiming to follow the proposals outlined in a recent bill titled, The Hedge Fund Transparency Act, which calls for these investment firms to file with the SEC and publicly divulge the value of their funds and the names of their investors.

This blanket-like proposal infuriates the venture industry, which has largely escaped the regulatory clutches of the SEC and Treasury Department. The National Venture Capital Association, which represents the venture capital industry, has lobbied hard to drive a wedge between it and hedge funds, characterizing venture firms as job generators and innovators, not wealth creators. Venture capital is a long-term business and an engine of the nation’s economy, it argues.

But with legislators pressured to heal a sickly economy and prevent another financial catastrophe, nearly every private pool of capital faces regulatory oversight. It’s why the Obama administration, which has generally befriended the venture capital industry, didn’t exclude VC firms from its plan to tax carried interest at the higher ordinary income rate.

We chatted today with Mark Heesen, the president of the NVCA, to talk about Geithner’s latest proposal. Here’s an edited excerpt of the Q&A:

Q. What is your reaction to Geithner’s testimony?

There are a couple of things that jump out to me in his discussion about “hedge funds and other private pools of capital.” No. 1, he says they’re looking at those types of funds that “individually or collectively pose a threat to financial stability.” As much as we want to talk about how the world revolves around venture capital, the fact is that it’s a very small asset class, relatively speaking.

We’re talking about $30 billion being invested per year. If suddenly you were to lose it all, would that pose a threat to financial stability? No. When you’re seeing buyout funds or hedge funds that raise one fund that is almost the entire amount raised by the entire venture industry, you have to realize these are very different asset classes.

The other thing that jumped out, he says, “…in the wake of the Madoff episode it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage.”

Well, our investors, those that invest on behalf of college endowments and pension funds, are not only highly sophisticated within the bounds of law, there even more sophisticated than the law requires them to be. They aren’t your individual, everyday investors in venture capital. These people aren’t going to get ripped like Madoff’s investors did.

Q. Is this your worst nightmare as the head of a venture capital trade group that venture firms are being wrapped in with hedge funds with regards to regulation?

Absolutely. This is déjà vu. After 9/11, when the Patriot Act came out, the Treasury was going to register a lot of different financial institutions because of the threat that they might be used by foreign entities for illicit purposes, like laundering money.

We were swept into that. So we sat down with the Treasury and Department of Homeland Security, and asked them, “Do you really think a terrorist group would put $5 million into a venture capital fund and sit there for 10 years until they got a return?” They of course said, “That’s not going to happen.” This is kind of the same idea.

Q. Do you think that Congress has enough of an understanding about venture capital to exclude these firms from regulation?

We’re at a point where policy makers have too much on their plate. They are not by and large educated in distinguishing between hedge fund and buyouts and venture. They’re expected to know everything, but they can’t know everything. So a simple solution is to use a broad brush. We have to be there to continue to educate.

History repeats itself, it’s kind of like Sarbanes-Oxley. There was a rush to regulate and then take care of problems that arise from it afterward. You’re seeing that now with a group of policy makers that “want to get something done.”

They have real pressure from their constituents who have lost their jobs or their mortgages. So they’re trying to get something done quickly. This is very much a Washington issue: We’ll deal with it now and clean it up later.

Q. Do you think it’s practical for the SEC to suddenly oversee hundreds of more firms?

I think you need to balance oversight and regulation with the practicality of government bureaucracy. The government can only do so much with the amount of people and money they have. They need to pinpoint the major concerns and work on those as opposed to trying to cover the ocean and do every job simultaneously.

The SEC goes to the hill every year and requests more people and more money. I don’t begrudge them for that. But should they spend time reviewing hundreds of venture capital registrations each year, or more financially questionable issues from other entities out there?

Q: So what happens from here for the NVCA?

We’ll talk to the treasury folks, but Obama has appointed very few people to key positions. You have your career bureaucrats, but they don’t make these policy decisions.

So getting into the Treasury to talk to those who make policy decisions as opposed to technical ones is hard. It’s only going to get more problematic going forward, Geithner can’t keep working for 23 hours a day. He needs help.

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The currency markets have been in a strange place recently. For the last few months the dollar maintained its strength even in the anticipation of more government debt and Federal Reserve policies that would seem to encourage dollar weakness.

With the most recent announcement of the newest plan to nuke the festering assets on the balance sheets of U.S. banks, the dollar is stronger, rallying even when the equity market is rising.

There are numerous expectations about what could transpire for the dollar in coming months. Some believe the greenback will, or should, weaken due to anticipation of a bloated federal budget and current-account deficit that concerns foreign investors about the U.S. system’s stability. Others suggest that if markets do recover, it would undermine the case for the dollar, as investors would be more persuaded to buy riskier assets denominated in other currencies.

“It’s really a struggle today, and a tug of war between improvement in risk appetite, which should be driving the dollar lower and foreign demand for dollars, and the assurance for foreign investors that there is basically a floor the U.S. government wants to create for these toxic assets,” says Kathy Lien, director of currency research at GFT. “The risk for the banks are diminishing by the day and that’s why banking stocks are rallying.”

Others arrive at a divergent view of the plan’s impact on the dollar. Chris Gaffney, vice president at EverBank World Markets Group, believes the dollar rally on Monday, March 23, 2009, is the result of traders reversing earlier gains after the dollar sold off sharply late last week.

While he believes the plan increases the risk to the U.S. currency, he noted that traditional safe-haven assets such as U.S. Treasurys and gold have not rallied along with the dollar. The lack of a positive move in those assets could also be a profit-covering move, but this interpretation has its own complications, because it undermines the case for safe-haven positioning by investors.

It may be that investors are reacting positively to a plan that increases investor appetite for risk, but are also heartened by the swiftness of the U.S. government’s moves, when compared with others.

“It’s fair to say there is an element of this that [the market] was oversold,” says Chris Furness, head of currency strategy at 4Cast Ltd. “Everyone and his brother were short at the time. There’s also a slight feeling in the background that maybe the U.S. administration is getting to grips with things, or rather more quickly than most of the rest of the world.”

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From Henry Paulson, former Secretary of the US Treasury and currently distinguished visiting scholar at SAIS.

In the midst of the market turmoil, the pressing priority for US and global policymakers is to repair the financial system and restore the economy. Just as important, however, will be addressing the serious flaws exposed by this crisis.

This process of reflection and reform will be critical to restoring confidence and enabling market-based capitalism to rebuild our economies.

We must recognise the real possibility that because the crisis is not behind us, there may be lessons to learn and problems to address that are not now obvious. Yet many lessons are obvious and I take confidence from the commitment of world leaders – in the US, Europe, China and elsewhere – to pursue comprehensive regulatory reform and co-ordinate internationally.

First, this will be a big, multi-year undertaking. The crisis has exposed serious flaws in many aspects of our financial system. There will be proposals for more effective regulations in areas ranging from over-the-counter derivatives and short selling, to the practices of financial institutions, investors, mortgage originators and credit rating agencies.

We will need to reflect on the long-held premise that sophisticated investors have the wherewithal to look out for themselves and require minimal, if any, supervision. In these areas and others, regulations must be crafted to foster market stability while maintaining the fundamental tenet of capitalism: if investors are to reap the rewards of taking risks they must also bear the negative results of their risk-taking.

Yet updating our regulations and market practices will not be enough. We must also fundamentally reform and modernise our regulatory architecture and authorities.

While regulators have co-operated in addressing this turmoil, it is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive.

Consequently, to focus only on new regulation would fall short: we must also modernise the regulatory system and authorities in the US.

This is not a new issue, but it is a difficult one. If we search for something positive in the carnage created by this financial crisis, it may be that it will provide the impetus for doing what many, including myself, have repeatedly called for: real reform of our regulatory architecture.

In the US we have a patchwork of financial regulatory agencies. Our agencies reside at both federal and state level. A company’s regulator is determined largely by its business form. Thus two financial firms providing virtually identical products with similar economic attributes may be regulated quite differently.

No one would ever design a system like this. It has evolved in an accretive way, without any real thought to long-term goals or objectives. It allows and promotes regulatory arbitrage.

This system allowed unregulated state organisations and non-bank affiliates of banks and thrifts to originate thousands of risky mortgages and it allowed AIG to build a huge and essentially unregulated hedge fund on top of tightly regulated insurance companies.

Business models, financial products and markets will continually evolve. That is the nature of a dynamic market. We must have a regulatory structure that recognises that dynamism and adjusts to it. Fortunately, we are not starting this process of reflection and reform in the midst of crisis.

In March 2008, after conducting a year-long process of study, I put forward a series of comprehensive recommendations to modernise our regulatory architecture in the Treasury’s Blueprint for a Modern Financial Regulatory Framework. The blueprint identified an optimal structure that was not designed to be accomplished overnight.

The ideal regulatory structure would reflect the reasons we regulate and would recognise that the financial system has changed dramatically since our regulatory architecture was designed.

Last March the Treasury proposed a system of three primary federal regulators: one charged with maintaining market stability across the entire financial sector, one for supervising the soundness of those institutions with explicit government support and one responsible for protecting consumers and investors.

Our proposed structure recognised that there would sometimes be a need for the Federal Reserve to provide liquidity support to institutions that it did not regulate historically. This would be a drastic realignment and simplification of regulatory agencies – in order to clarify responsibilities, provide powers commensurate with those responsibilities and improve accountability.

A regulatory structure organised by objective is far more likely to withstand the test of time. In an objectives-based model no business can change regulator simply by changing its form.

The dedicated business conduct regulator would be responsible for vigorously protecting consumers and investors, through its regulation of disclosures, business practices, chartering and licensing of certain types of financial institutions and rigorous enforcement programmes.

Consumers and investors would benefit from greater consistency across product lines and centralised accountability so that no product or service fell through the cracks. Mortgages are an example of a consumer financial product that has suffered from uneven and inadequate treatment in our current regulatory and enforcement regime.

A single safety and soundness regulator would supervise all institutions that are ultimately backed by taxpayer-funded guarantees and other forms of government support. It would end the division of such regulation among several regulators, which promotes ­“charter-shopping” and a race to the bottom. It would mean that businesses would compete on an economic basis, not on the basis of their regulators.

Finally, the crisis has made abundantly clear that our financial system would benefit from a regulator whose focus is on risks across the financial system. While the Fed is assumed to have this role, it does not have the mandate or powers to carry it out effectively. There is already growing support for the blueprint’s recommendation that Congress explicitly give this responsibility to the Fed, and provide it with the tools to meet that mandate.

It would require the Fed to have access to information from a broader set of financial organisations, including hedge funds and systemically important payment systems. This authority should also have the power to intervene if it concluded that the financial system was at risk. Because the breadth of authority provided must be great, the standard for using such authority, to protect the system as a whole, should be high.

Dissemination of information by this regulator should also help maintain market discipline, a concept that is still important. While it is true that both our regulators and market discipline failed in curtailing the run-up to this crisis, we are witnessing a strong dosage of market discipline today as investors require financial firms to deliver.

Another important reason to charter a market stability regulator is to provide an authority with the responsibility to examine and attempt to mitigate the too-big or too-interconnected-to-fail problem that we face.

Congress should create regulatory authorities capable of ensuring that any institution, no matter its size, can fail with minimal systemic impact. That requires authorities that balance market stability with private capitalism by imposing an orderly wind-down of the failing institution.

We have a process in place that gives the Federal Deposit Insurance Corporation ample and flexible authority to deal with a failing bank. After Bear Stearns’ collapse in March of last year, the Treasury and the Fed expressed concern that the government lacked this type of wind-down authority for a failing non-bank.

That concern became a reality when Lehman collapsed in September, and there was no authority at the Treasury or the Fed to save the institution, and no authority to manage the wind-down outside bankruptcy. A regulatory system that treats systemically important institutions differently solely because of their charter does not make sense in today’s globally interconnected markets.

Any rewrite of financial regulatory authorities must include the explicit federal authority to intervene and wind down a failing non-bank in an orderly manner.

Defining the proper wind-down authorities and their scope will require thoughtful analysis. Necessary authorities include the power in exigent circumstances, to guarantee liabilities, provide loans and take other stabilising measures. But the circumstances that would trigger these authorities must be narrowly defined, to minimise moral hazard and preserve incentives for proper risk management.

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal.

These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

Wrenching as this period is, the cost to our nation will be even larger if we do not learn lessons from it and overhaul our regulatory system so federal regulators have clear missions, powers to execute them and accountability for carrying them out.

A new regulatory architecture accountable to investors, with flexibility to adapt to changing markets and clarity of responsibility to interact with international counterparts to forge a seamless global market infrastructure, would inspire the confidence for the financial system to create prosperity in all sectors once again.

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Barack Obama’s populist streak risks undermining his authority. The US president said Tim Geithner, his Treasury secretary, should pursue every legal avenue to block $165m in bonuses to American International Group executives, but it seems like Geithner already has. The bonuses stink. But implying doubt over contract commitments and contradicting his own officials is unwise. Obama needs to be smarter.

True, Obama’s message might be more of a bullying tactic than a true-to-word statement. A threatened legal investigation mandated by the president might be enough for some of AIG’s employees to tear up their bonus contracts. This type of rhetoric has worked before. UBS chairman Peter Kurer used a similar tactic on his top executives, persuading some to hand back their bonuses.

The outrage is understandable with AIG on the receiving end of $180bn-odd of taxpayer cash. But Obama’s message comes a little late. Larry Summers, the president's chief economic adviser, noted on a talk show over the weekend that the US “cannot just abrogate contracts”. An administration official told the New York Times that Treasury had done its own legal analysis and concluded that the AIG contracts could not be broken.

Obama’s somewhat contradictory statements sound like knee-jerk populism. They also make his administration appear uncoordinated. What’s more, using political power to disrupt business contracts is dangerous territory for an administration anxious to restore investor confidence.

And it is unnecessary. Obama could be cleverer. Just threatening to name and shame these executives might encourage them to turn down bonuses. Or he could tell the employees accepting the biggest bonuses that they will have to justify their pay in front of Congress. Quickfire populism may play well in the short term, but Obama's famous cool under fire is what he needs to persuade investors he can turn financial markets around.

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Politics, investment and entertainment inevitably impinge on each other from time to time. But anyone trying to mix them should take care. That is at least one of the lessons from the past two weeks, which have seen US stocks drop to their lowest since August 1996. 

First, President Barack Obama attracted ridicule, and anger, for a foray into investment advice.

“What you’re now seeing is profit and earning ratios starting to get to the point where buying stocks is a potentially good deal,” he said, “if you’ve got a long-term perspective on it.”

He presumably meant price/earnings ratios. The reaction showed that Americans disliked being given investment advice by their commander-in-chief. His obvious discomfort with basic market terminology attracted ridicule among professional investors.

He added that he did not look at the “day-to-day gyrations of the stock market” and that the stock market “is sort of like a tracking poll in politics”. “It bobs up and down day to day,” he said. “If you spend all your time worrying about that, then you’re probably going to get the long-term strategy wrong.”

Critics complained that he was trivialising the damage the stock market had done to people’s savings, and that the market was not “bobbing up and down” under his watch, but falling relentlessly. Can the fall in share prices since he took office be taken as a vote of no-confidence in him, and his activist agenda?

The chart shows the S&P 500 since election day, along with the FTSE All-world index, which is deeply influenced by events in the US. It has fallen. The pattern is complex. There was a mini-crash in November, triggered by the Treasury’s announcement that it would not, after all, be buying troubled assets from the banks. That ended with the rescue of Citigroup.

After that, there was a 17 per cent rally that lasted until February 10, when Tim Geithner, the new Treasury secretary, made his much-trailed speech on his plan for the banks. He was not ready to reveal details, dashing many hopes. Over the next four weeks, the S&P fell a numbing 24 per cent, before staging a rally of 14 per cent this week. It is just above its low from November’s panic.

The latest sell-off was marked by extreme fear. Individual investors, according to one survey, were more pessimistic than they had ever been. From such an extreme it was not difficult to stage a bounce on little substantial news.

Oddly, the tracking poll analogy may be a good one. It is unwise for investors or politicians to pay heed to extreme moves from day to day, but the overall trend should send a clear message. The market has twice panicked when the Treasury has raised its hopes on a policy for the banks and then lowered them.

That stocks are barely higher now than in the November panic implies that the new administration has not won the market’s confidence when it comes to the banks and that it needs to do so before stocks can recover.

Beyond that, this month’s sell-off was driven by very bad economic data, and by the divisive political debate. That debate has played out in the unlikely venue of a late-night comedy show. Rick Santelli, a CNBC reporter, made an on-air outburst against Obama, attacking homeowners facing foreclosure as losers.

Mr. Santelli turned down an invitation to appear in an interview with Jon Stewart, a highly popular late-night comedian. Stewart’s response was to attack CNBC for presenting investing as entertainment, and thereby egging on the bubble in share prices.

This led to a public feud with another CNBC commentator, Jim Cramer, that dominated talk on Wall Street all week. It ended with a confrontation between the two on Stewart’s show, which left Cramer looking chastened. The populist anger, earlier directed against the president, now appeared to be aimed at those who had egged on the market.

This episode shows that there is more than enough populist anger to go around. It behoves everyone to stay calm, including investors. Investment decisions, like all others, should not be made in anger.

And ironically, Obama’s mangled advice was not at all bad. Valuations are indeed getting to the point where, historically, stocks have been a good buy, for those who can wait a while. Cyclical price/earnings ratios are not as low as they have gone at the bottom of history’s great bear markets, but are at levels that typically lead to good returns over the ensuing decade.

Investors should also follow Obama’s advice and ignore day-to-day gyrations. Extreme volatility is common in bear markets, while day-to-day swings are driven by raw emotion rather than rationality.

It is possible that the extreme sentiments in the US body politic reached their cathartic moment in the confrontation between Stewart and Cramer, and that we will come in time to link the incident with the bottom of this bear market.

But on balance that looks unlikely. The mere fact that markets could bounce so sharply this week suggests that confusion still reigns and we are still in a bear market. And that is entertaining for nobody.

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Does Barack Obama have the same problem in Tim Geithner that George W. Bush had with his first disastrous Treasury Secretary, Paul O'Neill?

That's the question on the minds of many Republicans and Democrats in Washington in recent days. The not-so funny joke around town is that every time Mr. Geithner opens his mouth, the Dow falls by another 200 points. Democrats are somberly whispering that Mr. Geithner may not be up to the job and they're not so convinced that President Obama had it right when he told them that the Boy Wonder was desperately needed to reverse the financial meltdown.

Mr. Geithner still hasn't recovered from his first miserable performance in prime time, when he went to Capitol Hill, laid out his bank rescue plan, and the market tanked, falling 500 points.

Then his performance in front of the Budget Committee last week was widely panned by investors and politicians. Senator Max Baucus, the Democrat from Montana, was quoted as saying that he was underwhelmed by Mr. Geithner's comments on the budget and the economy.

Republicans were infuriated by the Treasury Secretary's sermon that Congress has a "moral imperative" to raise taxes on the rich. House Republicans I talked to last week fumed: "Geithner has zero credibility in telling us about moral obligations to pay taxes." They, of course, are referring to Mr. Geithner's $30,000 of unpaid taxes. Staffers on the committee tell me members routinely ridicule Mr. Geithner's "non-plan to save the banks and solve the banking crisis."

David Malpass of Encima, a Wall Street economics firm, notes that after listening to Mr. Geithner's inane comments about the virtues of raising taxes, some investors are starting to wonder whether income redistribution is a higher priority for the Obama economics team than growth and recovery.

As Mr. Malpass puts it: "The equity sell-off is rapidly narrowing the wealth gap between rich and poor and the geographic wealth gap between New York and Washington." He faults Mr. Geithner for inaction on reining in naked short selling, not fixing the mark-to-market issue, not changing the uptick rule, and other regulatory fixes that could raise equity values.

What's indisputable is that Tim Geithner is no longer regarded as the indispensable man to lead America back to prosperity. As one Republican on the Ways and Means Committee told me, "When he comes up here, it's like children's hour." The speculation now is that if the markets don't reverse course soon, Mr. Geithner may be out, and his former boss Larry Summers may be back in at Treasury.

From Stephen Moore, WSJ's Political Diary.

The US government is straining every sinew to slow the housing market’s descent.

The latest details on a $75bn package of incentives and loss-sharing on home modifications reflects a level of nuance befitting the programme’s complex aims. Delaying the fall of house prices to market clearing levels may be unfortunate. But the scheme, aiming to modify up to 4m home loans, is of sufficient scale to put a dent in foreclosures and mitigate a downward spiral in values in the worst affected areas. Challenges, however, remain.

The key is to modify the “right” loans. The Treasury is putting great weight on calculating whether the net present value of expected cash flows on loans would be higher when modified or when left alone. That could weed out hopeless cases, while requiring a signed affidavit of financial hardship might deter chancers. But the assumptions used are crucial.

A cap on the discount rate prevents servicers from using a high rate to make modification appear uneconomic. But servicers with books over $40bn, which includes the top 15 with about 75 per cent of the market, according to National Mortgage News, can base redefault rates on their own portfolios. More than 40 per cent of loans modified in the second quarter of 2008 were 30-days delinquent again after three months, so that input could justifiably be high.

In spite of government incentives to both borrowers and servicers, it also remains unclear whether the scheme can reach the 20 per cent of mortgages, which are generally lower quality, within private-label securitisations. Apart from the logistical challenge of reaching reams of bondholders, those in junior tranches may have little incentive to acquiesce. Carrying out loan modifications for this group probably requires getting the trustee on board and inducing senior noteholders to share any gains with their juniors. There are more heads to knock together yet.

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Just as outsized rescue packages and swathes of red ink had seemingly lost their capacity to shock: enter AIG.

The insurance group on Monday revealed a net loss of very close to $100bn for 2008. True, $64bn in fourth-quarter charges related to restructuring and so-called “market disruption”, for example, played a large part. Fundamentally, though, AIG’s core insurance operations are buried by losses spewing from the troubled parts of the business.

The US authorities, alas, appear determined to perpetuate the fiction that AIG remains in some form a viable entity. Another complex recasting of the government’s support includes tweaking the government’s preferred shares to make them more junior, a $30bn equity capital facility, lowering interest payments on the Federal Reserve’s credit line and reducing that facility by swapping debt for stakes in two life assurance businesses.

That the latter remain even nominally under AIG’s control is astonishing. A cleaner separation would help decontaminate them from association with their parent, and ease the process by which they will eventually be sold at a decent price.

AIG’s miserable demise has further to run. The Treasury on Monday acknowledged that more government support might be required in managing the company’s overhaul. Furthermore, the emphasis placed on AIG’s role as a significant counterparty, plus the complexity of a business spread across 130 countries with 400 regulators, indicates that the government is committed to keeping AIG on taxpayer-funded life support, while protecting its counterparties, the large banks, from losses.

AIG demonstrates that apparently dramatic government action, taking 80 per cent of the company last year at a stroke, does little to avoid other tough choices. AIG’s financial products group still has $300bn in net notional exposure that must be resolved. That lesson may prove valuable in dealing with other failing institutions. Even government-owned zombies remain decidedly unpleasant.

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