Serving the FDIC's Interest

In a recent speech, FDIC chair, Sheila Bair laid our her vision for financial services regulatory reform.

She starts from the common-sense premise that "we need an end to the too big to fail doctrine". She proposes a "mechanism for the orderly resolution of these institutions similar to that used for FDIC-insured banks." She argues for extending this mechanism beyond the large bank holding companies to smaller bank holding companies, hedge funds and insurance companies. She expressed support for the international initiative towards the development of wind down plans providing they "be developed in cooperation with the resolution authority". Finally, she also proposes considering "limiting the claims of secured creditors to encourage them to monitor the riskiness of the financial firm." She believes that short term secured borrowing "may encourage greater fragility in the financial markets" and that taking money from secured creditors and giving it to general creditors would serve "to stem any systemic risks."

The most striking feature of her analysis is that, to her, the "too big to fail doctrine" is false. That with a structured resolution process no firm is too big to fail. As noted previously, an FDIC-style resolution process works well when disposing a relatively tiny amount of assets into a large market. It can not be reasonably expected to work as well disposing a more meaningful proportion of assets in market.

That large and/or interconnected companies should maintain "living wills" is an almost inescapable take-away from the Lehman bankruptcy. Mandating that any such company (including non-financials) maintain active shareholder and creditor approved pre-packaged bankrupcy plans appears a no-brainer. Bair, rightfully, notes that such plans can improve systematic resilience by highlighting risks and dependencies. More questionable is her insistence on regulatory agency participation in, or rather -- let's not kid ourselves -- control of, developing these plans. Without regulator intervention, this sort of rule would create structural pressure against firms too big or complex to fail. The bigger and more complex a firm is, the more difficult it will be for shareholders and creditors, by themselves, to reach agreement.

Demanding that smaller firms that could be otherwise be reasonably wound down through existing mechanisms maintain "living wills", as Bair appears to support, is the sort of regulation-as-barrier-to-entry that larger firms love.

At first glance, her argument to mandate haircuts for secured creditors is unequivocally idiotic. If shareholders, regulators and unsecured creditors cannot together adequately monitor the riskiness of a firm, how could secured creditors? How does taking money from secured creditors and giving it to unsecured creditors stem any systemic risk?

Most risible is the suggestion that secured lending "encourages more risky behavior." Bair surely knows this is false: Systemic risk is primarily caused by unsecured rather than secured lending; A firm's secured borrowing cannot get out of hand, as a firm has finite assets to borrow against. If one only lends securely, one is not put at risk by a borrower defaulting. In truth, unsecured borrowing is also, generally, a check on excessively risky behavior as lenders demand higher rates from firms perceived as more risky. The financial system did not work this way because the government subsidized unsecured lending: In the first instance via the implicit "too-big-to-fail" guarantee, but also via the FDIC itself -- a bank account is nothing more then a unsecured loan to the bank.

Her true motivation appears clearer when one considers that the FDIC is running out of money. It would sure benefit from being able to seize 20% from secured creditors of banks it takes over. Similarly, to argue for an FDIC-like resolution process to be expansively applied is, between the lines, to argue for a dramatic expansion of FDIC authority. It should be no surprise that Bair argues as forcefully for regulation in her agency's interest as she opposed regulation against her agencies interest. It is unfortunate that the regulator cannot be relied on to, instead, defend the public interest.

Babies with Candy

Krugman argued that ending the current "unconventional" economic measures would be a mistake since history shows that the two times they were previously tried in response to a "liquidity trap" they were ended "too soon".

Occam's razor might argue: The current "unconventional" measures are a mistake since they have been tried twice under similar circumstances and did not work.

The President, of course, expressed His understanding, contra- conservative critics (and it turns out Krugman), that it was pretty well settled that these sort of unconventional measures worked in the past.

Efficiency

Poking Holes in a Theory on Markets

...the efficient market hypothesis is ... a theory that ... the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists ... who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices... Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble...

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient.

The financial services industry, of course, has a great interest in undermining the efficient market thesis. To the degree it holds true, active fund managers (which is to say all of them) are snake oil salesmen, plain and simple.

Markets should be mostly rational, by the simple syllogism that markets are made up of people, and people, when it comes to their money, are mostly rational. Certainly, as the behavioralists show, people are never entirely rational and so markets are, perhaps, never entirely rational.

That said, the focus on broad behaviorism obscures, I think, a more fundamental irrationality embedded in markets, which is: People, acting rationally within in their individual constraints, do not always produce a rational outcome in aggregate.

More directly: In the current regime, what an investment manager thinks about a company is only a part (perhaps even a small part) of an investing decision. There are all sorts of additional concerns that factor in. For example, a manager has to be concerned about the optics of the investment her own, often under-informed, investors. A manager has to consider the changing regulatory and political environment in which the company operates (its fair to say that the investors the past nine months have been betting more about "what the government will do" than "what a company will do"). There are all sorts of constraints that operate in the name of "Risk Management" that seem to do far more to distort prices then reduce risk. Above all, a manager has to consider the regulatory environment in which she operates. All these considerations alter investment decisions.

In other words, the market is composed of people who are making decisions that only partially reflect economic information and expectations and so market prices only partially reflect that information and expectation. The more these external factors dominate investment decision making, the less rational markets are. And the more irrational markets appear the more likely these external factors are dominating.

Yet ... In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

“In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.”

He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”
...
Justin Fox’s ... thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons — and writing papers in their mathematical jargon — they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.
...
As Mr. Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo... Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds...

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you’re Warren Buffett, an index fund is where you should put your money. Even people who don’t follow that advice know they should...

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational...

The notion that no one was willing to call a bubble a bubble is silly. I don't think it would be difficult to find mountains of published quotes from the peak of the respective "booms" calling them "bubbles".

The job of an investment manager is not to avoid bubbles, on the contrary. Bubbles -- which make it very easy to buy low and sell high -- are an investment managers best friend. The job of an investment manager is to time her trades properly.

Finally, again, the notion that "professional investors" were captive to efficient market theory defies reason. If one is captive to efficient market theory, one does not actively trade.

Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble...

There is a stronger argument in regards to government officials. For example, regulators have long operated under the "theory" -- one that perhaps ought be revisited -- that introducing externalities into investment making decisions does not reduce the efficiency of markets.

On the other hand, Alan Greenspan -- given his famous "irrational exuberance" speech -- is an ill-fitting posterboy for "government officials unwilling to even judge that it was a bubble". The decision, on the part of government officials, of if, when and how to burst a bubble is a tremendously complicated one. There are many reasons (good and bad) why a government official might recognize a bubble but be unwilling to burst it.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

The crucial question, to my mind, is why that market does not exist. I don't believe the evidence supports the (behavioralist) assumption that smart market participants were entirely oblivious to the bubble around them. To understand why the efficient market theory failed, one has to understand the many reasons why a smart market participant who recognized the bubble around her might not force stock prices to become rational.

Babies With Candy 3/16

A Continent Adrift

...the situation in Europe worries me even more than the situation in America.

Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous... they’re actually a mitigating factor.

The clear and present danger to Europe right now comes from a different direction — the continent’s failure to respond effectively to the financial crisis...

On the fiscal side, the comparison with the United States is striking... America’s actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump... these programs will also help sustain spending in the slump.

But such “automatic stabilizers” are no substitute for positive action.

In previous columns, Krugman has questioned positive action being able to lift us out of the crisis (noting, for example, that it took a world war to get us out of the great depression). He also has expressed concern for long-term costs. Expectations of efficacy and cost aside, he never wavers from cheer-leading such policy.

Why is Europe falling short? Poor leadership is part of the story. European banking officials, who completely missed the depth of the crisis, still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.

This is an odd mirror to the run-up to the iraqi war. Then, in the eyes of Democrats, Europeans were wise friends whose council and co-operation we ought never reject unilaterally. To Republicans, they were weak and mushy and incapable of responsibility. Now, the views are reversed. The commonality may be a lack of decisiveness.

But there’s a deeper problem: ...unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.

This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries.

...there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.

Europe, in other words, is turning out to be structurally weak in a time of crisis.

It turns out, somewhat ironically, that we have the state dominated economy we thought Europeans had, and they have the divided government we thought we had.

To Krugman this is a factor in our favor.

The biggest question is what will happen to those European economies that boomed in the easy-money environment of a few years ago, Spain in particular.

For much of the past decade Spain was Europe’s Florida, its economy buoyed by a huge speculative housing boom. As in Florida, boom has now turned to bust...

In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.

This argument assumes that there is a pain free path out of a Spain, or Florida, style bust. There may well be not, and all the positive expensive attempts to avoid any pain may, in the end, only serve to radically increase it.

An economist like Krugman should welcome different governments pursuing different policies in response to the crisis as that will produce more and better data for economists to study. The partisan political commentator in Krugman may fear the tale that data will tell.

Babies With Candy 3/22

Catching up Financial Policy Despair

This is a mostly repetitive column. Krugman's tone getting increasingly more shrill as it appears Obama will not adopt the policy he prefers.

...Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy — specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

...now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

These plans, as observed here previously assume no such thing. Rather, they assume that the economy would be healthier if the banks were healthier, that the banks would be healthier if they had more cash and fewer toxic assets, that the cash the private sector is currently willing to provide in exchange for those toxic assets is not enough to restore the banks to help, but that with government incentives the private sector will provide sufficient cash.

There are good reasons to be skeptical about a number of these assumptions, but they are all far more solid then "bankers know what they are doing"

...Right now, our economy is being dragged down by our dysfunctional financial system, which has been crippled by huge losses on mortgage-backed securities and other assets.

This is a semi-truth. For a good 10 years before our economy was dragged down by a supposed dysfunctional financial system it was inflated by a government encouraged hyper-functional one. We have 10 years of economic growth that may well be every bit as real as Madoff profits.

Given that, its not clear to me that the financial system is entirely dysfunctional. What would be the response of a functional financial system to the recognition that it was flooded -- from housing, to student loans, to credit cards, to corporate financing -- with bad debt?

Put differently: Are our economic troubles a symptom of the financial system clamping down on credit dragging or is the credit crunch an inevitable consequence of an economy in which the repayment of too much debt was entirely dependent on increasingly easy credit?

If it is the former, the policies being pursued to "ease" credit are sensible. If it is the latter then such policies will prove cataclysmic.

As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now.

Its not clear to me that governments have, for centuries, been pursuing these policies.

As argued here before, one reason why doing this now might now might not be sensible is scale. Does the government really have no reason not to want to put all that bad debt on the federal balance sheet?

Also, given the scale, if the government takes "temporary" control over citibank it will likely find itself in long term control of Morgan Stanley.

Truly insolvent is a fuzzy word in this context. It will be a long time till we know the true value of many of the toxic assets and, so, whether or not a given bank was insolvent. On the other hand, a bank that loses the confidence of the market and so can't raise capital is, simply, insolvent. The more banks the government nationalizes the less confidence the market will have in the survivors and, therefore, the less solvent they will be. In other words, a policy of nationalizing banks will render banks that are absent that policy solvent, trully insolvent.

The temporary notion is downright silly. Control can be temporary if there are markets to sell assets into. But if the government seizes the largest banks there will be no such markets. Control, therefore -- even without the likely political meddling -- will be inevitably long term.

...The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels... Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama’s top economic adviser, is to use “the expertise of the market” to set the value of toxic assets.

Again, this assumption is besides the point. None of these plans care about the true value of these assets as much as getting them off the balance sheets of banks at a price that won't bankrupt all the banks.

I am, certainly, giving Geithner a bit of the benefit of the doubt here. But as much as I am skeptical of his competence, I have a hard time imagining the he hasn't figured out that the value a market assigns is a strong function of the financing available to market participants. He has to know that, by the terms of the offered financing, he -- more than the expertise of the market -- will be substantively setting the price. The idea then, must be to get these assets of bank balance sheets and into private hands better suited to hold on to them.

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.

This is an oversimplification and misrepresentation of the payouts. Depending on how much investors have to put down, they won't walk away if it simply goes down a little. The investors therefore own the first chunk of loss. On the other side, the Government, by virtue of being owed interest payments, owns the first chunk of gain. The Government even profits if the value decreases slightly.

While this seems a reasonable deal for the government -- especially given the primary goal is to clear assets from bank balance sheets, not profit from financial transactions -- I suppose one could argue. It borders on mindless, however, to brand it a one way bet.

...By my count, this is the third time Obama administration officials have floated a scheme that is essentially a rehash of the Paulson plan, each time adding a new set of bells and whistles and claiming that they’re doing something completely different. This is starting to look obsessive.

The technical term for this, I think, is projection. The administrations flip flopping policy is anything but obsessive. Krugman's commentary on the other hand.

The administration flip-flops are likely a result of the politics. The administration would prefer avoid the political cost of another expensive bank bailout. On the other hand, the administration cannot bear the political cost of the DOW dropping to 6500 and below. When the markets are in free fall these plans are introduced, when they stabilize they are shelved.

But the real problem with this plan is that it won’t work... the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact...

I do love Krugman-the-economist who, in most every column, feels the need to undermine Krugman-the-political-columnist.

It was not merely a few financial executives that bet their banks on the belief that unprecedented levels of household (and corporate) debt were no problem, it was the industry as a whole. In fact, it wasn't simply private industry, but government policy makers. They, we, all lost that bet, and are left with a truly insolvent economy as opposed to just a few banks that are truly insolvent.

Given the real problem, then, Krugman's partisan proposal solves little.

Babies With Candy V

Krugman opines The Big Dither

Here’s how the pattern works: first, administration officials, usually speaking off the record, float a plan for rescuing the banks in the press. This trial balloon is quickly shot down by informed commentators.

Then, a few weeks later, the administration floats a new plan. This plan is, however, just a thinly disguised version of the previous plan, a fact quickly realized by all concerned. And the cycle starts again.

Why do officials keep offering plans that nobody else finds credible? Because somehow, top officials in the Obama administration and at the Federal Reserve have convinced themselves that troubled assets, often referred to these days as “toxic waste,” are really worth much more than anyone is actually willing to pay for them — and that if these assets were properly priced, all our troubles would go away.

While Krugman may not find the plans credible, there are certainly informed commentators who do. He is certainly not the only political commentator dismissive of those who disagree with him.

A more rigorous analyst would question the process.

While it may well be true that bold steps are required, its hard to imagine that any set of bold steps will be greeted without resistance by "informed commentators". To give "informed commentators" a policy veto is to preclude adopting bold steps.

Its clear that the administration is attuned to the politics. It is natural for political policy makers to be attuned to the political implications of policy. It also may reflect sympathy for the school of thought which believes recessions to be, above all, crises of confidence and the way out of recessions to restore confidence. Bold steps, in that view, are less medication than placebo; The actual steps are less important that the public's confidence in them.

Krugman, to my mind, also mis-states the motivation behind the policies. The concrete problem that the administration is trying to address is the banks have on difficult to price, and therefore "toxic", assets on their balance sheets that impair their ability to serve their nominal economic role. Were we to price these assets at their current, fire sale, market price most of these banks be seriously under capitalized, if not insolvent. Its reasonable to believe that getting these assets off bank balance sheets at an non-ruinous price will go along way towards pushing our troubles away.

Thus, in a recent interview Tim Geithner, the Treasury secretary, tried to make a distinction between the “basic inherent economic value” of troubled assets and the “artificially depressed value” that those assets command right now. In recent transactions, even AAA-rated mortgage-backed securities have sold for less than 40 cents on the dollar, but Mr. Geithner seems to think they’re worth much, much more.

And the government’s job, he declared, is to “provide the financing to help get those markets working,” pushing the price of toxic waste up to where it ought to be.

Geithner is certainly right to a point.

These assets being loans, have a long-term value: Some amount of money will be paid back. In healthy, liquid markets, the market price is the best estimate available of the expected long-term-value. The current market prices are almost certainly depressed, as they more reflect fear of short term price fluctuations. An investment manager who has to mark her portfolio to market and report P&L to clients on a monthly, or quarterly, basis and whose clients are likely to substantively withdraw money in response to paper losses, is rationally more concerned with short-term-price rather than long-term-value expectations.

To the degree that our economy depends on these markets functioning, the government has a responsibility to help get those markets working again.

Financing buyers, however, is not, to my mind, really a means to get these markets working again. The price will be dependent on the terms of the financing. To work, I think, Geithner will have to set the terms such that the price approaches the long-term-value. A price set too high will save the banks, but not restore investor confidence in price stability. Krugman is right to question Geithner's -- any individual's -- ability to gauge that long-term-value.

A more thoughtful policy would be to adjust tax policy to encourage investment pools with longer lockups, and with P&L measured in cash returns not market values. The price managers of those pools would be willing to pay for assets will be far more based on expectation of long term value.

That said, if the goal is getting these assets off bank balance sheets as quick as possible, subsidizing buyers may well be the most sensible policy.

...The truth is that the Bernanke-Geithner plan — the plan the administration keeps floating, in slightly different versions — isn’t going to fly.

Take the plan’s latest incarnation: a proposal to make low-interest loans to private investors willing to buy up troubled assets. This would certainly drive up the price of toxic waste...

But would it be enough to make the banking system healthy? No.

Think of it this way: by using taxpayer funds to subsidize the prices of toxic waste, the administration would shower benefits on everyone who made the mistake of buying the stuff. Some of those benefits would trickle down to where they’re needed, shoring up the balance sheets of key financial institutions. But most of the benefit would go to people who don’t need or deserve to be rescued.

And this means that the government would have to lay out trillions of dollars to bring the financial system back to health, which would, in turn, both ensure a fierce public outcry and add to already serious concerns about the deficit...

Krugman's argument appears to be: Subsidizing private investors will not make the banking system healthy because benefit will be going to undeserving people. While, perhaps, rhetorically appealing, it is logically empty.

Krugman believes that de-zombification will make banking system healthy (I am skeptical). If these toxic assets on zombie bank balance sheets are replaced with enough cash, the banks will be de-zombified.

That cash can come from the government -- per Paulson's initial plan or proposed nationalization schemes -- or from subsidized, if undeserving, private investors (the subsidy is required because private investors are not currently willing to pay sufficient cash).

So why has this zombie idea ... taken such a powerful grip? The answer, I fear, is that officials still aren’t willing to face the facts. They don’t want to face up to the dire state of major financial institutions because it’s very hard to rescue an essentially insolvent bank without, at least temporarily, taking it over. And temporary nationalization is still, apparently, considered unthinkable.

Krugman has yet to explain how nationalization is a panacea. In a vanilla nationalization model, the government will replace these toxic assets on zombie bank balance sheets with sufficient public capital, then sell the recapitalized banks and toxic assets separately into the market over some period of time.

This seems to me, on the surface, to be far a more complicated, risk laden and expensive means to the same end as a well calibrated buyer subsidy. Which more simply explains this idea's powerful grip.

One suspects that Geithner, with a much better view of the matter, understands the dire state of major financial institutions far better then Krugman. And it may well be the very dire-ness and attending expense of recapitalization, that precludes Geithner, as Paulson before him, from considering a public-capital-only solution.

Babies with Candy III

Commenting on Krugman's latest offering:

Comrade Greenspan wants us to seize the economy’s commanding heights.

O.K., not exactly. What Alan Greenspan, the former Federal Reserve chairman — and a staunch defender of free markets — actually said was, “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.” I agree.

I don't. The idea is, on the surface, appealing. As was Paulson's asset buyout plan, and for the same reason. The promise of a single (more or less) bold, swift, unapologetic government action, which will stop the bleeding and right the ship. But, as I'll describe below, upon anything close to rigorous reflection, its hard to conclude that it stands much chance of working as advertised.

The case for nationalization rests on three observations.

First, some major banks are dangerously close to the edge — in fact, they would have failed already if investors didn’t expect the government to rescue them if necessary.

Second, banks must be rescued. The collapse of Lehman Brothers almost destroyed the world financial system, and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.

Third, while banks must be rescued, the U.S. government can’t afford, fiscally or politically, to bestow huge gifts on bank shareholders...

Let’s be concrete here. There’s a reasonable chance — not a certainty — that Citi and BofA, together, will lose hundreds of billions over the next few years. And their capital, the excess of their assets over their liabilities, isn’t remotely large enough to cover those potential losses.

Arguably, the only reason they haven’t already failed is that the government is acting as a backstop, implicitly guaranteeing their obligations. But they’re zombie banks, unable to supply the credit the economy needs.


While Krugman's observations are entirely correct, the conclusion he draws will not directly follow. He -- and this appears a tendency amongst liberal commentators -- conflates the two objectives of supplying banks with public capital.

As he noted, without the public backstop, these banks would likely implode. From the Lehman experience, we understand that the public has an strong interest in avoiding said imposion.

The second objective is that the banks need more capital "to supply the credit the economy needs."

The amount of capital required for the second is far in excess of the amount required for the first. Zombie banks may not juice the economy, but they don't threaten to destroy the global financial system the way a disorganized bankruptcy would.

Additionally, as I argued previously on this blog, claiming that credit is what the economy needs is akin claiming that alcohol is what Mickey Mantle needed. We are in economic pain due to systematic over-reliance on credit. For our long-term economic health, we need credit-withdrawal, not another fix.

To end their zombiehood the banks need more capital. But they can’t raise more capital from private investors. So the government has to supply the necessary funds.

But here’s the thing: the funds needed to bring these banks fully back to life would greatly exceed what they’re currently worth. Citi and BofA have a combined market value of less than $30 billion, and even that value is mainly if not entirely based on the hope that stockholders will get a piece of a government handout. And if it’s basically putting up all the money, the government should get ownership in return.

As discussed, Krugman pulled a logical fast one. He substituted the factual observation that we can't let Citibank go the way of Lehman, with the less solid assertion that we need to restore Citi fully back to life.

He is correct in noting that these banks cannot be recapitalized privately. He does not explain why this is the case. The reasons include: regulations that limit who can invest capital in banks and, more importantly, private capital is scared off by the spectre of nationalization.

Put differently: if the government formalized its role as backstop, which is required in any event, guaranteed that it would not punish new private capital, and reduced restrictions on where that capital could come from at least some banks would likely be able to recapitalize privately.

Tangentially, it seems like much of Obama's policy has reflected this pattern: He pursues some policy which restrains, or crowds out, private activity, and then uses that private inaction to justify dramatically increased government intervention. I am unsure if this is innocent or intentional, but its hard to imagine that Obama suddenly lost the rigor and discipline that characterized his campaign.

In any case, the "should" in "should get ownership in return" is, then, perhaps political necessity, but its not simply in the public's economic interest.

Still, isn’t nationalization un-American? No, it’s as American as apple pie.

Lately the Federal Deposit Insurance Corporation has been seizing banks it deems insolvent at the rate of about two a week. When the F.D.I.C. seizes a bank, it takes over the bank’s bad assets, pays off some of its debt, and resells the cleaned-up institution to private investors. And that’s exactly what advocates of temporary nationalization want to see happen, not just to the small banks the F.D.I.C. has been seizing, but to major banks that are similarly insolvent.

The real question is why the Obama administration keeps coming up with proposals that sound like possible alternatives to nationalization, but turn out to involve huge handouts to bank stockholders.

As Krugman notes later, the phrase "nationalization" is inapt if what is being advocated in a government ordered liquidation akin to what the FDIC does. Nationalization implies something different.

The idea that the government can, with the insolvent big banks do what the FDIC does with small banks -- in effect government-ordered bankruptcies-- bears little srutiny.

For one, if I understand correctly, the FDIC seizing is generally less akin to chapter 11 then chapter 7, which is to say, it more generally liquidates bank assets and pays back debt-holders in an orderly fashion, then restructures failed banks into viable ones. The former, obviously, requires far less business savvy -- and therefore is far more safely entrusted to the government -- then the latter. The nationalization Krugman appears to have in mind is very much the latter, and therefore the FDIC analogue-justification inapt.

Furthermore, consider that there are some 8000 FDIC insured banks in the US. Two banks seized a week adds up to a little over 1% a year. Even with the increase in bank failures the FDIC has a robust private market into which the it sells the institution or its assets.

Imagine, by way of comparison, of what would happen if the FDIC was seizing 50 banks a week. There would be at least two easy to foresee effects:

One, it would have far less ability to move seized institutions back into private hands. More likely it would be "forced" to operate those institutions for an indefinite amount of time.

Secondly, seizures are more likely to snowball. So long as seizures number 1% per year, they serve -- by avoiding fire-sales -- to strengthen healthy banks. Seizing 20% a year may well -- by undermining the sector -- serve to weaken healthy banks.

The same is true of Citibank and BofA. Any nationalization is unlikely to be particularly temporary and nationalizing Citibank and BofA may predictably weaken Goldman, Morgan and JPM to the point where they too "require" nationalization.

For example, the administration initially floated the idea of offering banks guarantees against losses on troubled assets. This would have been a great deal for bank stockholders, not so much for the rest of us: heads they win, tails taxpayers lose.

Now the administration is talking about a “public-private partnership” to buy troubled assets from the banks, with the government lending money to private investors for that purpose. This would offer investors a one-way bet: if the assets rise in price, investors win; if they fall substantially, investors walk away and leave the government holding the bag. Again, heads they win, tails we lose.

Krugman's arguments here are blatantly dishonest. Earlier he observed the motivation for government involvement as avoiding a Lehman style implosion and Japanese style zombie banks. As that is the case, taxpayers wins and losses are measured by whether implosion is avoided and credit starts flowing again.

Also the public-private partnerships being discussed are not the simplistic heads they win, tails we lose scenario Krugman dishonestly describes.

To take a concrete example, lets say there is an asset that right now a bank will sell for $100, but outside investors would only buy for a far lower price, say $25. Which leads to it being stuck on the bank balance sheet inhibited lending.

The government is offering to finance ~90% of the purchase price of such assets which dramatically raises the price outside investors are willing to pay (the cost to the investor is now 10% * $100 + interest on $90). If an investor is now willing to buy the asset, the bank has cash instead of a toxic asset on its books and the amount of money it can lend out is increased (which is, for Krugman, a win).

The investor has put down $10 of their own money and borrowed $90. So long as the asset retains most of its value the investor will repay the loan and the government profits. If the asset value drops more substantially, the investor may walk away from the loan and leave the government holding the asset, which it, in effect bought for 9/10ths the asking price. The asset may well, at that point be worthless, but it also may have the capacity to recover with the government now owning the upside.

Contrast this with the nationalization Krugman desperately prefers. If the government seizes the bank, it now owns this asset. To restore the bank to health -- Krugman's avowed goal -- entails either writing the value of the asset down to near zero or selling the asset into the market. (Either action is likely to create further downward pressure on still-surviving banks.) The market is only willing to buy the asset at $25. (In the case of the nationalized Swedish banks, the government actually offered guarantees and subsidies to the buyers of some assets.) To keep the bank well capitalized (its assets safely greater then its liabilities) the government would then have to make up for the $75 loss with public money, only some of which it would get back if it sold the bank back into market. If it writes the asset value down to near zero, and the perceived riskiness of the asset drops substantively while the bank is nationalized, the government does stand to make some return. Still, it will likely be a long time before the perceived riskiness of most of these asset drops substantively.

In sum, there is no strong reason to believe that nationalization stands to be a better deal for the taxpayer then alternatives that promise roughly the same outcome.

Why not just go ahead and nationalize? Remember, the longer we live with zombie banks, the harder it will be to end the economic crisis.

I am not sure what he wants us to remember. He never explained why this is the case, and I rather suspect it is not the case.

The longer we live with zombie banks, the more we learn to live in a world of constricted credit. The economy that will emerge from that world will be far more sustainable then the product of free-flowing credit.

How would nationalization take place? All the administration has to do is take its own planned “stress test” for major banks seriously, and not hide the results when a bank fails the test, making a takeover necessary. Yes, the whole thing would have a Claude Rains feel to it, as a government that has been propping up banks for months declares itself shocked, shocked at the miserable state of their balance sheets. But that’s O.K.

The stress test is, likely, more about politics then economics. In practice, the outcome of a stress test is controlled by embedded assumptions. It will be easier politically to seize a bank that fails the stress test.

And once again, long-term government ownership isn’t the goal: like the small banks seized by the F.D.I.C. every week, major banks would be returned to private control as soon as possible. The finance blog Calculated Risk suggests that instead of calling the process nationalization, we should call it “preprivatization.”

And once again, this is either foolish or dishonest. If the government seizes Citibank and BofA it will likely be "forced" in short order to seize the rest. And if the government seizes the sector its hard to imagine that long term government ownership isn't the most likely outcome.

To put my money where my mouth is, I'll offer Paul Krugman the following $1000 bet straight-up. If the government seizes Citibank and BofA, five years later, Morgan Stanley will be bankrupt or in government hands.

The Obama administration, says Robert Gibbs, the White House spokesman, believes “that a privately held banking system is the correct way to go.” So do we all.

Gibbs finished that phrase by calling for government regulation. The difference between regulation and ownership is a fuzzy one. Its not clear to me what control the government would have as owner that it does not have as regulator.

I suspect Obama understands this, which is why he isn't eager to nationalize the banks. He can control the banks entirely without bearing the political cost of nationalizing them.

But what we have now isn’t private enterprise, it’s lemon socialism: banks get the upside but taxpayers bear the risks. And it’s perpetuating zombie banks, blocking economic recovery.

What we want is a system in which banks own the downs as well as the ups. And the road to that system runs through nationalization.

We own the downs because we are overly dependent on the overflow of credit the banks provide. If the banks suffer, they tighten the credit we can't live without. The road to that system, then, leads to an economy that is less dependent on credit. Alternatively, perhaps, the road to that system leads to an economy in which the flow of credit is less dependent on the health of a few large banks. The reasons it does in our economy are less market or structural and more legislative/regulatory in nature.

Its hard to see how the road to either place runs through nationalization. It is hard to see any sensible argument explaining nationalization gets us to a place where banks own the downs.

Finally, to krugman, zombie banks block economic recovery because they don't extend the credit the economy needs. It is illuminating to review precisely how that works. Crudely: the large banks take cash from lenders and investors, they, generally, "lend" by creating securities backed by loans (which they either originate themselves or support a market for originators), which they mostly sell of to investors in exchange for cash, which they can put right back to work. Part of what is going on now is that there is a dramatically reduced market for these securities. There are a number of reasons for this including: the opacity of some of the most complex derivatives, dramatically increased sale of government-debt securities crowding out the market for private-debt securities, and, perhaps, above all, the market questioning the credit worthiness of borrowers.

This is, in other words, another question and egg problem. The return of credit requires the return of debt securities markets. It is unclear that it is zombie banks causing frozen debt security markets as opposed to frozen debt security markets causing zombie banks.

Babies With Candy II

As much as I have been hoping to hate on him, in Friday's column, Paul Krugman (mostly) sensibly extends and refines arguments from his previous column. That said, its still easy to see Krugman-the-partisan-columnist censoring Krugman-the-nobel-winning-economist.

...people at the Fed are troubled by the same question I’ve been obsessing on lately: What’s supposed to end this slump? No doubt this, too, shall pass — but how, and when?

To appreciate the problem, you need to know that this isn’t your father’s recession. It’s your grandfather’s, or maybe even (as I’ll explain) your great-great-grandfather’s.

Your father’s recession was something like the severe downturn of 1981-1982. That recession was, in effect, a deliberate creation of the Federal Reserve, which raised interest rates to as much as 17 percent in an effort to control runaway inflation. Once the Fed decided that we had suffered enough, it relented, and the economy quickly bounced back.

Your grandfather’s recession, on the other hand, was something like the Great Depression, which happened in spite of the Fed’s efforts, not because of them. When a stock market bubble and a credit boom collapsed, bringing down much of the banking system with them, the Fed tried to revive the economy with low interest rates — but even rates barely above zero weren’t low enough to end a prolonged era of high unemployment.

Its obviously not quite accurate to summarily characterize that the post-war recessions as because of the Fed's efforts. I rather believe that a meaningful understanding of the structural problems that brought us, almost inevitably, into the current mess requires a detailed understanding of progression (which is not quite the right term) of our economy from the late sixties on. Be that as it may, Krugman is, I suppose, entitled to a bit of creative license.

More interestingly, I seem to remember that during the Great Depression, in addition to the rough zero-interest-rate-policy Krugman mentions, the Government tried to revive the economy with some other set of programs that weren't enough to end that prolonged era of high unemployment. What was it called?

Oh yes: The "New Deal". Odd Krugman neglecting to mention it.

Now we’re in the midst of a crisis that bears an eerie, troubling resemblance to the onset of the Depression; interest rates are already near zero, and still the economy plunges. How and when will it all end?

To be sure, the Obama administration is taking action to help the economy, but it’s trying to mitigate the slump, not end it. The stimulus bill, on the administration’s own estimates, will limit the rise in unemployment but fall far short of restoring full employment. The housing plan announced this week looks good in the sense that it will help many homeowners, but it won’t spur a new housing boom.

Its not clear to me that Obama's rhetoric in selling the stimulus bill well-matches Krugman's lowered expectations. It is, in any case, not difficult to see in the above paragraph the conflict between Krugman-the-economist, who understands the stimulus bill to be minimally effective, and Krugman-the-partisan-columnist who is obliged to cheer his party's policy.

What, then, will actually end the slump?

Well, the Great Depression did eventually come to an end, but that was thanks to an enormous war, something we’d rather not emulate...

This is an improvement from his last column when he seemed to imply we should be considering policy to parallel WWII.

So will our slump go on forever? No. In fact, the seeds of eventual recovery are already being planted.

Consider housing starts, which have fallen to their lowest level in 50 years. That’s bad news for the near term. It means that spending on construction will fall even more. But it also means that the supply of houses is lagging behind population growth, which will eventually prompt a housing revival...

The same story can be told for durable goods and assets throughout the economy: given time, the current slump will end itself, the way slumps did in the 19th century. As I said, this may be your great-great-grandfather’s recession. But recovery may be a long time coming.

The closest 19th-century parallel I can find to the current slump is the recession that followed the Panic of 1873. That recession did eventually end without any government intervention, but it lasted more than five years, and another prolonged recession followed just three years later...

Its almost as if Krugman read my post on his last column!

Its worth noting that five years is a long time, but that the Great Depression did last longer. Its obviously not an apples to apples comparison, but superficially it would appear that the more active Government policies of the 1930s did not serve to shorten, or substantially mitigate, that downturn.

Krugman-the-economist, more or less, directly disagrees with the President who argued that "the federal government is the only entity left with the resources to jolt our economy back into life." But Krugman-the-partisan-columnist is always at the ready:

Let’s be clear: the Obama administration’s policy initiatives will help in this difficult period — especially if the administration bites the bullet and takes over weak banks. But still I wonder: Who’ll stop the pain?

,

Financial Illiteracy

Another measure of how poorly educated Americans are about finance. On tonight's jeopardy, one clue "Stock Lingo" for $1200

THIS GREEK LETTER
MEASURES HOW MUCH A STOCK HAS RISEN OR FALLEN
OVER A ONE YEAR PERIOD

One contestant, Matt, guessed "Delta", he was judged wrong. Another one guessed "Beta", she was certainly wrong. Alex announced the answer as "Alpha".

Alpha is, to my knowledge, no such thing. It is a measurement of how much of a stock, or portfolio's, return, is attributable to characteristics unique to the stock, or portfolio, as opposed to Beta which is a measurement of how much of a stock, or portfolio's, return is attributable to broader market factors.

Delta is the closest to accurate answer. In option parlance, Delta is the measure of how much the price of the option changes in response to a change in underlier price. Generally, however Delta often refers to the difference between two numbers.

Babies With Candy

Heretofore my posts have been sort of whatever-grabbed-my-attention. I think the blog would be better was posting more systematic. To that end, I introduce, what I hope will be the first of many recurring topics: Babies With Candy.

The theme of this topic is to comment, hyper-critically, on Paul Krugman's NY Times columns, to argue generally that he is more then a bit of a hyper-political fraud of an economist. The title of the topic stems from my sense that the task isn't particularly difficult.

Unfortunately for me, I am mostly in agreement with his latest column Decade at Bernie’s. Anyways, without further ado:

By now everyone knows the sad tale of Bernard Madoff’s duped investors. They looked at their statements and thought they were rich. But then, one day, they discovered to their horror that their supposed wealth was a figment of someone else’s imagination.

Last week the Federal Reserve released the results of the latest Survey of Consumer Finances, a triennial report on the assets and liabilities of American households. The bottom line is that there has been basically no wealth creation at all since the turn of the millennium: the net worth of the average American household, adjusted for inflation, is lower now than it was in 2001.

At one level this should come as no surprise. For most of the last decade America was a nation of borrowers and spenders, not savers...

Yet until very recently Americans believed they were getting richer, because they received statements saying that their houses and stock portfolios were appreciating in value faster than their debts were increasing. And if the belief of many Americans that they could count on capital gains forever sounds naïve, it’s worth remembering just how many influential voices — notably in right-leaning publications like The Wall Street Journal, Forbes and National Review — promoted that belief, and ridiculed those who worried about low savings and high levels of debt.

Krugman is certainly correct in arguing that we should have borrowed less and saved more. He is also certainly right that its worth remembering who encouraged such irresponsible behavior. In as much as American personal indebtedness begins with student and home loans, it silly to suggest that the chorus was strictly on the right. More productive then looking back, of course, is looking forward. For example, which congressman were demanding of Bank CEOs that they lend more.

Then reality struck, and it turned out that the worriers had been right all along. The surge in asset values had been an illusion — but the surge in debt had been all too real.

More accurately: The surge in asset values was a partial function of the surge in debt. (It was also, in part, a function of the Fed's easy monetary policy.)

So now we’re in trouble — deeper trouble, I think, than most people realize even now. And I’m not just talking about the dwindling band of forecasters who still insist that the economy will snap back any day now.

For this is a broad-based mess. Everyone talks about the problems of the banks, which are indeed in even worse shape than the rest of the system. But the banks aren’t the only players with too much debt and too few assets; the same description applies to the private sector as a whole.

And as the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self-defeating when everyone tries to do them at the same time. Attempts to sell assets and pay off debt deepen the plunge in asset prices, further reducing net worth. Attempts to save more translate into a collapse of consumer demand, deepening the economic slump.

With this, I am in perfect agreement and have posted similarly here.

Its worth, in this vein, noting the effect of easy credit + leveraged buy outs on the economy. The banks did not only lend recklessly to consumers, they lent recklessly to private equity. These shops used the easy money available to buy healthy businesses, raid them of their cash, and saddle them with debt, that they are now, increasingly, unable to repay.

Are policy makers ready to do what it takes to break this vicious circle? In principle, yes. Government officials understand the issue: we need to “contain what is a very damaging and potentially deflationary spiral,” says Lawrence Summers, a top Obama economic adviser.

In practice, however, the policies currently on offer don’t look adequate to the challenge. The fiscal stimulus plan, while it will certainly help, probably won’t do more than mitigate the economic side effects of debt deflation. And the much-awaited announcement of the bank rescue plan left everyone confused rather than reassured.

If the situation is as dire as Krugman describes, why-does-he-believe-that/in-what-way-will an inadequate (and somewhat unfocused) stimulus plan will help at all?

Its also not clear to me that some deflation is not a good, or at least necessary, thing. Can prices be sustainably maintained at levels that were artificially inflated by unsustainable lending practices (and monetary policy). A little deflation might bring us closer to more sustainable price levels. Put differently: Would the economic shock and awe that the administration has planned and Krugman deems inadequate be more effective were it aimed at preserving more sustainable price levels.

There’s hope that the bank rescue will eventually turn into something stronger. It has been interesting to watch the idea of temporary bank nationalization move from the fringe to mainstream acceptance, with even Republicans like Senator Lindsey Graham conceding that it may be necessary. But even if we eventually do what’s needed on the bank front, that will solve only part of the problem.

On some level, it does, generally, seem like a government run sorting out, in which some banks a scrubbed and blessed as healthy and others are forced out of business may be the least bad option available. However politicized, corrupt and wasteful the process is bound to be, there are worse outcomes if you are left, at the end, with at least some reasonably healthy banks.

On the other hand, I think there is good reason to fear that the scrubbed, newly healthy banks, will as quickly as they can -- and with the encouragement of government -- get back into the business of making reckless loans they haven't the skill to manage. That, especially as they will be survivors of a government scrubbing, the will be far more attentive to regulator- and legislator- than risk- management.

If you want to see what it really takes to boot the economy out of a debt trap, look at the large public works program, otherwise known as World War II, that ended the Great Depression. The war didn’t just lead to full employment. It also led to rapidly rising incomes and substantial inflation, all with virtually no borrowing by the private sector. By 1945 the government’s debt had soared, but the ratio of private-sector debt to G.D.P. was only half what it had been in 1940. And this low level of private debt helped set the stage for the great postwar boom.

Since nothing like that is on the table, or seems likely to get on the table any time soon, it will take years for families and firms to work off the debt they ran up so blithely. The odds are that the legacy of our time of illusion — our decade at Bernie’s — will be a long, painful slump.

One interesting thing about Krugman -- captured above -- is the way as an economist he seems to feel some professional obligation to write accurately even while, as a partisan columnist, covering over the truth in a politicized attempt to mislead his readers.

To recognize that it was WWII that pulled the US out of the Great Depression is to acknowledge that the New Deal was fundamentally ineffective (although he no doubt believes it "certainly" helped). Branding WWII as a "large public works program" rhetorically covers over the failure of the New Deal.

Identifying WWII as a "large public works program" is, of course, more spin then reality. During WWII the economy was effectively nationalized and many people -- draftees -- were coerced into working. The implication that he would prefer to see some parrelel option on the table is a bit perverse.

More fundamentally, if it is true -- as Krugman claims -- that given time, even without coercing labor, families and firms can work off their debt and that will lift us out of our slump, its why was WWII required to lift us out of the Great Depression? It started more then a decade after the stock market crash. Shouldn't we have been able to lift ourselves out of the depression without it?

The depression of the 1930s was, of course, neither the first, and apparently not the last, depression we have experienced. Nor was it the shortest historical depression. The simple truth, covered over in Krugman's column, is that we got out previously without "large public works programs" and we can do so again.

The conservative claim, with which Krugman-the-economist apparently agrees, is that free markets are intrinsically self-correcting and regenerative. That, given the time and opportunity, free people making free choices will rebuild vibrant economies out of the carcasses of dead ones. It follows that that ham handed intrusive Government economic meddling can crowd out private initiative and dampen the regenerative process. It is easy to see that happening now. Conservatives, though not Krugman, attribute the failure of the economy to recover in the 1930s to this.

Something is On The Way

CNN "reports" Obama's foreclosure fix on the way ("reports" in scare-quotes because Obama's plan is on the way, whether or not it will prove to be a fix is, for the moment, a matter of conjecture).

NEW YORK (CNNMoney.com) -- Obama administration officials are hammering out the details of a $50 billion foreclosure prevention program that the president is set to unveil Wednesday in Arizona, sources said...

The multipart plan will for the first time commit government money to spur loan modifications. One likely component will be interest-rate subsidies for at-risk borrowers, with the government matching the servicer's rate reduction. Borrowers would have to take an affordability test to see whether they could handle the monthly payment on the reworked loan...

On deck is controversial legislation to allow bankruptcy judges to modify loans on primary residences. The financial industry is staunchly opposed to this measure, but administration officials told them last week to expect it to happen this year.

As commented here before, the reworking of debt is one of the things that the free market, ordinarily, does rather well. Incentives are, generally, aligned. Lenders want to be in the business of collecting predictable payments, not seizing and selling homes and borrowers want to live in their homes with payments they can safely afford. When economic circumstances change, markets are, ordinarily, pretty good at renegotiating debt to reflect those changes. Credit Card debt -- which is frequently renegotiated -- is a particularly good example of markets at work. There are three primary reasons why that is not happening as much in the mortgage markets as it otherwise might:

1. Mortgage securities are generally pooled and tranched. Even when renegotiation would favor the pool as a whole (i.e.: maximize the Pool's net income), it is contra the interest of the lowest tiers. Pool Managers/Servicers who do renegotiate face the threat of lawsuit by the lower tranche-holders.
2. Pool Managers/Servicers are often themselves owners of lowers tranches and so face a conflict of interest.
3. Given the -- now proven reasonable -- expectation that the Government will in the future subsidize this debt, it is generally irrational to renegotiate without subsidy.

Again, as noted here, these clogs can all be addressed reasonably without expense to the taxpayer.

1. Pass laws to protect Pool Manager/Servicers who renegotiate from lawsuit.
2. Pass conflict-of-interest laws, to ensure that Pool Manager/Servicers are not beholden to the interests of a particular tranche.
3. Make explicitly clear that no subsidies will be forthcoming.

One has to take a pretty dim view about the efficacy of markets to believe that this can't be sorted out without political or judicial intervention. If markets can't do this, what can they do?

Judicial modification is a particularly hard to understand policy. Without Judicial modification, modification is by negotiation. Lenders, generally, will agree to modifications that they believe maximize their expected revenue, which is to say, turn a more expensive loan which the borrower is less likely to be able to repay into a less expensive loan which the borrower is more likely to repay. With Judicial modification, Judges can force modifications that lenders do not feel will maximize their expected revenue. In as much as we face a national crisis of under-capitalized banks -- we are told that our financial system would have collapsed without TARP providing public capital to banks; "Swedish" style plans where the Government acknowledges the general under-capitalization, seizes bank assets and sorts out winners and losers are increasingly considered -- it is hard to understand how the public interest lies in policy like this that will, above all, serve to reduce bank capital. In as much as we are being told only the government can get credit flowing again, its odd to see the same government pursuing policy which makes lending less attractive.

The $787 billion stimulus package set to be signed into law Tuesday increases the loan limits for mortgages insured under the Federal Housing Administration, as well as those that can be bought by Fannie Mae and Freddie Mac, to as much as $729,500, up from $625,500. The higher limit, which was in effect last year, is designed to help those with larger mortgages refinance into more affordable loans and to make it easier for people to purchase homes in high-cost areas.

To spur home sales, first-time buyers will get a tax credit worth up to $8,000 on their 2008 or 2009 taxes, under the stimulus package. The credit starts to phase out for buyers who make more than $75,000 for singles or $150,000 for couples. This measure, which builds on a tax credit enacted last year, is intended to help soak up the inventory on the market, which is also depressing home values.

There is, perhaps, some sensible argument along the lines of "We have all this bad debt in the system that needs to work its way out quickly, Government can facilitate that happening quicker." It is hard for me to understand arguments for shoveling new soon-to-be-bad debt -- encouraging people with less money to buy more expensive homes -- in the system.

Nationalization via Regulation

The Times published an article about how Bank credit decisions are hurting some businesses. In between the lines is who is making the decision:

...until recently, banks had largely chosen to keep past-due borrowers afloat, in the hope that a housing recovery might pave the way for them to repay their debts in full.

Only now, with the economic outlook darkening, are lenders stepping up foreclosures of troubled loans. Zelman & Associates, a housing analysis firm, estimates that losses on land and construction loans could eventually reach $165 billion, one reason federal regulators are pushing banks to come to grips with the problem.

“When we talk to regulators now, they say they’ve lost patience,” said Ms. Zelman, who is chief executive of Zelman & Associates.

There may be times and places where the regulator-as-coach is more appropriate then the regulator-as-referee, and the current crisis may well be one of them. On the other hand, this approach to financial service regulation well pre-dates the current crisis. It is also worth recognizing that the regulator-as-coach, more or less, amounts to nationalization.

On a related note, [Richard] Parsons to become chairman at Citigroup.

Citigroup's board has been the target of much scrutiny among investors for allowing the bank to invest so heavily in the risky housing market.
As that criticism escalated over the past several weeks, so did speculation that Parsons - one of the only directors with experience in both banking and leading a large company - would become chairman.

Before helping negotiate Time Warner's merger with America Online in 2000 and serving as the new company's CEO and chairman, Parsons was chief executive and chairman of Dime Bancorp, a thrift bank, in the early 1990s.

Parsons was also an economic adviser on President Barack Obama's transition team.

As the AOL merge was disastrous for Time Warner, Parson's service to President Obama, as opposed to his private sector accomplishments, likely drove this choice.

Risk and Regulation

The Times has a good article about RISK Mismanagement. Between the lines, it well illustrates the dynamics by which ill-concieved financial service regulation worked against the health and stability of the financial system.

There are many such models, but by far the most widely used is called VaR — Value at Risk... one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class... Another reason VaR is so appealing is that it can measure both individual risks — the amount of risk contained in a single trader’s portfolio, for instance — and firmwide risk... Top executives usually know their firm’s daily VaR within minutes of the market’s close.

Risk managers use VaR to quantify their firm’s risk positions to their board. In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors, and VaR became the main tool for doing so. Around the same time, an important international rule-making body, the Basel Committee on Banking Supervision, went even further to validate VaR by saying that firms and banks could rely on their own internal VaR calculations to set their capital requirements. So long as their VaR was reasonably low, the amount of money they had to set aside to cover risks that might go bad could also be low.

The intent of the regulators was sensible enough. Firms ought to report risk exposures to investors. Banks with riskier investments ought maintain larger capital cushions. In the end, however, attempts to enforce these good ideas with regulation are almost intrinsically problematic because risk is a rather difficult thing to quantify simply and objectively. There is almost willful oblivious-ness in coming up with a single number and blessing it as a functionally complete and objective measure of risk. But the bureaucracies -- large-firm management and the regulatory agencies -- required such a number.

Tangentially, its worth making explicit what is inherently put at stake by the notion that risk can be quantified simply and objectively: Were that true, free markets would be of limited practical value, and command economies would be the order of the day.

...Taleb, a trim, impeccably dressed, middle-aged man — inexplicably, he won’t give his age... He also went from being primarily an options trader to what he always really wanted to be: a public intellectual. When I made the mistake of asking him one day whether he was an adjunct professor, he quickly corrected me. “I’m the Distinguished Professor of Risk Engineering at N.Y.U.,” he responded. “It’s the highest title they give in that department.” Humility is not among his virtues. On his Web site he has a link that reads, “Quotes from ‘The Black Swan’ that the imbeciles did not want to hear.”
...
“Why do people measure risks against events that took place in 1987?” he asked, referring to Black Monday, the October day when the U.S. market lost more than 20 percent of its value and has been used ever since as the worst-case scenario in many risk models. “Why is that a benchmark? I call it future-blindness.

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” he asked. “He is not going to have a magnificent flight. Any small error is going to crash a plane. This is why the crisis that happened was predictable.”
...
Eventually, though, you do start to get the point. Taleb says that Wall Street risk models, no matter how mathematically sophisticated, are bogus; indeed, he is the leader of the camp that believes that risk models have done far more harm than good. And the essential reason for this is that the greatest risks are never the ones you can see and measure, but the ones you can’t see and therefore can never measure.


There is something almost explicitly svengali about this Taleb; His ultimate claim -- Risk models are imperfect, ergo, they are useless -- is more theatrical then intelligent. (Tangentially, his argument mirrors that of a former manager of mine against using unit tests).

On the other hand, the pilot analogy touches on a key point. What he describes -- any small error crashing the plane -- is a system that is not robust. Systems are not made robust by meditating over the un-imagineable. They are made more robust, in the first instance, by being made more adaptable, in the second instance, by incorporating lessons learnt-the-hard-way and, above all, by redundancy. Its not difficult to demonstrate how ill-concieved well-meaning attempts at financial service regulation often -- by adding rigidity and introducing centralized points of failure -- make the system more brittle. And the lessons-learnt by politician-regulators are often different then those of market participants.

...The Securities and Exchange Commission, for instance, worried about the amount of risk that derivatives posed to the system, mandated that financial firms would have to disclose that risk to investors, and VaR became the de facto measure. If the VaR number increased from year to year in a company’s annual report, it meant the firm was taking more risk. Rather than doing anything to limit the growth of derivatives, the agency concluded that disclosure, via VaR, was sufficient.

That, in turn, meant that even firms that had resisted VaR now succumbed. It meant that chief executives of big banks and investment firms had to have at least a passing familiarity with VaR. It meant that traders all had to understand the VaR consequences of making a big bet or of changing their portfolios...

...All over Wall Street, VaR numbers increased, but it still all seemed manageable — and besides, nothing bad was happening!

The primary job of the SEC, of course, is not to protect the stability of the financial system (for example, by limiting the growth of derivatives), but to protect investors. In mandating the publication of VaR, it actually suceeded to the degree that investors were informed about the increasing riskiness of their investments.

The question, then, is why investors were not concerned. I believe it can be easily argued that regulations intended to make investment easier and safer, to protect investors not just from fraud, but from research and dilligence, have the effect of dumbing down investors, and so reducing their ability to over-see the companies they own.

The way, in the end, VaR analyis owes its universal adoption to regulations illustrates a crowding out effect. I interviewed in the credit risk department of a large -- relatively unscathed -- bank in march 2007. In one of my conversations we talked rather explicitly about the limitations of the sorts or risk numbers people threw around, but also, how regulatory requirement (Basel II above all), sort of forced banks to spend resources on risk analysis they understood to be less then useful, that could have been better allocated to more useful analysis.

Which gets to some core problems with the current conception of regulation. If a regulator is better then a private firm at managing risk, then that firm ought not be in business. And if the firm is better, then the regulator ought not be telling it how to manage risk.

Further, this is an example of how regulation can introduce single points of failure (in this case: a flawed risk management practice) into a system.

In a crisis, Brown, the risk manager at AQR, said, “you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people’s intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic.”

This hits the nail on the head. Which is to say, VaR is a wonderful tool, with great utility in certain contexts (peacetime), but it is not a one-size-fits-all measure of risk. That some people viewed it as such says more about those people then it does about the tool.

And I think the frame-of-mind of those people is a key point here. If you are a "Risk Manager" in a giant bank, responsible for controlling risk across a mind-boggling array of products and activities, you need simple numbers. All the more so, if you are a regulator with responsibility across a whole economy. This is the black hole at the heart of the system. The choice between coming up with "God-Blessed" (to use a term loved by a Risk Manager I once worked with), if not-entirely-meaningful, numbers or throwing one's hands in the air.

Which is not to say that risk cannot be managed, only that risk management doesn't scale well. Or, rather, that it needs to be re-concieved as it scales. Which is to say, government regulators should be more concerned about, for example, structural risks like mis-aligned incentives, or the existence of firms too big to fail, then with how individual firms manage risk.

...the big problem was that it turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guldimann calls “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge.

This is a really interesing angle that I had not recognized. The danger, in setting rules, is that they always have unintended consequences. The more universal a rule, the more dangerous those consequences.

Overheard On CNN

Around 10:15, CNN's Chief Business Correspondent Ali Velshi on AC360 explaining the details of Obama's planned stimulus plan:

...Here's the surprise, up to 40% of it ($300 Billion) is going to go toward tax cuts... They divide up between individual and business tax cuts... [the business tax cuts are] maybe not a bad idea. But tax cuts for individuals tho, Anderson, it didnt work last time around, if it did, last spring, we wouldn't be in a recession...

That analysis is almost too silly to comment on. Its fascinating to me that CNN has learned to love tax cuts for businesses while warning their viewers of the futility of individual tax cuts.

Which, puts me in the odd position of sort of agreeing with CNN. As a political matter, I don't love business taxes since they decrease transparency. Corporate taxes are borne, in differing measures, by customers, employees and shareholders. Who precisely bears how much of a corporate tax is near impossible to measure. Its a way, therefore, of taxing people on the sly. To believe that government ought to be open and transparent is to be biased against corporate taxation.

LTCM Post Mortem

Column in the nytimes argues Bailout of Long-Term Capital: A Bad Precedent?

THE financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad.

Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

The notion that if only the Fed had not organized negotiations that led to a private consortium -- composed primarily of large LTCM creditors -- bailing out LTCM creditors, we would have been spared the excesses of the past few years is far from persuasive.

On the other hand, the more commonly held take-away -- that the LTCM near-disaster demonstrates the need for more hedge fund regulation -- is, to my mind, no more sensible.

The facts of the LTCM near-disaster were these: The heavily regulated pillars of our financial economy lent far more money then prudent to an unregulated high risk small business. The unregulated high risk small business failed, threatening the well being of its pillars-of-our-financial-economy creditors and, by extension, the broader economy. In effect, an orderly bankruptcy was negotiated.

It takes a certain narrow minded-ness to take away from that scenario the conclusion that particular high risk small businesses need to be regulated. A more sensible observer would be more afraid of the overly-risky loans the heavily regulated pillars of our financial economy were apparently making that put our economic well-being in jeopardy.

The most sensible course of action then -- and the one that could have safely averted our current crisis -- would have been to rethink banking regulation in light of its failure.

What this argues for now, as our fearless leaders dream up a financial regulation Patriot Act, is to remember that regulation works best when its results (effectiveness/cost) are carefully monitored.

Far more persuasive from Professor Cowen:

The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.

John Maynard Keynes famously proclaimed that “in the long run we are all dead.” From the vantage point of 1998, today is indeed the “long run.”

We’re not quite dead, but we are seriously ailing. As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next “long run,” too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.


One Last Madoff

HFN reports on the rumors flying around madoff

Doubt centered on the mathematical unreality behind his investment performance. The trading system he claimed he used could not produce the data he reported. Did the broker-dealer arm of his investment business furnish Madoff with inside information? What was so earth-shattering about his trading technique that he had to keep it a complete secret? That uncertainty was enough to dissuade the Wall Street elite from throwing in with Madoff.

What this touches on is a piece of delicious, if tragic, irony. While most Madoff investors were likely as innocent as an ignorant investor can be, others were surely sophisticated enough to recognize the "mathematical unreality behind his investment performance." Some, too smart for their own good, suspected that Madoff was leveraging his broker dealer business to trade in inside information, and, therefore invested in him to get in on the scam, unsuspecting that they were not eating, but being eaten.

Madoff

Why the SEC Missed Madoff’s Con


Bernard Madoff's firm managed $17.1 billion in assets, he declared this past January in his investment adviser filing with the SEC. He also checked the box showing that he had between one and five employees who performed investment advisory functions, including research, at the firm.

"That's unheard of," Peter Henning, a former SEC attorney and prosecutor, told ProPublica. "You wouldn't have a mutual fund run by one person. You have to have someone out there doing the research."

But there's no evidence that anyone paid much attention to the filing. According to reports, the SEC never inspected Madoff's firm, which first registered as an investment adviser in September 2006. That's despite years of suspicion of Madoff's remarkably consistent returns.

One whistleblower, a former exec at a rival firm, wrote the SEC as early as 1999 to warn that Madoff was running the "world's largest Ponzi Scheme." He repeated his warnings to the SEC through this past April. There were other critics and naysayers, including a 2001 article in Barron's questioning Madoff's unrealistically consistent returns.

The inspection likely never happened, the Washington Post reports, because the SEC "does not have the resources to examine investment advisers on a regular schedule." Instead, they target certain firms that use high-risk investment strategies -- and Madoff's didn't fit the profile. It also didn't hurt that he was a prominent fixture on Wall Street, a former chairman of the Nasdaq stock exchange. Only 10 percent of the 11,300 investment advisers registered with the SEC are examined on a regular basis, an SEC official tells the Post.
...
If the SEC had taken a look at Madoff's investment adviser business, a number of red flags might have warned them of the scheme. There's the lack of staff, as we noted above. There's also Madoff's auditor -- a shoestring operation run out of New City, N.Y. A "former SEC enforcement official" tells the Post that there are only a few accounting firms with the sophistication to audit an investment adviser of Madoff's size.

But the SEC didn't follow up on the complaints and suspicion. One reason, Henning said, might be the lack of any complaints from any of Madoff's clients. "One of the things you look for is a victim. That was the brilliance of what Madoff did. Everyone was making money so no one complained." The sheer scope of the fraud might have also been beyond imagining. "No one ever looks for a $50 billion Ponzi scheme. What he did is anything short of amazing."

In the SEC's defense, regulatory gaps kept Madoff off the radar screen for most of the years that he operated...


Calls to beef up the SEC's authority and staff are a natural response now. But I think, with some further reflection, they are misplaced.

It seems clear, in retrospect, that there were bright red flags around Madoff (in particular, the lack of respectable auditor), and that thoughtful investors would have steered clear of him. Investors who didn't were, simply (if understandably), greedy -- they looked at his returns and wanted in. This is not to understate, or ignore, the human tragedy, only to face the reality. The question, then, is, whether blinded-by-greed investors ought to be subsidized by taxpayers. Which, frankly, is what is being called for.

Instead of spending hundreds of millions to beef up the SEC, why not simply prepare an informational pamphlet for potential hedge fund investors, with useful factoids like "Be wary of investing in funds without respectable auditors" or "Be wary of investing in funds whose investment process and strategy, you do not understand" and the #1 rule, which tragically too many people ignored "Never ever put all your eggs in one basket"?

Tangentially, this also illustrates how optimistic it is to expect government regulators to provide sensible oversight. It seems like the SEC employed a fundementally flawed heuristic for determining the riskiest funds to target. I think more thoughtful regulators would have recognized that "shoestring auditors" was a brighter red flag then nominally "high risk investment strategies". On the contrary, it seems evident to me that a fund engaged in fraud would not advertise itself as pursuing a high risk investment strategies.

In the end, this is just the latest sign that, as a society, we are rapidly losing any trace of personal responsibility or accountability. That the question we are asking is "How did the SEC miss this?" rather than "Why are people suprised that an opaque investment with shyster auditors turn out to be a fraud?"