Baseline Scenerio

Am in Canada and was out of touch for a couple of days. May be again as more vacationers come up to choke up the bandwidth.

The Baseline Scenario
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
How to Sell Toxic Waste
You Don’t Get a Vote!
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
Posted: 15 Jun 2009 05:17 AM PDT
Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.
Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.

Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator.

Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.

Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors.

Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.

Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.”

Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.

Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.

And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.

Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.
By Simon Johnson

How to Sell Toxic Waste
Posted: 15 Jun 2009 05:00 AM PDT
One point I’ve made a couple of times is that complex structured financial products are sold, not bought. If you want to see how they are sold, check out Zero Hedge’s post on the lawsuit brought by those same Wisconsin school districts that were the subject of the Planet Money/New York Times feature back in November. The second attachment is the Stifel Nicolaus PowerPoint presentation used to sell those school districts a levered bet on a AA- tranche of a synthetic CDO.
It really takes you back to 2006, doesn’t it?
By James Kwak

You Don’t Get a Vote!
Posted: 14 Jun 2009 09:48 PM PDT
Barack Obama came to office as the conciliator, the bipartisanizer, the anti-Bush. But this is going too far.
The administration’s style has been to float policy proposals in public, listen to the responses (from other politicians, from the private sector, and from the blogs that Obama does not read), and adjust accordingly. When it comes to the financial regulation proposal that Tim Geithner is scheduled to deliver on Thursday, there may be little left after all the adjusting.
We heard last week that the initial plans to consolidate regulatory agencies have been scrapped, with the exception of closing the hapless Office of Thrift Supervision. Now The New York Times has a story that is ostensibly about the feud between John Dugan, the Comptroller of the Currency (and regulator of many large national banks), and Sheila Bair, head of the FDIC, but is also about the compromises that have dictated the administration’s regulatory plan.
The Treasury secretary, Timothy F. Geithner, the main author of the administration’s plan, in recent weeks has refereed among the competing views of Ms. Bair, Mr. Dugan and Ben S. Bernanke, the Federal Reserve chairman. . . .
With the administration and crucial lawmakers rejecting a single agency, the four officials have often disagreed on just how to streamline and strengthen regulation. Some points of contention include views on which agencies should play central roles in overseeing financial companies whose troubles could pose problems for the overall system, and whether to create a new agency to protect consumers from abusive mortgages or credit cards.
Officials say the latest version of the plan, in large part, is a compromise of various viewpoints.
I don’t want to get into the merits of these issues here. But when you are reforming the regulatory structure of an industry where the existing regulators got it horribly, embarrassingly, catastrophically, world-historically wrong, the last thing you want to do is strike a compromise between the positions of the existing regulators. Members of Congress get votes, and they already have enough ties to the banking industry to worry about; letting the regulators, who don’t have votes, shape the deal makes it more likely that the final result will be watered down into nothingness. Which, of course, is exactly what the industry wants:
Most of the banking industry couldn’t be happier with the current system. Bank executives and lobbyists say that the system, while flawed, enables regulators to tailor rules for a variety of financial institutions.
I know that it’s not as simple as saying that regulators don’t have votes, because they certainly have allies that do have votes, and they have allies who give money to the people who have votes. But the underlying problem is that somehow the Obama Administration managed to back itself into a corner where it had no one but the existing regulators to turn to. Geithner, Bernanke, Dugan, and Bair were all manning the ship when it hit an iceberg, and only Bair can claim that she arrived late enough not to share in the blame. (Bernanke, though he became chairman of the Fed only in 2006, was on the board of governors from 2002 and then was head of the Council of Economic Advisors.)
Shouldn’t someone with an independent perspective have been charged with this task? Paul Volcker, whom we heard so much about during the transition? Warren Buffett, whose name Obama liked to use on the campaign trail? Austan Goolsbee? Christina Romer? What happened to the best and the brightest?
All I can think is that Obama basically doesn’t think that financial regulation is that important. Or he thinks that the existing system is close enough. Or he figured that Congress would have the final word, anyway.
Or maybe Larry Summers will pull a rabbit out of his hat since, according to the Times, he is in charge anyway. While I have criticized his anti-regulatory positions of a decade ago, by his reputation – brilliant, strong-willed, etc. – I would expect more from him than from the bank regulators who helped bring us the crisis.
By James Kwak

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