Baseline Scenario

(c) 2009 F. Bruce Abel

More excellencies from Simon Johnson and Baseline Scenario, on what to do with the Big and the Bad Banks. And more:

The Baseline Scenario
The Problem at Moody’s
The Consensus On Big Banks Begins To Move
Revisiting the Crime Scene
The Problem at Moody’s
Posted: 21 Oct 2009 04:00 AM PDT
Kevin Hall of McClatchy has an article about Moody’s that goes beyond the usual — giving AAA ratings to products “structured by cows” and taking money from the cows (actually, the “cows” comment was from S&P). He documents how Moody’s forced out executives who questioned the lax rating policies, replaced them with executives from the structured finance division, and filled its compliance division with people from that same division.
In this week’s column at The Hearing, we discuss this as an example of a common tension within businesses — between the revenue-generating side of the business and the people responsible for product quality. The problem is that in the short term, you can maximize revenues by cutting corners on quality, but in the long term, cutting those corners can come back to hurt you. Or it can hurt your customers. Or the whole economy, as it turns out. Unfortunately, however, there is no particular reason to believe that companies will resolve this tension in a way that is good for them in the long term, let alone the economy.
By James Kwak

The Consensus On Big Banks Begins To Move
Posted: 21 Oct 2009 03:09 AM PDT
Just when our biggest banks thought they were out of the woods and into the money, the official consensus in their favor begins to crack. The Obama administration’s publicly stated view – from the highest level in the White House - remains that the banks cannot or should not be broken up. Their argument is that the big banks can be regulated into permanently low risk behavior.
In contrast, in an interview reported in the NYT this morning, Paul Volcker argues that attempts to regulate these banks will fail:
“The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company.”
Volcker may not have the ear of the President (as the NYT points out), and Alan Greenspan – also arguing for bank breakup, but along different lines – might also be ignored. But watch Mervyn King closely.
Mervyn King is governor of the Bank of England and a hugely influential figure in central banking circles. Time and again he has proved to be not only ahead of his peers in terms of thinking about the latest problems, but also the person who is best able to frame an issue and articulate potential solutions so as to draw support from other officials around the world.
Mervyn King also does not mince words. In a major speech last night, he said, “Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.” (full speech)
He hits hard (implicitly) at the White House’s central idea on large banks: ”The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion”. And he lines up very much with Paul Volcker’s views – breaking up big banks is necessary, doable, and actually essential.
Remember and repeat this Mervyn King line: ”Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”
The big banks will push back, of course. But Mervyn King’s words mark the beginning of a new stage of real reform; the consensus starts to crack.
By Simon Johnson

Revisiting the Crime Scene
Posted: 20 Oct 2009 05:25 PM PDT
Mike Konczal has a post featuring the Grayson/Clay/Miller amendment to the current Consumer Financial Protection Agency proposal. The basic idea is that the agency would be required to do a periodic, statistical analysis to identify those financial products that were most implicated in causing bankruptcies and foreclosures in each state. The CFPA would then have to announce what these products are and who sold them, and could then take corrective action to restrict those products.
This reminds me of something that Andrew Lo said in his Congressional testimony back in November, of which I’ve discussed other aspects in the past. Lo recommended creating a Capital Markets Safety Board modeled on the National Transportation Safety Board:
“[T]he financial industry can take a lesson from other technology-based professions. In the medical, chemical engineering, and semiconductor industries, for example, failures are routinely documented, catalogued, analyzed, internalized, and used to develop new and improved processes and controls. Each failure is viewed as a valuable lesson, to be studied and reviewed until all the wisdom has been gleaned from it, which is understandable given the typical cost of each lesson.
“One successful model for conducting such reviews is the National Transportation Safety Board (NTSB), an independent government agency whose primary mission is to investigate accidents, provide careful and conclusive forensic analysis, and make recommendations for avoiding such accidents in the future. In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough investigation, including interviewing witnesses, poring over historical flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder or ‘black box’ and, if necessary, reassembling the aircraft from its parts so as to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a report summarizing the team’s investigation, concluding with specific recommendations for avoiding future occurrences of this type of accident. The report is entered into a searchable database that is available to the general public (see http://www.ntsb.gov/ntsb/query.asp) and this has been one of the major factors underlying the remarkable safety record of commercial air travel.”
Lo was talking more about financial crises than about individual bankruptcies, but the analogy still holds. If a regulator notices that a lot of people are dying in a particular kind of accident in a particular kind of car, it will investigate to find out what is going on.
Now, the statistics could actually be a bit tricky. It’s entirely possible that the most toxic products on the market will not be the ones that are involved in the most bankruptcies and foreclosures. Most bankruptcies are (I believe) caused by illness, job loss, or divorce, which strike people independently of whatever mortgage they happen to have. If we just count up the mortgages of people who go bankrupt, we might find that more had 30-year fixed mortgages than had option ARMs, simply because more people in general have 30-year fixed mortgages than option ARMs. But for now I will make a bold assertion that these statistical problems could be addressed — it doesn’t seem like the world’s most complicated model to estimate.
The Grayson/Clay/Miller amendment attempts to sidestep the banking industry’s main contention, which is that the CFPA will have a “chilling” effect on financial innovation. It also plays a kind of “sweeper” position (”free safety” is the American football metaphor) in that it can catch products that do not on their face seem all that bad, but turn out to be homewreckers later. The common-sense argument for it is that no one could reasonably oppose a provision that simply asks the CFPA to investigate existing problems and clean up after them. Still, the industry will no doubt come up with arguments against it. That, at least, is what Felix Salmon assumes, reading the overall trends.
By James Kwak