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This one is good! The Mystery of Capital

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The Mystery of Capital
The VC Tax Break
Focus On This: Merkley-Levin Did Not Get A Vote
The Mystery of Capital

Posted: 21 May 2010 09:05 AM PDT

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

The administration’s argument, as mentioned above, is that these kinds of rules should be negotiated internationally, not set by Congress, which is overly political. But as Bloomberg pointed out earlier this week, international negotiations are nothing if not political. And as Konczal highlighted, the administration is also taking the banks’ side in the international arena.

The Collins Amendment wants to make basic capital requirements simpler, with the option of adding more complex requirements on top (“shall serve as a floor for any capital requirements the agency may require”). Opponents want regulators to have as much discretion as possible. I think it’s important to have a simple floor, because discretion and complexity are just a way of fooling ourselves into thinking we can measure something that is inherently unmeasurable.

A while back, Steve Randy Waldman weighed in on bank capital requirements. He goes much further and deeper than Simon and I did in our article about capital requirements. “Bank capital cannot be measured,” he says. His point is both practical and epistemological.

On the practical side, look at Lehman: it was well capitalized on paper right before it collapsed, and then a few days later it had negative equity of at least $20 billion. (And it wasn’t because of some fire sale, Waldman explains.)

Here’s the epistemological side (the part I like the most):

“Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . . Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital.”

This is a point that I think is often lost. People talk about capital like levees to protect against a flood, but it’s like levees that you can’t see and measure, only guess at. Capital is probabilistic, so it’s only as dependable as your ability to assess those probabilities.

And, of course, with banks the errors always come out the same way — overstating capital:

“For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the ‘option value’ of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.”

And here’s Waldman’s conclusion: “We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.”

Ultimately, capital requirements alone are not the answer. But as long as we’re going to base our banking regulation on them, we should make them as resistant to definition error and measurement error as possible.





The VC Tax Break

Posted: 21 May 2010 07:47 AM PDT

By James Kwak

The House of Representatives is considering a bill that would change the tax treatment of venture capitalists’ income (and that of private equity fund managers as well). Currently, VCs typically are paid “2 and 20″ — that is, an annual fee of 2 percent of assets, plus 20 percent of profits. For example, let’s say a fund starts out with $200 million. Most of that money is invested by the fund’s limited partners — pension funds, endowments, insurance companies, the usual suspects. After ten years (roughly the average life of a VC fund), the investments made by the fund are now worth $400 million — a pretty humdrum return of 7 percent per year (before fees). The venture capitalists themselves will earn about $14 million ($200 million x 2% x 7 years)* plus $40 million (20% x ($400 million – $200 million)) equals $54 million. (Note that they earn that $40 million even for doing worse than the stock market’s long-term average return.) The limited partners get what’s left over after those fees. And before you start crying for the VCs, remember that a typical VC firm will have multiple VC funds going at once.

Right now, the $14 million is taxed as ordinary income, but the $40 million is taxed as capital gains — that is, at a tax rate of 15%. The bill would tax the $40 million as ordinary income (actually, 75% as ordinary income and 25% as capital gains), for an effective tax rate of about 35%.

The current tax treatment has never made sense to me. The lower rate on capital gains is supposed to provide an incentive for capital investment.** This is why, if you buy stock and sell it more than a year later, you pay tax on your gains at a lower rate. So clearly the actual investment returns on money invested in the VC fund should be treated as capital gains — but not the VCs’ 20 percent fee, since that’s compensation for fund management services, not returns on their investment. (VCs typically invest their own money in a fund, but it is only a small fraction of the whole, and no one is debating how that money should be treated.)

One argument I’ve heard is that the 20 percent comes out of the capital gains of the fund itself, so it should be treated as capital gains. But that’s nonsense. If the limited partners got to keep it, it would be capital gains. Once they pay it to the VCs, it becomes an investment expense for the limited partners and a performance bonus for the VCs.

Gerry Langeler, a venture capitalist, made a valiant effort to defend his tax break in the New York Times, but his arguments are so full of holes I wonder if even he believes them.

He starts off trying to equate the VCs’ 20 percent to the profit a homeowner makes on the sale of his house.

“If you buy a house and take out a mortgage, you usually put a small percentage down, with the bank carrying the balance. To keep the math simple, say the house costs $200,000 and you put down $20,000. Ten years later, if you sell the house for $300,000, you have a gain of $100,000 on that $20,000 investment. It is taxed as a capital gain because your capital was locked up for a prolonged time, there was a material risk of loss and the gain was not ‘guaranteed’ to you for just showing up every day, the way a salary is. You used the bank’s capital as leverage on your $20,000 investment, but that does not matter from a tax standpoint. Neither does the fact that you worked around the house over those 10 years to improve its value.

“Now, let’s compare that with carried interest in a venture capital partnership. We in the industry invest a small percentage of the total dollars in our partnerships, like the house purchase above, with our limited partners investing the rest. Our investments are locked up for prolonged periods of time, often five to 10 years before we see any return. There is a real, material risk of loss of capital. In fact, many venture funds in the bubble lost money, including partners’ capital. Like the house situation, our downside loss potential is ‘fixed’ by what we invested, while our upside is unbounded.

“We do a lot of work ‘around the house’ to help our start-up companies grow. Our investors get their return on the profits we make. For those investors that are taxpaying entities, they pay tax on the gain at capital gains rates, just as they would if they had invested in a home. No one is proposing to change that tax treatment.

“If there is a profit on the entire partnership, then and only then do we as managers of those partnerships get our carried interest — usually about 20 percent of the total profit. That carried interest is delivered in the form of stock in those start-ups, stock that has been held for 5 to 10 years. Unlike our salaries (rightly taxed as ordinary income), the carried interest is not guaranteed by our just showing up, and it is only delivered if a long-term gain in the form of capital is created.

“Carried interest in a partnership bears a striking resemblance to our personal ‘carried interest’ in our homes.”

This argument ignores the difference between equity and debt. When you buy a house, your mortgage is debt. You are in the first loss position. When a VC puts some of his own money in his fund, that’s equity; it’s on an equal footing with the limited partners’ money, and they share losses proportionally. Investment gains on that money — the VCs’ actual investment in the fund — are already treated as capital gains; it’s the 20 percent we’re talking about here. Saying that a VC is “leveraging up” his investment in his fund with LPs’ money is nonsense. If Gerry Langeler really wants to put in all the equity in his VC fund and borrow the rest from investors — well, good luck trying to find people who will lend 90 or 95 percent of the money in a VC fund. If that’s what he’s doing, he’s getting 100 percent of the profits after servicing his debt, not 20 percent; that’s what owning all the equity means.

More fundamentally, even if the return profile of carried interest has a resemblance to the return profile of buying a house, that doesn’t make it capital gains. The fact that there’s risk involved doesn’t make something capital gains; if that were the case, then banks could start paying long-term bonuses (based on multiple years’ work) and calling that capital gains. The fact that the upside is unlimited doesn’t make something capital gains; if that were the case, then sales commissions would be capital gains. The fact that there’s downside . . . wait, there is no downside. If the fund loses money, the VCs don’t make up 20 percent of the losses to the limited partners. Their downside is restricted to their direct investment in the fund.

The second argument attempts to equate VCs to founders.

“In another example, closer to home, say an entrepreneurial team starts a business and raises money from venture capitalists. Those entrepreneurs pay ordinary income taxes on their salary (of course), but any gains on their stock — generated by leveraging our money and our help, as well as their hard work — are taxed as capital gains.

“The powers in Washington say that one rationale for taxing venture capitalists’ carried interest as ordinary income is that this is a ‘fee for service’ situation. But how is that different from an entrepreneur’s founders stock? He or she is being compensated based on the wealth created by direct labor. If ours is now a fee for service, then so is that of the entrepreneur. Can you imagine the uproar about stifling company formation and job growth if Congress suddenly chose to double the tax on entrepreneurs in this country?”

Again, Langeler can’t tell the difference between a founder and an investor. To start off, what does it mean to say that founders are “leveraging our money”? The concept of leverage only applies to debt. VCs invest by buying convertible preferred shares, which are a form of equity, not debt.*** They are buying a share of the company, and they get all the upside on that share. That’s not leverage. Seen purely from the standpoint of the capital structure, VC investments dilute the founders. Granted, the company is getting something valuable — cash — in exchange for that dilution. But it’s giving up some of the upside. That’s the opposite of leverage.

And if Langeler doesn’t know how VCs’ carried interest is different from founder stock, he doesn’t know how his business works. It typically works like this. At time zero, the founders decide to start a company and do some work. At time one, which could be the next day, they actually create the company and they invest all of the capital. At this point, they own the whole thing. And they keep working. From that point forward, the founders are compensated for their labor through their salaries, which are taxed as ordinary income. (And in most cases, the founders either pay themselves no salary or a considerably below-market salary for several years.) Someday they may sell their founder stock for a large gain, but they got that stock because they owned the company to begin with.

At time two, the VC fund comes along and buys a piece of the company. As part of that deal, one of the VCs gets a seat on the board of directors. At that point, he has a fiduciary obligation to act in the best interests of all of the shareholders. Any work he does for the company is in that capacity. He is working for the investors in the company. The limited partners want this, because if they’re going to put their money in a company, they want someone they trust (the venture capitalist) watching over that company. So the VC on the board is acting directly as a fiduciary for the shareholders and indirectly as an agent of the limited partners. That is why the LPs are willing to pay him 20 percent of the profits. The fact that it’s 20 percent of profits, rather than an amount that’s fixed up front, makes it a bonus, and bonuses are always taxed as ordinary income; it doesn’t make it a capital gain.

The compensation for both the work Langeler does as a board member and the work the founders do as employees should be taxed as ordinary income. Langeler wants the compensation for his work as a board member to be taxed the same way as the appreciation on the founders’ initial ownership share in the company. That’s not apples and oranges; that’s apples and chartreuse.

Langeler continues:

“The gains of the limited partner investors in the stock owned by venture capital partnerships are taxed as capital gains. The gains by entrepreneurs on their stock holdings are taxed as capital gains. Under the new proposal, the only people taxed as ordinary income on the capital wealth created in that start-up would be the venture capital partners themselves.”

Um, right. That’s because the VC partners didn’t invest any of the capital.****

And it’s worse than that. The last sentence in that excerpt is an insult to anyone who ever worked at a startup company but who was not a founder. Many early stage employees contribute much, much more to the “capital wealth created in that start-up” than any VC. For Langeler, they don’t even exist.

(There’s a similar but better argument made by Bill Burnham a few years ago: that the 20 percent is compensation for the venture capitalist’s “sweat equity” for helping the company. But if you’re going to make that argument, I don’t see how you avoid acknowledging that founders also invest “sweat equity” beyond their actual capital contributions. Like the VCs, they own stock that everyone agrees should be treated as capital gains, and then they do some work. Why is the VCs’ work any different from the founders’ work? Especially when you consider that founders–and most early employees–are making considerably less than their opportunity costs, and hence their risk extends beyond their initial capital investments.)

There’s more, but I’ll stop there. Really, I have nothing against the VC industry. I regularly cite venture capital as one of the best parts of the financial system (and one that does not rely on anything that could be called “financial innovation”), my former company would not exist without VCs, and many of them are smart, hardworking people who have contributed greatly to the economy. Some VCs (well, one at least) are even in favor of the proposed tax change. The treatment of carried interest as capital gains is by no means the biggest problem with our tax code. I might be able to live with it if the argument were simply, “VCs are good, and this special perk is intended to provide an incentive for them to do what they do” (Daniel Shaviro thought about this line of argument, but wasn’t particularly impressed).

In short, I wouldn’t even have bothered with this post. Except that duty called.

* This isn’t quite right, because the $200 million is a capital commitment that gets drawn down, and the 2% fee is probably assessed on current asset value, not initial fund size, but this we’re not discussing this part of the fee here.

** I don’t actually this is a good idea to start with. The premise is that people are irrationally conservative when it comes to preservation of capital. and hence you have to provide an incentive for them to put their capital at risk. But even if you accept that premise, the better solution is allow full refundability of losses — meaning that you get to take a tax deduction for all of your capital losses. That solves the problem more directly, since it provides a benefit in the state of the world that people want to be protected against, and it is less distorting. In any case, the effect of the lower capital gains tax rate is to lower taxes for rich people, since they are the ones with capital gains. But for the purposes of this post, let’s just assume that capital gains are taxed at a lower rate than ordinary income.

*** Convertible preferred has debt-like features, but they only matter in a bad outcome (they give the VCs a disproportionate share of whatever value is left in the company). So from the founders’ perspective, a VC investment provides the downside of debt, but not the upside.

**** Again, you can debate whether labor should pay higher taxes than capital — my instinct is that it shouldn’t — but everyone, including Langeler, is taking that as a starting point for this debate.





Focus On This: Merkley-Levin Did Not Get A Vote

Posted: 21 May 2010 06:02 AM PDT

By Simon Johnson

After 9 months of hard fighting, yesterday financial reform came down to this: an amendment, proposed by Senators Jeff Merkley and Carl Levin that would have forced big banks to get rid of their speculative proprietary trading activities (i.e., a relatively strong version of the Volcker Rule.)

The amendment had picked up a great deal of support in recent weeks, partly because of unflagging support from Paul Volcker and partly because of the broader debate around the Brown-Kaufman amendment (which would have forced the biggest 6 banks to become smaller). Brown-Kaufman failed, 33-61, but it demonstrated that a growing number of senators were willing to confront the power of our biggest and worst banks.

Yet, at the end of the day, the Merkley-Levin amendment did not even get a vote. Why?

Partly this was because of procedural maneuvers. Merkley-Levin could only get a vote if another amendment, proposed by Senator Brownback (on exempting auto dealers from new consumer protection rules) got a vote. Late yesterday afternoon, Senator Brownback was persuaded, presumably by his Republican colleagues and by financial lobbyists, to withdraw his amendment.

Of course, Merkley-Levin was only in this awkward position because of an earlier lack of wholehearted support from the Democratic leadership – and from the White House. Again, the long reach of Wall Street was at work.

But the important point here is quite different. If Merkley-Levin did not have the votes, it was in the interest of the megabanks to have it come to the floor and be defeated. That would have been a clear victory for the status quo.

But Merkley-Levin had momentum and could potentially have passed – reflecting a big change of opinion within the Senate (and more broadly around the country). The big banks were forced into overdrive to stop it.

The Volcker Rule, in its weaker Dodd bill form (“do a study and think about implementing”), perhaps will survive the upcoming House-Senate conference – although, because this process likely will not be televised, all kinds of bad things may happen behind closed doors. Regulators may also take the Volcker Rule more seriously – but the most probable outcome is that the Fed and other officials will get a great deal of discretion regarding how to implement the principles, and they will completely fudge the issue.

Most importantly, everyone who wants to rein in the largest banks now has a much clearer idea of what to push for, what to campaign on, and for what purpose to raise money. This is the completely reasonable and responsible ask:

The Volcker Rule, as specifically proposed in the Merkley-Levin amendment
Constraints on the size and leverage of our largest banks, as proposed by the Brown-Kaufman amendment
When the mainstream consensus shifts in favor of these measures, or their functional equivalents, we will have finally begun the long process of reining in the dangerous economic and political power of our largest banks.

Krugman -- What's the Matter With Georgia?

(c) 2010 F. Bruce Abel

I always get tricked with a headline mentioning "Georgia." Ever since we visited Genny in Tbilisi.

Click on title above.

Volker's Ideas

(c) 2009 F. Bruce Abel

A good read. And read the comments too. Volker is a voice from the past and somehow reminds me of dear friend Bill Herron who died too young about 6 years ago.

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Thursday, October 22, 2009



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Volcker’s Voice Fails to Sell a Bank StrategyOctober 21, 2009, 2:49 am — Updated: 1:17 pm -->
Listen to a top economist in the Obama administration describe Paul A. Volcker, the former Federal Reserve chairman who endorsed Mr. Obama early in his election campaign and who stood by his side during the financial crisis, Louis Uchitelle wrote in The New York Times.
“The guy’s a giant, he’s a genius, he is a great human being,” said Austan D. Goolsbee, counselor to Mr. Obama since their Chicago days. “Whenever he has advice, the administration is very interested.”
Well, not lately. The aging Mr. Volcker (he is 82) has some advice, deeply felt. He has been offering it in speeches and Congressional testimony, and repeating it to those around the president, most of them young enough to be his children.
He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.
“I am not pounding the desk all the time, but I am making my point,” Mr. Volcker said in one of his infrequent on-the-record interviews. “I have talked to some senators who asked me to talk to them, and if people want to talk to me, I talk to them. But I am not going around knocking on doors.”
Still, he does head the president’s Economic Recovery Advisory Board, which makes him the administration’s most prominent outside economic adviser. As Fed chairman from 1979 to 1987, he helped the country weather more than one crisis. And in the campaign last year, he appeared occasionally with Mr. Obama, including a town hall meeting in Florida last fall. His towering presence (he is 6-foot-8) offered reassurance that the candidate’s economic policies, in the midst of a crisis, were trustworthy.
More subtly, Mr. Obama has in Mr. Volcker an adviser perceived as standing apart from Wall Street, and critical of its ways, some administration officials say, while Timothy F. Geithner, the Treasury secretary, and Lawrence H. Summers, chief of the National Economic Council, are seen, rightly or wrongly, as more sympathetic to the concerns of investment bankers.
For all these reasons, Mr. Volcker’s approach to financial regulation cannot be just brushed off — and Mr. Goolsbee, speaking for the administration, is careful not to do so. “We have discussed these issues with Paul Volcker extensively,” he said.
Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.
The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.
Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.
“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.
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. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.
Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail.
On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.
Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.
“People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” Mr. Volcker said, acknowledging criticism that he is nostalgic for an earlier era. “That argument,” he added ruefully, “brought us to where we are today.”
He may not be alone in his proposal, but he is nearly so. Most economists and policy makers argue that a global economy requires that America have big financial institutions to compete against others in Europe and Asia. An administration spokesman says the Obama proposal for reform would result in financial institutions that could fail without damaging the system.
Still, a handful side with Mr. Volcker, among them Joseph E. Stiglitz, a Nobel laureate in economics at Columbia and a former official in the Clinton administration. “We would have a cleaner, safer banking system,” Mr. Stiglitz said, adding that while he endorses Mr. Volcker’s proposal, the former Fed chairman is nevertheless embarked on a quixotic journey.
Alan Greenspan, the only other former Fed chairman still living, favored the repeal of Glass-Steagall a decade ago and, unlike Mr. Volcker, would not bring it back now. He declined to be interviewed for this article, but in response to e-mailed questions he cited two recent public statements in which he suggested that the nation’s largest financial institutions become smaller, so that none would be too big to fail, requiring a federal rescue.
Taking issue implicitly with the Volcker proposal to split commercial and investment banking, he has said: “No form of economic organization can fully contain bouts of destructive speculative euphoria.”
For his part, Mr. Volcker is careful to explain that he supports 80 percent of the administration’s detailed plan for financial regulation, including much higher capital requirements and “guidelines” on pay. Wall Street compensation, he said in a recent television interview, “has gotten grotesquely large.”
Before the credit crisis, the big institutions earned most of their profits from proprietary trading, and those profits led to giant bonuses. Mr. Volcker argues that splitting commercial and investment banking would put a damper on both pay and risky trading practices.
His disagreement with the Obama people on whether to restore some version of Glass-Steagall appears to have contributed to published reports that his influence in the administration is fading and that he is rarely if ever in the small Washington office assigned to him.
He operates from his own offices in New York, communicating with administration officials and other members of the advisory board mainly by telephone. (He does not use e-mail, although his support staff does.) He travels infrequently to Washington, he says, and when he does, the visits are too short to bother with the office. The advisory board has been asked to study, amid other issues, the tax law on corporate profits earned overseas, hardly a headline concern.
So Mr. Volcker scoffs at the reports that he is losing clout. “I did not have influence to start with,” he said.
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7 Comments
1. October 21, 2009 6:06 am Link
“I did not have influence to start with,” he said.
That I am afraid in itself is very depressing to hear.
To Date the Administration has bet with the Banks. They have overdosed the Banks on a Golden Flood of Free Liquidity and the markets have risen on this rising Tide. At some Point, the Liquidity will need to be withdrawn and that Day of Reckoning can not be put off for ever.
It is in the NationaL Interest to have a robust and muscular Banking System. And now we have a Bunch of High Rollers, who had all the Cash just when the Tables were fixed in their Favour.
Volcker has been a Voice of Sanity in a sort of Looking Glass World and President Obama really needs him very close because if it unwinds again, the current Team will be like the Emperor with no Clothes and nowhere to run to.
Aly-Khan Satchuhttp://www.rich.co.ke/Twitter alykhansatchu— Aly-Khan Satchu
2. October 21, 2009 6:40 am Link
Volker’s advice is sound but the Baby Boomer juveniles and their progeny running the show are emotionally incapable of practicing delay of gratification, thrift and economic common sense.
I remember Volker’s 1970s bitter economic medicine. He got his way because the government and the opinion makers were mostly grownups shaped by the Depression.
Born just before war the folks born after me always seemed more than little nuts to me.— MARK KLEIN, M.D.
3. October 21, 2009 8:15 am Link
Please keep talking Mr. Volcker ; Your wisdom is sorely needed by the Obama administration which has been blinded by the promise of political contributions dancing in their heads.It’s time to put the genie back in the bottle: In light of everything we’ve gone through, it’s amazing that the obvious needs to be so belaboured.— pete
4. October 21, 2009 8:15 am Link
Paul Volcker is 100% right. Legislation to implement what he proposes would have significant support across party lines in Washington. Furthermore, the public would welcome this action.While I applaud the Obama ((NYTimes, why have you not corrected your Spell Check to accept the word “Obama as correct? This is negligent. Fix it)) Administration for just about all of its initiatives, I note that it has a deplorable tendency of nibbling around the edges of urgent situations where swift and bold action is called for. What we have here is an example of this.— C. Alexander Brown, Rockcliffe Park, Canada
5. October 21, 2009 8:19 am Link
Anyone see Frontline’s “Warning” last night? Diff stations, diff dates and times. Intellectual vindication! She was RIGHT! The folks who told Brooksley to SHUT UP, Congress, Greenspan, the President’s Working Group looking like they would CRY or refusing to be interviewed. You little bucket shop chickens, Larry and Robert! Go to your rooms and don’t come out until I can look at you all without wanting to charge you with treason. Like that’s ever gonna happen.
Ignore this man Volcker’s advise at your own peril! He’s absolutley RIGHT! After watching that show, I’m ready to follow Volcker around and repeat his every word like Garret Morris’s SNL character would repeat Chevy Chase at the end of the news for the Hard of Hearing. “Ferdinand Franco is still DEAD! Our Banks are MONOPOLOIES! Even Brooksley swears this vile economic pumping and dumping is never gonna stop! Break them UP! BREAK them UP! BREAK THEM UP!”
Looks like Obama’s going down like Wilson, and Volcker’s going down like Veblen. Our Congress and President need to come forward and admit the reason they aren’t doing anything is because this is a giant Jenga puzzle built of circus peanuts and just fixing it is going to blow us all to hell. Well, I knew it was coming, but I don’t care anymore, thank Wilco. LET HER BLOW!
Ah! Get back in your rooms Clinton, Lugar, Gramm, ALL of you miserable excuses for government. Sorry, Dealbook. I put this all together myself over the past year and have been trying to say it repeatedly only to discover I’M NOT CRAZY! Now, I know how Brooksley feels. Obama, give that woman your Nobel! Then crawl to Volcker and do what he says. He’s not some weak guy behind a curtain. He IS that flaming giant head, and you better do what he says!— Abby Tucson, AZ
6. October 21, 2009 9:12 am Link
Yes Yes Yes. The most sound reasoning I have heard. I am SICK AND TIRED OF WALL STREET PLAYING WITH MY MONEY , MAKING PROFIT ON MY MONEY THEN bankrupting the system and taking my house. WHy not separate commercial and investment banking? It should always have been this way . What happened to Brookesly Born. There was one of the only voices o f reason in the past decade. Speaking alone as usual. IN MY AMERICA NOW, MONEY TALKS LOUDER THAN PRINCIPLE OR THE GREATER GOOD FOR ALL. Frustrated American.— Judy Leonard
7. October 21, 2009 6:02 pm Link
What is truly depressing about what happened to Brookesly Born is that there was never a honest effort to discuss the issues by the Greenspan-Summers-Rueben group. They knew they were right and didn’t want to be confused by any other logic than their own.
Think a minute about the vaulted “magic” hand of the market. In a market the best wins because consumers choose the best. This implies an informed decision. When you are choosing to buy derivatives that by definition are opaque it is not possible to make an informed decision. It seems that at a minimum some standards need to be set for reporting if the market is to have a chance of working. That the Greenspan gang blocked all attempts at even the most reasonable requirements is an indictment of their judgement. That the current administration is depending on Lawrence Summers for guidance is troubling to say the least.
I do appreciate that Mr. Greenspan has at least partially admitted to errors in judgment. Unfortunately, Mr. Greenspan errors have hurt us all and the most vulnerable of us have been hurt the most.— Bill MacAllister

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

Baseline Scenario

The Baseline Scenario
Protect Consumers, Raise Capital, And Jam The Revolving Wall St-Washington Door
Posted: 20 Sep 2009 04:32 AM PDT
Ben Bernanke has a great opportunity to lead the reform of our financial system. His standing in Washington and on Wall Street is at an all-time high, as a result of his bailout/rescue efforts. He is about to be reappointed with acclaim for a second term as chairman of the Federal Reserve’s Board of Governors. And he has a lot to answer for.
Look, for example, at his speech of May 17, 2007, which discusses some of the problems in the subprime market and contains the memorable line: “Importantly, we see no serious broader spillover to banks or thift institutions from problems in the subprime market; the troubled lenders, for the most part, have not been institutions with federally insured deposits” (full speech; marks in the margin are from an anonymous and careful correspondent.)
Three points jump off these pages.
With the kind of analytical capacity and world view demonstrated in this speech, there is no way that Fed can be regarded as capable of protecting consumers vis-a-vis financial products going forward. The Fed’s claims to that effect undermine their legitimacy and plausibility. They failed consumers completely, and they should reflect deeply on the organizational culture and internal incentives that brought them to this sad point. “Give us another chance” is not convincing; there is too much at stake.
If the Fed is capable of such mistaken views as Bernanke expressed in May, 2007, you must assume that regulation will break down again in the future. Tightening the rules on bank behavior is fine, but the banks will down the road again fool the Fed, other regulators, and perhaps even themselves on the true risks they face. It is therefore essential that our financial system carry much more capital than has been the case in the recent past. We should go back to pre-1935 or even pre-1913 levels (see slide 40 in this presentation). In a New York Times op-ed today, Peter Boone and I call for at least tripling current capital requirements as the right goal (of course, this should be phased in over a few years.)
The intellectual capture of Washington by Wall Street was well underway in May 2007; it is now complete. This is why the banking barons felt no need to show up and show respect for the President on Monday. They have so many of their people (mindset-wise) placed throughout the administration, and the principle of revolving between Wall Street and Washington so well established, that they know: If they ever need another massive bailout, the people standing behind this or any future President will say there is no alternative. That’s why Peter and I also call for a 5 year gap between holding a responsible position on Wall Street and a top job in Washington, and vice versa. Stop with the political appointment of regulatory “doves” and end the notion that you can go directly from a failing bank to directing efforts to rescue such banks.
Ben Bernanke can play the broad reformist role of Marriner Eccles, chair of the Fed during the Great Depression. Or he can go back to being a cheerleader for the financial sector, following in the discredited footsteps of Alan Greenspan.
This is his choice.
By Simon Johnson

Why Own When You Can Lease

Not what you expect. Has implications for the banks.
http://www.nytimes.com/2009/08/01/opinion/01alpert.html?_r=1

Morgenson -- A Blue Chip Financial Writer

http://www.nytimes.com/2009/06/21/business/21gret.html?pagewanted=1&8dpc

Dangers in the New Payback Permission to the Banks

http://www.nytimes.com/2009/06/11/opinion/11thu1.html

New Yorker Must Read This Week Explaining the Financial Catastrophe

Outsmarted
High finance vs. human nature.
by John Lanchester June 1, 2009
Complex risk engineering ignored emotions like avarice and envy.
Keywords
Economic Crisis;
Banking;
“Fool’s Gold” (Free Press; $26);
Gillian Tett;
“A Failure of Capitalism” (Harvard; $23.95);
Richard A. Posner;
Economy

The world of banking, it’s becoming clear, operates according to different norms from those of the rest of the business world. Take the offsite corporate weekend. Normal behavior on these occasions consists of punishing the minibar and nursing consequent hangovers, hitting on long-fancied colleagues, and putting embarrassing items, ideally pornographic videos, on one another’s hotel bills. For form’s sake, a few new ideas are cooked up, and then gradually allowed to die a natural death when everyone is back at work and liver-function levels have stabilized.

In June, 1994, when a team from J. P. Morgan went on an off-site weekend to Boca Raton, they conformed to normative behavior in certain respects. Binge drinking occurred; a senior colleague’s nose was broken; somebody charged a trashed Jet Ski and many cheeseburgers to somebody else’s account. Where the J. P. Morgan team broke with tradition was in coming up with a real idea—an idea that changed the entire nature of modern banking, with consequences that are currently rocking the planet.

The new idea was based on an old one, that of the swap. Say you’re in the grocery business, and feel gloomy about your prospects. Your immediate neighbor is in the stationery business, and he feels gloomy about his prospects, less so about yours. You get to talking, and one of you hits on a brilliant idea: why not just swap revenues? You take his earnings for the year, and he takes yours. The actual business doesn’t change hands, making the swap, in banking terminology, “synthetic.” The first currency swap took place in 1981, and allowed I.B.M. to trade surplus Swiss francs and Deutsche marks for dollars held by the World Bank. The two institutions exchanged their obligations to bondholders and their bond earnings without actually exchanging the bonds. The deal, brokered by Salomon Brothers, was worth two hundred and ten million dollars over ten years and ushered in a whole new field of finance. As Gillian Tett tells it in her book “Fool’s Gold” (Free Press; $26), by the time of the Boca Raton off-site, swaps had become a roaringly successful feature of the banking world: the volume of such interest-rate and currency derivatives was worth twelve trillion dollars, more than the entire U.S. economy.

But competition was making those swap deals less profitable. The quest was for a new, and therefore newly lucrative, product to sell. What got the J. P. Morgan team rolling was this thought: instead of swapping bonds or currency or interest rates, why not swap the risk of default? In effect, it could sell the risk that a borrower won’t be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a crucial part of the business. A product that made it possible to reduce that risk—by selling it to somebody else—had the potential to create a gigantic new market.

The broad outline of the financial crash is becoming well known. The value of Gillian Tett’s book is in the level of detail with which she tells the story, concentrating on the specific sequence of inventions and innovations that made it possible. Tett, a Financial Times reporter who covered the credit markets, was one of the few people to have seen the implosion coming. A critical factor was that she has a Ph.D. in social anthropology—a “hippie” background, as one banker told her, intending no compliment. It helped her focus on what she calls “social silences” in the world of banking. It’s not always what people say that contains the most important information; often, it’s what they take for granted. To Tett, it was obvious that the banking sector was running irresponsibly large risks in the overexpansion of credit and the overingenuity of its financial engineering. So she was perfectly placed to follow the story as it happened, and to pull together the story of how we got here.

There are a number of different ways of peeling this particular onion; Tett does so through the J. P. Morgan team that helped create the new credit derivatives. These lie at the heart of the current crisis, and Tett’s account of their invention and dispersal makes “Fool’s Gold” a gripping and indispensable book.

The Boca Raton meeting first bore fruit when Exxon needed to open a line of credit to cover potential damages of five billion dollars resulting from the 1989 Exxon Valdez oil spill. J. P. Morgan was reluctant to turn down Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-called Basel rules, named for the town in Switzerland where they were formulated, required that the banks hold eight per cent of their capital in reserve against the risk of outstanding loans. That limited the amount of lending bankers could do, the amount of risk they could take on, and therefore the amount of profit they could make. But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out. No need to suck up useful capital.

In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the E.B.R.D. would be on the hook for it—and, in return for taking on the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P. Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn’t even have a name: eventually, the one settled on was “credit-default swap.”

So far, so good for J. P. Morgan. But the deal had been laborious and time-consuming, and the bank wouldn’t be able to make real money out of credit-default swaps until the process became streamlined and industrialized. The invention that allowed all this to happen was securitization. Traditionally, banking involves a case-by-case assessment of the risk of every loan, and it’s hard to industrialize that process. What securitization did was bundle together a package of these loans, and then rely on safety in numbers and the law of averages: even if some loans did default, the others wouldn’t, and would keep the stream of revenue going, thereby diffusing and minimizing the risk of default. So there would be two sources of revenue: one from the sale of the loans, and another from the steady flow of repayments. Then someone had the idea of dividing up the securities into different levels of risk—a technique called tranching—and selling them off accordingly, so that riskier tranches of debt would pay a higher rate of interest than safer ones. Bill Demchak, a “structured finance” star at J. P. Morgan, took the lead in creating bundles of credit-default swaps—insurance against default—and selling them to investors. The investors would get the streams of revenue, according to the risk-and-reward level they chose; the bank would get insurance against its loans, and fees for setting up the deal.

There was one final component to the J. P. Morgan team’s invention. The team set up a kind of offshore shell company, called a Special Purpose Vehicle, to fulfill the role supplied by the European Bank for Reconstruction and Development in the first credit-default swap. The shell company would assume $9.7 billion of J. P. Morgan’s risk (in this case, outstanding loans that the bank had made to some three hundred companies) and sell off that risk to investors, in the form of securities paying differing rates of interest. According to J. P. Morgan’s calculations, the underlying loans were so safe that it needed to collect only seven hundred million dollars in order to cover the $9.7-billion debt. In 1997, the credit agency Moodys agreed, and a whole new era in banking dawned. J. P. Morgan had found a way to shift risk off its books while simultaneously generating income from that risk, and freeing up capital to lend elsewhere. It was magic. The only thing wrong with it was the name, BISTRO, for Broad Index Secured Trust Offering, which made the new rocket-science financial instrument sound like a place you went to for steak frites. The market came to prefer a different term: “synthetic collateralized debt obligations.”

Inevitably, J. P. Morgan’s innovation was taken up by more aggressive and less cautious banks. Mortgage-based versions of collateralized debt obligations were especially profitable. These C.D.O.s involved the techniques that the J. P. Morgan team had developed, but their underlying assets were pools of mortgages—many of them based on the most lucrative mortgages, the now notorious subprime loans, which paid higher than usual rates of interest. (These new instruments could be pretty exotic: some consisted of C.D.O.s of C.D.O.s, pools of pools of debt.) J. P. Morgan was wary of them, as it happens, because it didn’t see how the risks were being engineered down to a safe level. But institutions like Citigroup, U.B.S., and Merrill Lynch plunged in.

The new financial instruments, as clever as they were, had an unfortunate side effect: they broke banking. At its heart, banking is a simple business. Customers deposit money at a bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. This isn’t glamorous or interesting, but banking is not supposed to resemble skydiving or hip-hop; what recommends it is that it’s a good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of the loans is critical, because those loans are the bank’s earning assets.

This isn’t some incidental issue; it’s the very core of what banking is. But the model of packaging plus securitization spurned the principle that a bank had to individually assess and monitor every loan. The mathematics of valuation models—horrendously complex equations to assess probabilities and correlations, cooked up in mad-scientist style by the firms’ “quants”—took on the burden of assessing statistical risk. The idea that a banker looks a borrower in the eye and takes a view on whether he can trust him came to seem laughably nineteenth-century. As for the risks? Well, as Lawrence Summers said when he was Deputy Secretary of the Treasury, “The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.”

Alas, Richard A. Posner, a judge on the U.S. Court of Appeals for the Seventh Circuit, observes with pointed restraint, “That turned out not to be true.” The result has been, in the title phrase of Posner’s new book, “A Failure of Capitalism” (Harvard; $23.95). He argues that we are now in a bona-fide depression, which he defines as “a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation.” His book is an attempt to write “a concise, constructive, jargon- and acronym-free, non-technical, unsensational, light-on-anecdote, analytical examination of the major facets of the biggest U.S. economic disaster in my lifetime and that of most people living today.”

Accounts of the banking-and-credit crisis tend to focus their explanations, which usually also means their blame, on one or more of the following four factors: greed, stupidity, government, and the banks. The process resembles a children’s game in which you spin an arrow and it lands on a word. Tett spins twice, and lands on greed and the banks; Posner suggests that he doesn’t know what the word “greed” means, and his spin lands firmly on government. “We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails,” he writes. “The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.”

This isn’t an original conclusion, but the way Posner arrives at it is new and bracing. His first claim to fame was as one of the founders of a school of thought that takes economic ideas and techniques and applies them to the law, as well as to life more generally. He has published nearly twenty books in just the past decade, a superhuman rate of productivity, bearing in mind that Posner is also a practicing judge, a senior lecturer at the University of Chicago, and an energetic blogger (in association with the Nobel Prize-winning economist Gary Becker). He has the rare kind of mind that is a pure pleasure to watch in action, regardless of the subject and the argument being made.

“A Failure of Capitalism” argues that the risks taken by the banks were rational, for two main reasons. First, it’s only with the benefit of hindsight that we can know that a bubble in prices was taking place. Bankers had to assign a probability to the prospect that there was a bubble, and, second, to the prospect that, if there was a bubble and it burst, house prices would fall by twenty per cent or more—this being the decline that precipitated the general crisis of bank insolvency. Now, suppose that the risk of both things happening was one per cent. Whether an event with that likelihood is worth worrying about depends on what its consequences will be. From the larger point of view, the consequences included systemic meltdown; but Posner invites us to focus our attention on what they looked like for individual bankers. They had strong incentives for taking the maximum amount of risks in their lending, since risks are correlated with rewards, and the bankers were so well paid that they didn’t really have to worry about being laid off. “The greater the gains are from taking risks that enable very high short-term profits, and the better cushioned the executive is by his severance package against the cost of losing his job, the more risks he rationally will take,” Posner notes. Besides, if a bank avoids these risks, and its competitors don’t and therefore make more money during the boom, the cautious bank risks going out of business anyway, because its clients will walk away.

People taking out what now look like crazily risky mortgage loans were being rational, too, because they were acting on the widespread assumption that house prices would continue rising. If house prices fell, well, tough luck, they’d walk away from the loan and go bankrupt—but they probably had lousy credit ratings anyway. “Thus the downside of the home buyer’s speculative investment is truncated, making his ‘reckless’ behavior not only rational but also consistent with his being well informed about the risks,” Posner writes. The conclusion: “Risky behavior of the sort I have been describing was individually rational during the bubble. But it was collectively irrational.” As for the idea that the bankers were dumb to get so carried away: “I am skeptical that readily avoidable mistakes, failures of rationality, or the intellectual deficiencies of financial managers whose IQs exceed my own were major factors in the economic collapse. Had the mistakes that brought down the banking industry been readily avoidable, they would have been avoided.”

This is a familiar place for these arguments to end up: economists often find that apparently erratic behavior is, at heart, rational. It helps that the definition of rationality can be stretched to include emotion, which “is not necessarily or even typically irrational,” Posner argues. Reckless greed, incompetent assessments of probability, blindness to the inevitability of downturns, failure to hedge risks so big that they threaten a firm’s very existence: all are rational.

It seems a pity that a man as unflinching as Posner didn’t put his ideas under more pressure from the specifics of what the bankers did. He is willing to criticize those who have criticized bankers—“the distinguished economist Paul Krugman,” for instance, “who should know better”—but no banker is named and blamed. One can regret that Posner didn’t get the chance to read Tett’s book, which offers the opportunity to assess in detail the kind of risks that the bankers were taking.

Blythe Masters, who was in charge of the Exxon Valdez deal, and of selling the very first BISTRO notes, and thus one of the creators of the entire credit-default-swap industry, was among those baffled by the C.D.O. boom. “How are the other banks doing it?” she asked. “How are they making so much money?” The answer, Tett says, is that “she was so steeped in the ways of J. P. Morgan that it never occurred to her that the other banks might simply ignore all the risk controls J. P. Morgan had adhered to. That they might do so was simply outside her cognitive map.”

In particular, those banks had accumulated huge amounts of super-senior debt. In the first BISTRO, remember, only seven hundred million dollars was reserved to cover $9.7 billion of risk. The remainder of the debt was regarded as marvellously safe. Bankers call that kind of debt “super-senior,” i.e., better than AAA grade, safer than U.S. Treasury bills, so secure that it didn’t need to be insured. So what to do with it? Some banks simply let the super-senior debt accumulate on their balance sheets. The amount of this debt “was a closely guarded secret, even within the banks themselves,” Tett writes, and the collapse in their value helped bring down the big banks. It would be interesting to read Posner’s analysis of these specific actions, which to the layman seem, as they seemed to so many of the J. P. Morgan team, insanely reckless.

A common mistake of very smart people is to assume that other people’s minds work in the same way that theirs do. This is a particular problem in economics. Its mathematically based models and assumptions of rational conduct can appear, to non-economists, like toys, entertaining but, by definition, of limited utility. Even Posner, who spent years extending the purview of economic thought, thinks that “the depression is a wake-up call to the economics profession.” It’s no surprise to find the Yale economist Robert J. Shiller as one of the first respondents to that call. Shiller—not content with having predicted the bursting of the dot-com bubble in his book “Irrational Exuberance”; co-creating the standard measure for tracking house prices, the Case-Shiller index; going on the record with worries about the housing bubble as early as 2003; and writing one of the first books on the crash, “The Subprime Solution,” in 2008—has now, with George A. Akerlof, the 2001 Nobel winner in economics, co-written a book on the influence of emotions on economics. “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism” (Princeton; $24.95) takes its title from John Maynard Keynes, who, in a famous passage of his 1936 treatise “The General Theory of Employment, Interest and Money,” mused about how businessmen manage to make decisions, given the level of uncertainty about the future. “Our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing,” he wrote. We can’t know the future, and therefore our inclination to act, to do things, “can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction.” Akerlof and Shiller extrapolate from this an idea of animal spirits encompassing “noneconomic motives and irrational behaviors,” a slightly broader idea than Keynes’s usage, but one that allows them to study a range of negative impulses as well as the basic urge to optimism about which Keynes was talking.

“Animal Spirits” is addressed to a general reader, but it’s hard not to feel that the book’s real audience is among economists. The general reader needs no persuading about the influence of non-rational, non-economic forces on economic thinking. Within the economic profession, however, the subject of strict rationality is the occasion of a permanent pitched battle. (Posner: “The very existence of warring schools within a field is a clue that the field is weak, however brilliant its practitioners.”) “Animal Spirits,” like “A Failure of Capitalism,” is a campaigning maneuver in this ongoing struggle.

Akerlof and Shiller have a set of specific proposals for how the animal spirits might be incorporated into their science. They set out a framework of factors—Confidence (and the lack thereof), Fairness, Corruption and Bad Faith, Money Illusion (the failure to understand the impact of inflation), and Stories—and then apply their ideas to a series of specific questions. Some of this is very timely, such as a chapter on “The Current Financial Crisis” and one asking “Why Are Financial Prices and Corporate Investments So Volatile?” But it’s clear that the great white whale of modern economics, a thing that would appease the descendants of both Milton Friedman and John Maynard Keynes, is a quantifiable, evidence-based theory of how bubbles are formed, and, hence, how to forestall them. Bubbles are irrefutably clear in hindsight; but an economist who found a way of proving their presence with foresight would be doing humanity a profound favor.

We aren’t there yet, though Akerlof and Shiller’s book does give the profession some suggestions for the search. There is barely a page of “Animal Spirits” without a fascinating fact or insight, and by no means all from a reflexively liberal viewpoint. One of their culprits for the crisis is Andrew Cuomo, who, as Secretary of Housing and Urban Development, sharply increased the mandated lending to underserved communities by Fannie Mae and Freddie Mac, and in the process lowered credit standards, thus making it “easy for mortgage lenders to justify loosening their own lending standards.” Despite the various ideological and methodological differences with Richard Posner, Akerlof and Shiller’s fundamental view of how capitalism should work is similar: “What allows capitalism to function is the regulations,” they write. This should be an enduring lesson of the crisis—an understanding that the rules governing the operating of markets were not handed down on stone tablets but are made by men, and are in constant need of revision, supervision, and active, imaginative enforcement. All these books coincide on this point: human beings make markets. A general recognition of that fact, led by the economic profession and taken to heart by politicians, would be a step so important as to be almost worth what it has cost to be reminded of it. ♦

And the following link is worth following up on for its excellent comments afterward, and comments on comments, especially the weakness of Tett's reasoning and experience in places:
http://www.amazon.co.uk/Fools-Gold-Unrestrained-Corrupted-Catastrophe/dp/1408701642

Krugman -- Be Wary

http://www.nytimes.com/2009/05/08/opinion/08krugman.html?_r=1&hpw

The Word "Bank"

(c) 2009 F. Bruce Abel



It occurs to me that for the bailout to work we must wipe out a word from our vocabulary: "Bank," as in "Oh, you work for a bank, do you? I don't trust you, even though I work for a bank myself. In fact I don't even trust myself here at this bank, because I am addicted to trading credit default swaps."

We must now create another word, another category.

What is that word? I don't know. What about "Trank." This implies trust. But, now that I think about it, the phrase "Bank Trust Department" must be removed also.

TALF Program is Seen as Open to Fraud

http://www.nytimes.com/2009/04/21/business/economy/21bailout.html?hp

The NYT Article and Sunday's Obama Leaks That Drove the Market Down Today

A surprise to me:



comments (122)
By EDMUND L. ANDREWS
Published: April 19, 2009
WASHINGTON — President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials.
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In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.
Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return.
While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks.
The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term.

Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board.

Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them.
Treasury officials estimate that they will have about $135 billion left after they follow through on all the loans that have already been announced. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults.

In his budget proposal for next year, Mr. Obama included $250 billion in additional spending to prop up the financial system. Because of the way the government accounts for such spending, the budget actually indicated that Mr. Obama might ask Congress for as much as $750 billion.

The most immediate expense will come in the next several weeks, when federal bank regulators complete “stress tests” on the nation’s 19 biggest banks. The tests are expected to show that at least several major institutions, probably including Bank of America, need to increase their capital cushions by billions of dollars each.

The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

The White House chief of staff, Rahm Emanuel, alluded to the strategy on Sunday in an interview on the ABC program “This Week.” Mr. Emanuel asserted that the government had enough money to shore up the 19 banks without asking for more.

“We believe we have those resources available in the government as the final backstop to make sure that the 19 are financially viable and effective,” Mr. Emanuel said. “If they need capital, we have that capacity.”

If that calculation is correct, Mr. Obama would gain important political maneuvering room because Democratic leaders in Congress have warned that they cannot possibly muster enough votes any time soon in support of spending more money to bail out some of the same financial institutions whose aggressive lending precipitated the financial crisis.

The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.

After the conversion, the Treasury would end up with about 36 percent of Citigroup’s common shares, which come with full voting rights. That would make the government Citigroup’s biggest shareholder, effectively nudging the government one step closer to nationalizing a major bank.
Nationalization, or even just the hint of nationalization, is a politically explosive step that White House and Treasury officials have fought hard to avoid.

Administration officials acknowledged that they might still have to ask Congress for extra money. Beyond the 19 big banks, which are defined as those with more than $100 billion in assets, the Treasury has also injected capital into hundreds of regional and community banks and may need to provide more money before the financial crisis is over.

Treasury officials say they have more money left in the rescue fund than might be apparent. Officials estimate that the fund will have about $134.5 billion left after the Treasury completes its $100 billion plan to buy toxic assets from banks and after it uses $50 billion to help homeowners avoid foreclosure.

In practice, the toxic-asset programs are not expected to start for another few months, and it could be more than a year before the Treasury uses up the entire $100 billion. Likewise, it will be at least a year before the Treasury uses up all the money budgeted for homeowners.
But the biggest way to stretch funds could be to convert preferred shares to common stock, a strategy that the government seems prepared to use on a case-by-case basis.

Ever since the Treasury agreed to restructure Citigroup’s loans, officials have made it clear that other banks could follow suit and convert their government loans to voting shares of common stock as well.

In the stress tests now under way, regulators are examining whether the big banks would have enough capital to withstand an economic downturn in which unemployment climbs to 10 percent and housing prices fall much further than they already have.

As their yardstick, regulators are expected to examine a measure of bank capital called “tangible common equity.” By that measure of capital, every dollar a bank converts from preferred to common shares becomes an additional dollar of capital.

The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5 percent.

If all the banks that are found to have a capital shortfall fill that gap by converting their shares, rather than by obtaining more cash, the Treasury could stretch its dwindling rescue fund by more than $100 billion.

The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.
Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall.