Tuesday, December 30, 2008

Give Hank Greenberg Some Credit

The Washington Post's series on AIG Financial Products is actually quite good so far (see Part I here, Part II here). But in its history of AIGFP, I think the Post gives short shrift to Hank Greenberg. I'm dating myself a bit with this story, but here goes: Back in the early 1990s, when AIGFP was being run by former Drexel Burnham executive Howard Sosin, Greenberg had to set up a shadow group to infiltrate AIGFP (his own subsidiary!), which the Post article refers to in passing. But what the Post doesn't really explain is that when Greenberg found out from the shadow group how much risk AIGFP was taking on, he ousted Sosin in a very public battle, and reined-in AIGFP's risk-taking. There was a famous article in the IDD in 1993 called "The Shadow War at AIG" that detailed the entire episode (wow, I really am old!). The IDD article basically showed that Greenberg did the right thing, even though AIGFP was a virtual profit-making machine for Greenberg at the time:

As the shadow group read through the 40,000-plus memos, it became evident that there were some "unsettling things" going on at AIG Financial Products, an AIG official said. Not only did the shadow group have questions about the quality of AIGFP's models -- and thus some of its hedge positions -- they found virtually no reserve pool to back Sosin's positions, according to the official. AIG was stunned that Sosin could have left AIG so exposed, sources say. If the positions were not adequately hedged, that again would be increasing the profits of AIGFP in the short term, but exposing AIG to increased risk in the long term. The company quickly set up a reserve pool that would not only back up some of the positions, but might also pay for expenses if AIG were to lose the arbitration case.
How many other CEOs would have done the same thing? Sad to say, not many. Not many at all. Say what you want about Hank Greenberg, but the man deserves some credit for reining in the out-of-control risk-taking at AIGFP back in 1993. (I'm a little disappointed that the Post series doesn't make fun of Sanford Bernstein for titling its 1998 report on AIG: "American International Group, Inc.: The Emperor of Financial Services." But I can make my peace with that.)

Monday, December 29, 2008

New Derivatives Data

The OCC released its Q3 report on trading and derivatives activity today. There appears to be minimal data on Morgan Stanley, and no data on Goldman Sachs, the two newest bank holding companies. That's only fair, I guess, since MS and GS only became bank holding companies in the very last days of Q3. The highlights from the Q3 data, while admittedly incomplete and already dated, seem to confirm what we already knew: JPMorgan was (and still is) the biggest player, by far, in the CDS market. JPMorgan's notional CDS topped $9 trillion (table 1), though at least according to this data, JPM was still a net CDS buyer (table 12). The OCC data suggest that BofA and HSBC were both net CDS sellers. JPM's current credit exposure came in at $163 billion as of Sept. 30, which was up about $20 billion from the end of Q2. This is much less than I expected, since the Q3 numbers for JPM take into account its takeover of Bear Stearns, which the Q2 numbers did not. The press release is here; the full report is here.

Tyler Cowen, in his Sunday New York Times column, says yes. His reasoning, however, leaves much to be desired. Tyler argues that by saving Long-Term Capital Management (LTCM), regulators missed a golden opportunity to teach the markets a much-needed lesson in moral hazard:

With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.
The problem with this argument is that no taxpayer money was put on the line for LTCM — it was a "bail-in" involving a consortium of LTCM's 14 largest creditors, all Wall Street banks. If no taxpayer money was put on the line, how could the LTCM rescue set a precedent that "loans to unsound financial institutions would be made good by the Fed"? There was no indication during the LTCM crisis that if the private-sector bailout couldn't be hammered out, then the Fed would step in with taxpayer money. No one ever thought that was a realistic scenario. Indeed, that's what made that weekend at the New York Fed in 1998 so unbelievably tense and dramatic: everyone knew the government wasn't going to ride to the rescue if they couldn't hammer out a deal, so everyone realized that it was an all-or-nothing proposition. Remember, Bear Stearns pulled out of the LTCM bail-in fund at the last minute, which almost doomed the rescue (Poetic-Justice Alert). If the major players in the LTCM bail-in actually thought that the government would ride to the rescue if they didn't agree to a private-sector bail-in, why didn't they all abandon the bail-in when Bear pulled out? Why didn't they just say, "screw it," and let the government sort it out? Because a government bailout wasn't on the table that weekend. That's a big reason why a private-sector rescue was still finalized, despite the very conspicuous absence of LTCM's second-biggest creditor and clearing bank, Bear Stearns. The precedent the LTCM rescue set was that if an instution was too-big-to-fail and a private-sector bailout could be negotiated by the New York Fed, then it would probably get a private-sector bailout. We can argue about whether that was a good precedent to set, or whether it contributed to the current financial crisis. But you can't, as Tyler does, blame the LTCM rescue for setting a precedent that it plainly did not set. I also want to take issue with something else Tyler says, because this is a myth that has long outlasted its expiration date:
What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.
First of all, the consortium that bought LTCM was also "entirely private," so I don't know what point he's trying to make there. Second, I distinctly remember that the offer from the Warren Buffet-led group was aptly characterized by one lawyer that weekend as "a publicity stunt masquerading as an offer." It was not a serious offer: it was all of one page, and required shareholder approval even though Buffett knew quite well there was no time for shareholder approval at that point. Third, Tyler fails so mention who the other two members of the Buffett-led consortium were: Goldman Sachs and American International Group (AIG). Does anyone really think it would have been a good thing if AIG had acquired a hedge fund with $100 billion in derivatives positions way back in 1998? I didn't think so.

Tuesday, December 23, 2008

CDS News

Well, this is surprising:

CME Group Inc. (CME) is in advanced discussions with six dealers to take equity stakes in its credit-default swap trading and clearing platform, as it lines up against a rival backed by nine of the market's largest participants. The expected deal flow would help the exchange regain momentum in the looming battle to clear trades in the $33 trillion CDS market after IntercontinentalExchange Inc. (ICE) effectively took over a bank-backed effort to process the swaps. ... Three major credit-derivatives dealers, along with Citadel's own CDS business, are "all that's initially needed for sufficient volume," said Thomas Miglis, senior managing director of information technology at Citadel. He added that as many as six banks may be onboard at the time of launch; some of these dealers are also backing the ICE venture.
Miglis doesn't say which dealers are supposedly now backing both ICE and CME, so I'll reserve judgment. Also of note:
swaps on countries and mortgage bonds won't be supported [on CME's platform].
Maybe ICE and CME really are content to split the CDS market, with CME clearing plain-vanilla single-name and index CDS, and ICE essentially continuing the current highly-customized (bespoke) over-the-counter CDS market, only now with a central clearing party. However, I kind of doubt the Fourteen Families (i.e., the big CDS dealers) would cede their iron grip on the CDS market to CME so easily, especially after going to such lengths to assemble ICE, The Clearing Corporation, and Creditex.

Friday, December 19, 2008

Are Asset Bubbles Inevitable?

Virginia Postrel thinks they are, because bubbles occur even in controlled experiments. This, Postrel argues, casts doubt on the idea that regulations can curb asset bubbles:

These lab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation.
Even if we grant the premise that the experimental results Postrel cites in her article say much of anything about real-world asset bubbles, it's still wrong to conclude that the results weaken the argument for regulations aimed at preemptively curbing asset bubbles. All the experiments show is that under a certain set of highly-simplified conditions, asset bubbles appear to be inevitable. They say nothing at all about the occurrence of asset bubbles under conditions which include regulations aimed at preemptively curbing asset bubbles. If anything, the experimental results Postrel cites strengthen the case for preemptive regulations. To that end, may I somewhat selfishly recommend this considered proposal from Roman Frydman and Michael Goldberg (I had Professor Frydman for Applied Economics, and his wife for a brutal Stochastic Modeling class at Stern):
To institutionalise the importance of acknowledging imperfect knowledge, new regulations should be adopted that require every rating agency to issue multiple ratings for each security, which would make explicit the fact that the risk of default depends crucially on the magnitude and duration of departures from historical benchmarks. Beyond rating reforms, central banks should announce on a regular basis – as some now do with regard to inflation – a range of benchmark values for key asset markets. The idea behind these announcements is to make it more risky for market participants to continue to place too little weight on departures from the benchmark in their trading. This would moderate their willingness to bet on greater departures, thereby limiting the magnitude of price swings. But governments can do even more. As an asset price moves beyond the non-excessive range, margin and other capital requirements should increase for those who want to take positions that push the price farther away from the benchmark. Since every long swing is different – the benchmark itself can change over time due to changes in technology and the social context – the central bank should be given discretion to widen or narrow the range as our imperfect knowledge unfolds. Such decisions should be accompanied by detailed explanations of the central bank’s assessment, which would enable quality control by the public. Limiting excessive swings does not call for central banks to confine asset prices to a pre-specified target zone. ... Instead, the limit-the-swings changes in capital requirements and central banks’ regular announcements of a range of benchmark values aim to increase the risk of capital losses from betting on greater departures.
Frydman and Goldberg's proposal is an extension of their groundbreaking work on imperfect information and exchange rates.

With the near-constant discussion of what should go into Obama's stimulus package (tax cuts? infrastructure spending?), it's disappointing that this proposal from Laurence Kotlikoff and Ed Leamer, which is the best idea I've heard yet, hasn't managed to get any traction:

A better way to spur consumer spending is for Uncle Sam to run a six-month national sale by having a) state governments suspend their sales taxes and b) the federal government make up the lost state sales revenues. The national sale could be implemented immediately. Here’s how it would work. Uncle Sam would pay each state a fixed percentage — say 5 per cent — of the 2007 consumption of its residents. States would be required to reduce their retail sales tax rates by enough to generate a six-month revenue loss (calculated using 2007 data) equal to the amount they’ll receive from Uncle Sam. For states with low or zero sales tax rates, implementing this policy requires making their sales tax rates negative, ie subsidising purchases. Shoppers would see a negative tax on their sales receipts, lowering their outlays. State governments would reimburse businesses for paying the subsidy and, in turn, be reimbursed by the Feds. States would be free to broaden their sales tax bases to apply the National Sale to all retail sales, not just the sales currently covered in their sales tax systems. To make the policy progressive, states could also reduce sales tax rates by more for goods and services that are disproportionately consumed by the poor.
This is a great idea. The government could even mount an ad campaign promoting the National Sale—because if there's one thing we know, it's that Americans love a good sale.

An article from the Mises Institute:

Madoff is a perfect case study showing that the SEC is incapable of protecting investors as well as free market institutions are, writes Briggs Armstrong.
Full article here, and no, it's not a joke. Sadly, Armstrong thinks he's making a serious argument.

Thursday, December 18, 2008

In Praise of Shaun Donovan

I didn't get a chance to comment on this last week, but I wanted to mention that Obama couldn't have picked a better nominee for HUD Secretary. Shaun Donovan is absolutely top-notch. There's probably no area of policy I know more about than affordable housing, so I'm a hard person to please when it comes to nominating a HUD Secretary. But I was overjoyed when I heard that Obama had nominated Donovan. He has a deep knowledge of housing policy, both at the federal and state level. Most importantly, he understands better than anyone the importance of zoning, density, and multifamily housing. Donovan will inherit a truly dysfunctional HUD, but if there's anyone who can refocus HUD's attention onto the issues that actually the provision of affect affordable housing, it's Donovan.

Wednesday, December 17, 2008

NYT Editorial Board Repeats Morgenson Idiocy

The NYT editorial board recycles a thoroughly discredited accusation about the Fed's decision to save AIG (h/t Felix Salmon):

The revised version of the story (in which there is no disparate treatment, only officials following the letter of the law in each case) sidesteps questions about whether the bailout of A.I.G. — arranged by Mr. Geithner — was influenced by the specific needs of some of the insurer’s counterparties, like Goldman Sachs. The Times’s Gretchen Morgenson reported that Lloyd Blankfein, the chief executive of Goldman, was the only Wall Street executive at a meeting at the New York Federal Reserve on Sept. 15 to discuss the A.I.G. bailout. A Goldman spokesman said Mr. Blankfein was not there to represent his firm’s interests, but rather that Goldman “engaged” the issue because of the implications to the entire system.
To suggest that the Fed's decision to bail out AIG was improperly influenced by Goldman is about as absurd as it gets. First of all, the Fed already responded to Morgenson's ridiculous article, explaining that representatives from the other Wall Street banks were at the meeting as well, although Blankfein was technically the only CEO there. Second, and most importantly: The Fed hired Morgan Stanley to advise them on the AIG bailout. From Bloomberg:
The Fed has hired Morgan Stanley to examine alternatives for AIG, a person familiar with the situation said. Morgan Stanley will review what role, if any, the government should play in helping the insurer.
Gretchen Morgenson is the most incompetent financial reporter I've ever seen.

Monday, December 15, 2008

Brad DeLong Assumes a Can Opener

Brad DeLong aruges for lowering mortgage interest rates to 4% to boost the housing market. I think Brad needs to re-check his assumptions:

The mortgage interest rate is made up of four things. Compensation for inflation--call it 2% per year. Real time preference--the fact that because we will be richer in the future we value future goods at less than par in terms of present ones--call it 2% per year. The default discount--which in a well-run housing market should be small. And the risk discount--the extra return mortgage lenders demand because they are not sure when their payments are going to come exactly or what they will be worth exactly when they do come--and I am under the spell of Richard Thaler and Matt Rabin who argue that this discount should also be very small.
Too bad we don't have a well-run housing market. Assuming away the default discount in mortgage interest rates right now is a bit like assuming a can opener.

Oh God, Paul, say it ain't so:

Nobel laureate for economics Paul Krugman has slammed the German government’s handing of the economic crisis, saying Chancellor Angela Merkel and Finance Minister Peer Steinbrück have completely failed to understand the situation. “They are still thinking in the category of a world as it looked one or two years ago, with inflation and deficits as the biggest danger,” he told Der Spiegel. “The result – they have misinterpreted the seriousness of the economic crisis and are wasting valuable time – for Germany and for Europe. Maybe they lack intellectual flexibility.”

Friday, December 12, 2008

David Brooks and Risk Tolerance

David Brooks writes:

When investors in New York become gripped by fear, they pull inward. When Washingtonians are gripped by fear, they rush outward, with bigger and more daring plans. The risk tolerance in the financial world has shrunk to zero, but the risk tolerance in the political world has risen to infinity.
No, David. Bigger plans mean that politicians are becoming more risk averse. Fiscal prudence in the face of plummeting aggregate demand is significantly riskier than fiscal expansion. The bigger the fiscal stimulus, the less the economy will suffer in the short-term. And letting the banking system fail is the riskiest strategy of all, as we learned in the 1930s. And yet Brooks is still regarded as an "intellectual" Republican. Go figure.

Thursday, December 11, 2008

Which One Does Not Belong?

It's always amusing to watch Marc Ambinder talk about policy. In this post, Ambinder reports that Obama's economic advisers are worried about "the complete economic collapse of a large, unstable nation":

To be sure, Pakistan is nearly broke, and U.S. policy makers seem to be aware of that; but a worldwide demand crisis could lead to social unrest in countries like Indonesia and Malaysia, Singapore, the Ukraine, Japan, Turkey or Egypt (which is facing an internal political crisis of epic proportions already). [emphasis added]
Since when is Japan an "unstable nation"? If a country can survive a Japan-like Lost Decade and still be considered "unstable," then we're all screwed.

Just 8 days after Fed Governor Randall Kroszner gave a speech completely eviscerating the argument that the Community Reinvestment Act (CRA) had anything to do with the subprime crisis, the NYT decides to publish an op-ed by Howard Husock aruing that the CRA deserves a significant portion of the blame for the subprime crisis. Whichever editor decided to publish this op-ed should be immediately fired for gross incompetence. Randall Kroszner, in a speech on December 3:

[T]he findings of a recent analysis of mortgage-related data by Federal Reserve staff...runs counter to the charge that the CRA was at the root of, or otherwise contributed in any substantive way, to the current subprime crisis. ... Only 6 percent of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas. ... This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. ... We found that loans originated under the NWA program [a portfolio of CRA-covered loans] had a lower delinquency rate than subprime loans. Furthermore, the loans in the NWA affordable lending portfolio had a lower rate of foreclosure than prime loans. The result that the loans in the NWA portfolio performed better than subprime loans again casts doubt on the contention that the CRA has been a significant contributor to the subprime crisis. ... [F]oreclosure filings have increased at a faster pace in middle- or higher-income areas than in lower-income areas that are the focus of the CRA. Contrary to the assertions of critics, the evidence does not support the view that the CRA contributed in any substantial way to the crisis in the subprime mortgage market.
Howard Husock, in tomorrow's NYT:
One cannot say with any certainty whether the more important cause of the current housing crisis was affordable-housing mandates or the actions of investment banks and ratings agencies.
Fire Andrew Rosenthal. Right now.

Tuesday, December 9, 2008

Two Absolute Must-Reads

1. A 2005 internal Fannie Mae presentation, titled "Facing Strategic Crossroads"

The presentation is the smoking gun in the debate over whether Fannie and Freddie entered the subprime and Alt-A markets in order to satisfy government mandated affordable housing goals, or for market-related reasons. This presentation ends the debate: private market forces pushed Fannie and Freddie into the subprime and Alt-A markets. The presentation is simply incredible reading.

See especially page 5, which says: "We face two stark choices: (1) Stay the Course; (2) Meet the Market Where the Market Is." Page 9 lists the "significant obstacles [that] block our ability to pursue a 'Meet the Market' strategy," one of which is "lack of knowledge of credit risks." (Ya think?) Page 10 shows that Fannie essentially elected to pursue a hybrid strategy: Fannie continued to "test whether current market changes are cyclical vs. secular," but also "dedicate[d] resources and funding to 'underground' efforts to" enter the subprime and Alt-A markets. Page 11 is the real smoking gun though:

Funny, no mention of affordable housing mandates.

The presentation is like an incredible window into the mortgage market during the housing bubble; it perfectly captures the prevailing mentality of the time. Not that anyone should be surprised, but the presentation also proves, once again, that Tanta was right.

2. The DOJ press release on Illinois Gov. Rod Blagojevich's indictment on federal corruption charges

The charges are nothing short of stunning. The headliner is obviously Blagojevich's repeated and shockingly explicit attempts to sell President-elect Obama's vacant Senate seat. But the allegations relating to the pay-to-play scheme, as well as Blogajevich's misuse of state funds to induce a purge of unfriendly Chicago Tribune editorial writers, are also incredible. The DOJ press release contains all the highlights from the 76-page criminal complaint.

A lot of Blogajevich's alleged statements are so cartoonish that it's almost hard to believe the quotes are accurate, but as a colleague who practices white collar crime informed me in an email:
If the USA [U.S. Attorney] says in the complaint that they've got Blogajevich saying these things on tape, then they've got it. Instant classic in public corruption law.
Read the whole DOJ press release.

This is bad news:

Most U.S. mortgages modified by lenders to help keep struggling borrowers in their homes fell back into delinquency within six months, the chief regulator of national banks said. Almost 53 percent of borrowers whose loans were modified in the first quarter of this year re-defaulted by being more than 30 days overdue, John Dugan, head of the Treasury Department’s Office of the Comptroller of the Currency, said today at a housing conference in Washington.
It's possible that this is just a reflection of how shitty the current mortgage modification programs are (Hope Now, anyone?), instead of evidence that mortgage modification programs can't work at all. The FDIC has been promoting the mortgage modification model it's been using since it took over IndyMac as an unmitigated success, so I'd like to wait for the results from that experiment before I give up on mortgage modification programs entirely. (Although Sheila Bair is a relentless self-promoter, so I'm naturally skeptical of her claims.) In any event, the OCC's survey is disheartening.

Sunday, December 7, 2008

Financing Lawsuits with Bailout Money

The WSJ reports that one of the sticking points in the negotiations over an auto bailout between the Dem leadership and the White House is:

A demand by senior Democrats that funds under the bailout not be used by the automakers to finance lawsuits challenging state car-emission limits.
On a theoretical level, I think I have to side with the White House on this one; although on a practical level, I suspect the Democrats are right. It's tempting to view such lawsuits as frivolous and akin to playing the lottery—and they may well be. I don't know nearly enough about the suits at issue to offer an informed opinion on the merits of the claims. But two justifications for using bailout money to finance these lawsuits come to mind. First, I know from experience that states often promulgate regulations that stretch the limits of the authority they were delegated when the state knows that a powerful industry, such as automakers, will challenge the regulations in court regardless of how stringent they are. The mentality in state capitals is that they need to stretch the limits of their authority because the more authority their initial regulations claim, the more authority they'll end up with when the dust settles from the inevitable legal challenge. Indeed, I've promoted this mentality to state officials in the past, and I still think it's the best strategy if the state simply wants to maximize the authority it has available in a certain policy area. State courts tend to work within the framework presented to them by the litigants, so states need to claim as much authority as possible in order to move the goalposts. Unfortunately, the strategy of "claim as much authority as possible in the initial regulations" often devolves into a different strategy: "promulgate regulations that wildly overstep the authority actually delegated, and let the court work it out." If this is what happened with the state car-emissions regulations, then the automakers should absolutely be allowed to use some of the bailout money to finance lawsuits challenging these regulations. My gut tells me that this isn't the case, and that the automakers' suits are probably unnecessary, but like I said, I'm not nearly familiar enough with this area of law to say one way or the other. I'm just offering a theoretical justification for using bailout money to finance these lawsuits. Second, from a pure cost-benefit perspective, it's possible that successfully challenging a state's car-emissions regulations could give the automakers the most bang for their buck. That is, if a court overturned a state's current car-emissions regulations (on whatever grounds), that could reduce the automakers' costs enough that financing the lawsuits would be the most cost-effective way to use the bailout money. Again, I doubt this is the case (especially given the extremely high legal costs of those kinds of suits), but it's at least possible. I'd be interested to hear from someone who is familiar with the merits of the automakers' suits challenging states' car-emissions regulations. Of course, in the time it took me to write this post, I probably could've figured out whether the automakers' suits have much legal merit, but then again, you're a jerk.

Friday, December 5, 2008

It's ICE

Not that it was totally unexpected, but in the race between IntercontinentalExchange (ICE) and CME Group to get the first CDS clearinghouse up and running, ICE is going to win. ICE just won approval for a New York trust charter from the New York Banking Department. Unless I'm mistaken, the only step left is approval from the Fed, which obviously should be forthcoming.

New York Supreme Court rejects shareholder challenge to fairness of JPM's rescue of Bear Stearns. A huge win for the business judgment rule.

Making the rounds:

Monday, November 24, 2008

Two Observations on the Financial Crisis

Having spent the past two months at hedge funds and money center banks, let me offer a couple broad observations about the financial crisis. First, Wall Street and Greenwich were absolutely convinced that the government would save Lehman. They interpreted the Bear Stearns rescue as a signal that no major financial institution would be allowed to fail. This view was only reinforced by the Fannie & Freddie rescues. If Bear was too systematically important to fail, the thinking went, then Lehman was definitely too important to fail. The fact that there was no political will for a Lehman bailout didn't even cross the mind of most people on Wall Street. If it did cross their mind, they usually used it to dismiss Paulson's hard-line public statements as mere political posturing. (And let's be honest: despite Paulson's ever-shifting stories, the lack of political will was the reason the government didn't save Lehman.) A May report by Moody's on systemic risks in the CDS market shows how deeply ingrained the idea that the government would save Lehman was:

It should be said at the outset that the actual likelihood and systemic consequences of a default by a major counterparty, would depend, to an important degree, on the systemic importance of such a counterparty. The more important the function played by an institution, the more likely it is to be considered by regulators to be "too big to fail" or "too complex to unwind". Thus, a systemically important institution would be more likely to trigger intervention from the regulatory authorities to prevent a disorderly liquidation that may imperil the broader financial system. Indeed, this is what happened with Bear Stearns, when the Federal Reserve and JPMorgan Chase stepped in to save it from collapsing. The largest CDS dealers are highly rated securities firms and banks, which play systemically important roles in the efficient functioning of the financial markets. ... In Moody’s opinion, the systemic importance of these firms [which included Lehman] therefore provides meaningful incentives to regulatory authorities to prevent such firms’ disorderly failure, given the disruptive effect this would likely have on the derivatives market.
Needless to say, when Lehman actually failed, the financial markets were completely unprepared, and therefore panicked. My second observation: This financial crisis was inevitable; saving Lehman would not have averted a financial panic. There's simply no way the financial system could have fully deleveraged without a full-scale financial panic. The financial markets are so complex and interconnected, and the problems were already hidden across so many asset classes, that a deleveraging process was guaranteed to lead to uncontrollable fear at some point. The Lehman failure led to a full-blown panic primarily because it hurt the money market funds so hard. No one thought that the once-sleepy world of money market funds had so much exposure to Lehman. When the Reserve Primary Fund broke the buck, everyone collectively realized just how interconnected—and therefore unpredictable and uncontrollable during a deleveraging cycle—the financial markets really are. My point is that the deleveraging process would have eventually caused large losses in a completely unexpected area of the financial system whether we saved Lehman or not. When contagion can spread faster than investors can get their minds around it, fear replaces rational analysis. So yes, letting Lehman fail was a mistake. But anyone who thinks that if we had just saved Lehman, we could have maintained the necessary trust and confidence in the banking system throughout the entire deleveraging process, is frankly delusional. This financial panic was bound to happen. The fuse was lit years ago.

Sunday, November 23, 2008

Citi Bailout: An "Extremely Unusual" Deal

The government and Citi have (finally) agreed on a bailout, and the structure of the deal is a bit of a shocker. From the WSJ:

Treasury has agreed to inject an additional $20 billion in capital into Citigroup under terms of the deal hashed out between the bank, the Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corp. Treasury officials will charge a higher interest rate for the capital injection -- 8% for the first few years -- than it has charged to dozens of other banks now borrowing money under the government's the $700 billion rescue package approved by Congress last month. In addition to the capital, Citigroup will have an extremely unusual arrangement in which the government agrees to backstop a roughly $300 billion pool of its assets, containing mortgage-backed securities among other things. Citigroup must absorb the first $37 billion to $40 billion in losses from these assets. If losses extend beyond that level, Treasury will absorb the next $5 billion in losses, followed by the FDIC taking on the next $10 billion in losses. Any losses on these assets beyond that level would be taken by the Fed. Citigroup would also agree to work to modify -- if possible -- troubled mortgages held in the $300 billion pool, using standards created by the FDIC after the collapse of IndyMac Bank.
The government guarantee is essentially the same deal that Citi had struck with the FDIC in its failed acquisition of Wachovia, with slightly less favorable terms. In the original deal between Citi and the FDIC, the FDIC was going to backstop a $312 billion pool of assets, with Citi responsible for the first $30 billion in losses and the government responsible for the rest. Now the government is guaranteeing a slightly smaller pool of assets ($300 billion instead of $312 billion), and Citi is responsible for slightly more of the losses ($37/$40 billion instead of $30 billion). Making the deal more punitive is appropriate, seeing as Citi is already benefiting from huge amounts of government aid. Whether this is a good deal depends, obviously, on what's in the $300 billion pool of assets. Also crucial is what remains on Citi's balance sheet, including its various SIV's. If the aim of this deal was to shore up confidence in Citi (and from all indications, it was), then the deal should include mandatory disclosure of all Citi's off-balance-sheet liabilities. UPDATE: Here's the term sheet, which has some additional information. Highlights:
  • $306 billion pool of assets to be guaranteed, not $300 billion.
  • Citi will bear the first $29 billion in losses, and the remaining remaining losses will be shared by the government (90%) and Citi (10%).
  • Dividends on common stock in excess of $0.01 per share per quarter are suspended for 3 years, unless the government consents to the dividend. It's unclear whether common stock dividends in the next 3 years will require the consent of the Fed, Treasury, and the FDIC, or some combination thereof.

Wednesday, November 19, 2008

Regulators push for disclosure of bespoke CDS

Regulators want to get a peak at the world of non-standard CDSs:

The Federal Reserve Bank of New York, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission want information about credit-default swaps that don't conform to standard terms to be disclosed in a central warehouse that would make sure all trades get recorded, said the person, who declined to be identified because the discussions are private. The requirement would provide more detail about the types of contracts that almost drove American International Group Inc. into bankruptcy.
My prediction: they will not like what they see. The number of bespoke CDSs is much higher than people commonly believe. But I suspect what will really shock the regulators are the terms of the bespoke CDSs. Some of the (non-standard) amendments the parties add in the Confirmations and Credit Support Annexes are just outrageous. If I get a chance tomorrow, I'll post my favorite amendment I've run across so far (which one trader dubbed the "embedded option to screw your wife").

Sunday, November 16, 2008

Auto Bailout

I'm undecided on the auto bailout. At first I was opposed to it, because if there's anyone who has ever needed Chapter 11 bankruptcy, it's the Big Three. Their business model and their capital structure are both clearly unsustainable; they badly need to restructure, and that's what Chapter 11 is for. I'm still leaning heavily toward rejecting the auto bailout, but this, from Wilbur Ross (a.k.a. the King of Bankuptcy), has given me pause:

Investor Wilbur Ross, who made billions turning around distressed steel and textile companies, said a Chapter 11 filing by General Motors Corp. or another U.S. automaker wouldn't work and might devastate the economy. Going to court to reorganize would be "a very inhospitable environment for any of these guys," Ross, 70, said in an interview yesterday. "It would be a total mess." ... "If we were in a different overall economic environment, one of them going down wouldn't necessarily kill" the industry, he said. A weakened economy and frozen debt markets make an automaker bankruptcy impossible, with a Chapter 11 filing for reorganization resulting in liquidation instead, Ross said.
It isn't entirely clear why Ross thinks Chapter 11 would be impossible, but the lack of available financing seems to be his main concern. If that's the problem, then instead of lending the Big Three $25 billion to keep them out of Chapter 11, the government should let them file for Chapter 11 and then agree to provide DIP financing.

Friday, November 14, 2008

The Importance of the New York Fed

Ben Bernanke thinks losing the President of the New York Fed in 1928 left policymakers rudderless when the markets crashed in 1929:

In the run-up to the Depression, Bernanke argued, better leadership could have made a difference. In a November 2002 speech honoring the economist Milton Friedman, Bernanke, already serving on the Fed's board of governors, recounted the tale of Benjamin Strong. As head of the Federal Reserve Bank of New York in the 1920s, Strong opposed the Fed's attempt to curb Wall Street speculation by tightening monetary policy when "there was not the slightest hint of inflation," Bernanke said. But Strong died of tuberculosis in 1928, and his views lost sway. "We don't know what would have happened had Strong lived; but what we do know is that the central bank of the world's economically most important nation in 1929 was essentially leaderless and lacking in expertise," Bernanke lamented. "This situation led to decisions, or nondecisions, which might well not have occurred under better leadership. . . . And associated with these decisions, we observe a massive collapse of money, prices, and output."
Of course, if current New York Fed President Tim Geithner becomes the new Treasury Secretary, we won't lose his experience or leadership. But given the vital role the New York Fed plays in policymaking, I doubt Obama will be willing to risk moving Geithner to Treasury while the markets are still in such a precarious position.

Thursday, November 13, 2008

Headline of the Day

From Bloomberg:

The subtle mockery is priceless.

Wednesday, November 12, 2008

Good News on CDS Clearinghouse

This is good news:

The Federal Reserve is working on a plan that would give it authority to regulate the clearing of trades for the $33 trillion credit-default swap market, according to people with knowledge of the proposal. The Fed, the U.S. Securities and Exchange Commission, the Treasury Department and the Commodity Futures Trading Commission are discussing a memorandum of understanding that lays out oversight of clearinghouses that would become the central counterparty to credit-default swap trades, said the people who asked not to be named because the discussions are private. The SEC and CFTC would also share trading information under the plan, the people said.
Everyone knows there will be more regulation of the CDS market soon, but the worry is that each regulator will impose a different regulatory regime, without any coordination, resulting in an onerous patchwork of regulation. If CDS market participants have to navigate a confusing patchwork or regulations, that could damage the liquidity of the market (which is one of the main attractions of CDS right now). Good for the Fed!

Tuesday, November 11, 2008

The Myth of Wall Street's Genius

Michael Lewis has a long piece in Portfolio called "The End of Wall Street's Boom" that I highly recommend. A recurring theme in the piece is that Wall Street financiers just aren't as smart as everyone thinks they are. I couldn't agree more. Virtually no press account of the financial crisis is complete without paying homage to how smart the financiers who got us into this mess are. (Usually the homage is paid by referring to the "financial wizards on Wall Street," or asking how "some of the smartest people in the world" ended up being so terribly wrong?") Wall Street's perceived genius has reached almost mythic proportions, especially among clueless pundits like David Brooks and Sebastian Mallaby. I was never terribly impressed with the overall level of intelligence on Wall Street when I worked there in the '90s. But since returning to Wall Street (or more accurately, Greenwich/Wall Street) a couple months ago, I've been shocked by how many utter morons there are now in financial houses and hedge funds. I've encountered more than a few traders who, when pressed, reveal a very meager understanding of their own product. The one area that seemed to attract genuinely brilliant people back in the late '90s and early '00s was risk management. But no more. Risk management departments are now disproportionately populated by spoiled Harvard legacies with no apparent intellect. All the genuinely smart people I knew on Wall Street back in the day seem to have moved on to hedge funds or retired. I'm not saying there aren't any brilliant people in the big financial houses (there are), I'm just saying that they're the exception rather than the rule. More generally, though, I think the current financial crisis pretty well demonstrates that Wall Street financiers aren't, in fact, "some of the smartest people in the world." I wish the media would put that ridiculous myth to bed.

Ben Stein offers a bizarre piece of advice to President-elect Obama:

HAVE REALISTIC EXPECTATIONS Plan what must be done to effect the minimum amount of change you’ll be happy with. All politicians basically promise the moon and the stars to their supporters. For any new president, it’s crucial to try to decide what can be reasonably changed — like naming a new Treasury secretary and having higher taxes for the wealthy. Then the president must set to work on those while his prestige and mandate are still fresh and strong.
Naming a new Treasury secretary isn't something that Obama may-or-may-not be able to do, depending on his political capital. It's automatic. And with a large Democratic majority in the Senate, confirmation of Obama's nominee will also be automatic. (Yes, potential Treasury secretary Larry Summers made some controversial remarks about women in the sciences a few years ago, but there's absolutely zero chance of that threatening his confirmation.) As for the two leading candidates for Treasury secretary—Larry Summers and Tim Geithner—I sincerely hope that Obama picks Geithner. I met Geithner once a few years ago, and have heard him speak a couple times, and he's very impressive. He's also extremely well-respected on Wall Street. But I think Obama will end up picking Summers instead, primarily because there's no obvious replacement for Geithner at the New York Fed. President of the New York Fed is a critically important position—one which, probably more than any other position, requires someone with the full confidence of Wall Street. Unless William McDonough can be persuaded to come out of retirement, I just can't see Obama plucking Geithner from his position at the New York Fed in the middle of a financial crisis that's driven in large part by a crisis of confidence. Like Yves Smith, I'm not a huge fan of Summers, but people much smarter than I insist that he's a once-in-a-generation mind, so I suppose I'd be content with Summers as Treasury secretary.

Tuesday, November 4, 2008

DTCC: $33.6 Trillion in CDS Registry

DTCC: Gross notional total of credit default swaps in DTCC registry is $33.6 trillion. $15.4 trillion in single-name CDS, and $14.8 trillion in CDS linked to indexes. DTCC claims that its registry captures about 90% of the CDS market. That's actually larger than I was expecting, but still much smaller than the numbers constantly cited by the media.

Tremendous day in the markets, virtually across the board. In the equity markets, the S&P closed up 4.08% (and over 1000 again!), the Nikkei surged 6.27%, and the FTSE 100 was up over 4% as well. Almost equally as important, the equity markets traded in a narrow range all day. To that end, the VIX plunged 11.08%, closing below 50 for the first time in over a month. The IG11 was trading around 180bps when I last checked. Treasurys soared, swap spreads were lower, etc. The list goes on. Most notable was the change in sentiment. The abject fear that has characterized the markets since Lehman's failure was nowhere to be found for long stretches of the day. Today's reprieve will almost certainly prove to be temporary, but it was nonetheless a much-welcome breather.

With the first round of exit polls on the horizon, I should get my electoral projection on the record. Here it is:

As for the Senate, I see the Democrats picking up 7 seats, bringing their total to 58. Democrats will pick up Virginia, Colorado, New Hampshire, Alaska, New Mexico, North Carolina, and Georgia; however, they'll lose Minnesota and Kentucky. Should be an interesting evening, at least in the Senate.

Saturday, November 1, 2008

Oh, the irony

From Helen Avery’s article (via Felix Salmon) about the failure of Lehman Brothers Europe, and the devastating consequences for its prime brokerage clients:

“US hedge funds maintain the UK law is archaic and should be changed to protect prime brokers’ clients, and some have complained to the Bank of England.”
Hedge funds are, by definition, open only to wealthy investors. The entire justification for not requiring hedge funds to register with the SEC is that their clients are supposedly wealthy enough—and therefore sophisticated enough—that they don’t need the protection of the SEC. But now that some US hedge funds have been burned by Lehman Brothers Europe's rehypothecation practices, the hedge funds are crying about how UK law doesn’t protect clients enough! The irony. It’s too much.

Friday, October 31, 2008

"The Obama Premium"

It's been amusing, if increasingly grating, to watch people like James Pethokoukis push the bonecrushingly stupid argument that Obama's rise in the polls is the real reason the markets have been crashing. John Authers of the FT points out that even if you accept the dubious premise that politics has been driving the markets, Pethokoukis and company are still wrong:

[O]ther global stock markets have suffered worse than the US in the past two months, and funds have flowed to the dollar. This implies, if anything, that the US is benefiting from an “Obama premium”.
Authers also rebuts the argument—currently being pushed by the RSCC—that if the Democrats control the presidency and both houses of Congress, life as we know it will end (or something like that):
[R]esearch by the CFA Institute shows that stocks do better when one party runs both branches of government.

The U.S. government, along with governments around the world, have taken extraordinary steps to unfreeze the credit markets. The government has, among other actions, recapitalized 25 banks to the tune of roughly $158 billion, guaranteed all senior debt issued by banks over the next 3 years, and extended unlimited swap lines to several other central banks. The G7 countries also made it very clear that they won't allow another big bank to fail ("no more Lehmans"). Yet despite the historic government actions, the credit markets have barely budged. The Libor-OIS spread, which the Fed uses to measure the perception of risk in the credit markets, remains extremely high—it's currently 255 bps. While this is down from its high of 350 bps on October 9, in normal times the spread hovers around 20 bps, so 255 bps is still absurdly high. Credit default swap spreads (CDX) also remain extremely wide, with the IG 11 trading at 199 bps. Why have credit markets been responding so slowly? A good deal of the delayed reaction is attributable to, oddly enough, all the government actions. Since Lehman went under the Fed and the Treasury have been creating new programs at a dizzying speed. For example, we've had the Troubled Assets Relief Program (TARP), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the recapitalization plan. And, of course, who could forget the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCPMMMFLF)! It takes a lot of time to work through the details of each program, determine who is eligible, weigh the costs and benefits of participating, assess the program's overall impact on the credit markets, etc. Most importantly, every financial institution has to adjust its risk models accordingly. This isn't a simple task, and in an environment where financial institutions are as risk-averse as I've ever seen, no one wants to start lending again until they're absolutely sure they understand the terms and ultimate impact of each new government program. The launch of the CPFF this week was a reassuring event for everyone. But every time a new story surfaces about a possible bailout for another industry (e.g., insurance companies, automakers) or another possible government program (e.g., the bailout for homeowners now being discussed), more uncertainty is injected into the credit markets. I'm not saying that the government shouldn't create new programs just because they'll cause temporary uncertainty and timidity in the credit markets—if a new program is truly necessary, then that kind of short-term pain should be worth it. I'm just saying that, based on what I've seen, a good deal of the delay in the improvement of the credit markets is due to financial institutions taking their time digesting each new government program.

Chicago Tribune columnist Steve Chapman is a hack. Everyone knows this. But this is bad even for someone as cartoonishly ignorant as Chapman. In this morning's column, he wrote:

For nearly a year, we've been told that the economy is on the verge, if not the thick, of a painful recession. But the traditional definition of a recession is two consecutive quarters of negative growth -- and we have yet to endure even one such quarter.
Yes, Steve, we have: GDP growth was negative in the fourth quarter of 2007. (Also, two consecutive quarters of negative growth isn't really the "traditional" definition of a recession, it's the "old" definition. It's "traditional" to use the NBER Business Cycle Dating Committee's definition of a recession, and the Committee long ago abandoned the "two consecutive quarters of negative growth" definition. Why would the Tribune's editors let Chapman use the old definition of a recession to argue about whether we're in a recession now?)

Tuesday, October 28, 2008

WSJ Catches On

Today's WSJ has an article that finally puts the "volatility spiral" I discussed in the previous post at the center of the post-Lehman rout:

Brokers and exchanges calculate the level of collateral required to trade securities on margin based on potential losses in stress tests, determined by historical volatility. But stocks, bonds and derivatives busted out of historical volatility ranges in the wake of Lehman Brothers Holdings Inc.'s failure in mid-September, and so brokers and exchanges had to change their assumptions. They increased the amount of collateral needed as the range of possible losses on trades grew. Every time the collateral requirement increased or the account lost a critical mass of money, it triggered a "margin call," forcing funds and investors to sell securities to come in line with the new requirement. So every successive drop in the stock market triggered another round of margin adjustments, another round of margin calls, and another round of forced selling.
At this rate, we should expect the New York Times to run an article on the volatility spiral in mid-November, and the Washington Post to deliver a front-page exposé on volatility around March 2009 (which of course will win a Pulitzer).

Monday, October 27, 2008

The Importance of Volatility

The most important financial market indicator right now is not the Dow, not swap spreads, and defintely not the TED spread. It's not even Libor (though Libor is still important, for obvious reasons). It's volatility. The most widely-used measure of volatility is the VIX, which measures the implied volatility of options on the S&P 500 index for the next 30 days. The VIX is commonly called the "fear index," which leads to the impression that the VIX is purely a measure of investor sentiment. But given the importance of volatility in financial markets, especially right now, it's much more than a measure of investor sentiment. Volatlity is important because it dramatically affects banks and hedge funds' value-at-risk (VaR). VaR estimates the maximum a bank or hedge fund can expect to lose over a specific time period at a given confidence interval. VaR is the primary tool of risk management. Low volatility leads to low VaR, and high volatility leads to high VaR. Banks and hedge funds' leverage ratios are generally tied to VaR—the lower an institution's VaR, the more it can lever up. More importantly for right now, the higher an institution's VaR, the less leverage it can use. The problem is that we experienced an unusually long period of low volatility this decade, which allowed banks and hedge funds to lever themselves to the hilt. In fact, the low volatility stronly encouraged banks and (especially) hedge funds to lever themselves to the hilt—profit opportunities get snapped up faster during boom years, so hedge funds need to lever small profit margins to maintain their high returns. But when Lehman failed, volatility spiked to unheard-of levels, and has remained there ever since. Just look at the five-year chart of the VIX:

Because financial institutions base their leverage on VaR, the ridiculously high level of volatility post-Lehman has forced them all to simultaneously raise huge amounts of cash to reduce their leverage. The result has been the mother of all coordinated sell-offs—everything must go, and no asset class is safe. Of course, the mass forced liquidation has just increased volatility, forcing yet more fire sales, and leading to still-higher volatility. And so on, and so on. Gillian Tett of the FT, who is the only mainstream commentator I've seen highlight the leading role of volatility in forcing the mass sell-offs, reported that banks are also reducing their leverage by slashing their lending to hedge funds. I haven't seen a whole lot of that, but given the current state of the markets, reducing lending to hedge funds would seem like a better way to reduce leverage than selling into illiquid markets. I wish I could say that this vicious cycle will end soon—or that it will end at all—but from what I've seen and what I hear from others, there's still no end in sight.

Sunday, October 26, 2008

Thomas Friedman: Not A "Details" Guy

Thomas Friedman warns his readers that having the government as a shareholder in banks might stifle innovation because the government might force banks to become overly cautious. If Friedman had taken the time to look at the details of the recapitalization plan, pesky though they are, he'd see that the government is only getting nonvoting shares. He also suggests that banks might become overly cautious because their CEOs will be worried about a scolding from a Congressional committee, which is an argument that only someone who has never worked in either finance or government would make. (Note that in Friedman's hypothetical example, the two young entrepreneurs walk into a bank and immediately talk to the bank president, who then personally evaluates their loan application. I wonder if Friedman has ever actually been to a bank before.) He also says that the thing we need more than anything is "better management" at banks. How does he propose that we accomplish this?

Save the system, install smart regulations and get the government out of the banking business as soon as possible so that the surviving banks can freely and unabashedly get back into their business: risk-taking without recklessness.
So in order to get better management at banks, Friedman thinks the government needs to get out of the existing management's way. Wow. Final score for today's column: Logic - 2; Friedman - 0.

Saturday, October 25, 2008

Not All Economists Are Created Equal

I very much agree with Ezra Klein:

One sidenote of the past few months is that folks turned to economists when what they needed were finance experts. But there are relatively few finance experts who aren't affiliated with financial institutions, and so much of their commentary is tainted. Economics, however, hasn't quite caught up to the size and centrality of the financial industry in the modern economy, and so though economist knew relatively more about what was going on than the median American did, they actually knew much less than people assumed. But it's hard to blame the profession. The growth of finance has been hard to keep up with.
Ezra is wise beyond his years. As a general rule, you should be initially skeptical of any academic economist who purports to provide expert analysis on the workings of the financial markets. The truth is, the financial markets are enormous, wide-ranging, and exceedingly complex, both on the macro and micro levels. The media constantly refer to credit default swaps as "esoteric" instruments, but in the financial world, CDSs are among the simpler instruments. Try getting your head around leveraged super senior (LSS) notes of synthetic CDOs. And that's only one of the thousands of instruments in the global financial system, all of which constantly interact with each other in a dynamic, multi-layered market. An academic economist who doesn't specialize in finance has likely never heard of quite a few of the securities and derivatives that are commonly used today—or, at least, they hadn't heard of them before the financial crisis. There are certainly some financial economists who are genuine experts, but they're few and far between. It has been funny, though a bit sad, to watch many academic economists weigh in on the financial crisis as if they had any clue what they're talking about. They truly live in their own little bubble, arguing about a model of financial markets that bears very little resemblence to the real-world financial markets.

Monday, October 20, 2008

Volcker Supported Recapitalization?

The Wall Street Journal article on Paul Volcker becoming a key economic adviser to Obama says:

Like other prominent economists, Mr. Volcker also advocated early on for the recapitalization of banks. On this advice, Sen. Obama proposed direct-equity infusions in banks in his frequent conference calls with Treasury Secretary Henry Paulson.
Say what? Volcker was a prominent supporter of the plan to purchase illiquid assets from banks—that is, the original Paulson Plan. On September 17, Volcker, along with Nicholas Brady and Eugene Ludwig, wrote an influential op-ed in the WSJ that said:
There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. ... This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.
This op-ed was published on Wednesday of the Week From Hell—that night, Paulson and Bernanke had their famous come-to-Jesus meeting with the Congressional leadership, convincing them of the need for a bailout. By Sunday night the Treasury had unveiled Paulson Plan 1.0, which was—you guessed it—to create a mechanism to purchase illiquid assets from banks! Maybe Volcker did an interview, or wrote another op-ed that I'm not aware of, in which he advocated for recapitalization of the banks, but I find that highly unlikely. If anything, Volcker threw his weight behind the Paulson Plan—a plan that Obama supported, but considered second-best to directly recapitalizing the banks.

I neglected to mention in my last post that the one blog I actually did start reading last week is EconomPic Data. I'm one of those people who likes to visualize data, so the daily charts and graphs of relevant economic data is perfect for me. Highly recommended.

Sunday, October 19, 2008

Financial Crisis Coverage

Brad DeLong mocks the Washington Post for thinking that it has the ability to provide "authoritative" coverage of an event like the financial crisis:

[W]hen an episode like the financial crisis hits, nobody even half-informed with even half a brain looks to the Post for "authoritative" coverage. To the Financial Times, the Economist, and the news pages of the Wall Street Journal; to Calculated Risk, Marginal Revolution, Econbrowser, Economists View, Naked Capitalism, and The Big Picture; to John Berry, Paul Krugman, and Larry Summers. But not to the Post. Not for "authoritative" coverage. The presumption has to be that the Post's reporters are--like Neil Irwin last Wednesday--warping the story to please their sources, or simply out of their depth. The Washington Post crashed and burned long ago.
DeLong is, of course, right: on financial markets coverage, the Washington Post belongs at the kids' table. It has no one, at all, with the requisite intelligence and knowledge of financial markets. When no one at the newspaper actually understands what's going on right now in the financial markets, it's hard to provide "authoritative" coverage of the financial crisis. Where should people turn for truly authoritative coverage of the financial crisis? The Financial Times, the Wall Street Journal, Bloomberg, and Reuters. If you're getting your news on the financial crisis from anywhere else, then you're not actually following the financial crisis. Prior to this week (in which an associate spelled me as the resident 18-hour-a-day guy at the investment house, allowing me to rest up by working mere 10-hour days for a week!), the only times since the financial crisis started that I've been to read any of the econoblogs was when I was at the airport, so I don't really know who's been providing the best commentary. And unfortunately, on Monday it's once more into the breach, for me. Stack of Credit Derivative Master Agreements, here I come!

Via Robert Skidelsky, the foremost authority on all things Keynes:

"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

There's little doubt that the financial sector is about to be re-regulated in a serious way. This is sorely needed, and the conservatives and libertarians who say that increased regulation of Wall Street is a bad idea because regulation can't solve every problem, forever and ever, quite simply have no idea what they're talking about. (I'm looking at you, David Brooks.) Whatever regulatory reform we get will undoubtedly be watered-down, since the regulatory reform won't come until the worst of the crisis in the financial markets has passed, at which time the public outrage over the financial crisis—and thus the political will to re-regulate Wall Street—will have diminished. However, that doesn't necessarily mean that practices on Wall Street won't get better. One of the biggest reasons we're in this mess is our underestimation of tail risk—for example, banks' risk models were/are based on limited historical data (which didn't include a period of financial panic comparable to today's), so banks systematically underestimated the possibility of a financial panic. This led them to lever up excessively, use untested derivatives to circumvent capital requirements, etc., etc. Regulators were also guilty of underestimating tail risk—risk weights under Basel II severely overestimated the effectiveness of credit derivatives in hedging risk. Here's my point: Once this financial crisis has passed, the historical data used in risk models will include data from the current financial panic. The models will presumably estimate a much higher (and much more accurate) possibility of a global financial panic. That is, the risk models will be based on a much better understanding of tail risk. Similarly, regulators will also know much more about tail risk. Using derivatives like credit-default swaps to hedge risk won't reduce banks' risk weights under Basel II nearly as much, which will in effect increase capital requirements. We'll all benefit from knowing what a global financial crisis looks like. I call it the "now we know" factor. So even if the regulatory reform of Wall Street is severely watered-down (and knowing Congress, I expect it will be), we'll at least get some benefit from the "now we know" factor.

Wednesday, October 15, 2008

Recommended Readings

1. Kenneth Arrow argues that a main cause of the financial crisis is asymmetric information. A new NBER working paper by Gary Gorton makes the same argument. 2. Brad Setser sees little evidence of the nightmare scenario I mentioned last night (i.e., China broadly redirecting its monetary policy away from foreign exchange interventions):

China’s trade surplus remains very large – and that it is still adding to its reserves at a fast clip. ... And while there is good reason to think that the growth in Russian and GCC foreign assets is poised sharply, evidence that China’s surplus is about to fall remains, for now, rather thin.
3. On VoxEU, Virginie Coudert and Mathieu Gex provide empirical evidence showing that correlations do, in fact, go to one in financial crises. 4. Check out all the economic data on tap for tomorrow. If it's half as bad as today's data, we could be in for a truly wild day on the markets (even by today's standards). If tomorrow's data is really bad, then all I can say is: God help us.

Peter Boone, Simon Johnson, and James Kwak have an op-ed in today's WaPo, titled, "How to Manage the Banks." What's their proposal? Here it is, the sum total of the proposal that merited a place on the Post's op-ed page:

Congress should create a consolidated and powerful regulator that can stand up to the banks.
Umm, yeah, because OFHEO did such a bang-up job as Fannie and Freddie's own personal regulator. We should go with that approach again.

Tuesday, October 14, 2008

What Scares Me

What could still cause a complete meltdown of the global financial system? Economic growth in Asia slowing so much that the Asian central banks -- particularly the People's Bank of China -- decide that monetary policy should be focused on fighting possible recessions rather than intervening in the foreign exchange market (i.e., buying U.S. government debt). Yes, China would just be hurting itself, and it would be an objectively irrational decision. But that doesn't mean they won't do it anyway. That scares me. And it should scare you too.

The Treasury taps Simpson Thacher to serve as legal adviser for the recapitalization plan. Good firm with a top-notch PE practice (they represent KKR), so it definitely has the necessary expertise to advise on the recapitalization portion of the bailout. My wife knows more about Simpson Thacher than I do. Here's what she had to say about the appointment in an email:

Very professional and no-nonsense but still congenial and respectful overall. Excellent transactional. A little inconsistent in lit[igation]. Mostly diligent litigators but I remember a couple jerk showboaters who dragged negotiations down. Not indicative of the firm though.
Hopefully they can craft a program with a decent legal foundation. And by "a program with a decent legal foundation," I mean "a program that doesn't totally screw any of my clients."

UPDATE: Barry Ritholtz notes in the comments that he "took the vitriol down a notch," so I've replaced the old excerpt with Barry's new and slightly less vitriolic version. It's still pretty scathing though, and it calls out the hacks for their idiocy and/or mendacity. And they richly deserve it. Barry Ritholtz lays down the law on the Fannie/Freddie/CRA line:

Those who continue to blame the CRA, Fannie Mae, etc. reveal their fundamental misunderstanding of how credit operates in general, what the financing process was like from 2002-07, and how this situation came to pass. Or worse, they understand it, and choose to lie about it anyway for partisan political purposes. You either understand these simple facts, or you don't. If you cannot comprehend this, well, then, I am at a loss as to what that says about your cognitive functioning. But if you understand this, but spit out the nonsense anyway, then you are merely a partisan with no respect for the truth. And that seems to be the main people blaming the CRA and Fannie/Freddie for the credit/housing crisis -- those folks who either can't think -- or wont.
Preach it, Barry.

[UPDATE: Upon reflection, I was way too hard on David Bernstein in this post, and I shouldn't have been so mean-spirited. I had been working for 15-16 hours and was impatiently waiting for Westlaw to get its act together when I wrote this post, so my frustration level was, umm, high. That, combined with the fact that for the past week I've had to write uncharacteristically measured responses to motions that deserve mockery and ridicule, left me itching to tee off on somebody. I happened to disagree with something Bernstein wrote last night, so he was the unfortunate recipient of my frustration. I still disagree with Bernstein, but the personal insults were unnecessary and immature, and I've therefore removed them. In the future, I'll try not to write posts on the tail-end of all-nighters.]

An unfortunate consequence of the financial crisis taking center stage in the news is the barrage of commentary and opinion-pieces on the financial crisis from people who know absolutely nothing about financial markets. The offending commentary has come predominantly from the political arena—amateur political commentators (a category that includes political journalists and columnists, despite their claims of expertise) know even less about finance than they do about politics, and that's saying something. I make it a rule not to read any commentary on the financial crisis from a political commentator.

But some people who I do still read (though not specifically for financial commentary) are apparently afflicted by the same "speaking without knowing" syndrome as the political commentators when it comes to the financial crisis.

For example, on more than one occasion Will Wilkinson has confidently asserted: "We don't need more regulation or less. We need better regulation." Really? Wilkinson is a smart guy and I enjoy his philosophical writings, but I'm gonna go out on a limb and say that he doesn't know the first bloody thing about the regulatory structure currently governing the financial markets. It's incredibly complex, and something casual observers simply cannot pick up in a matter of weeks. It takes years for even financial market participants to learn, and most people on the investment side (as opposed to the legal side) still don't really understand a lot of the regulatory requirements. So how in the world does Wilkinson know that "[w]e don't need more regulation or less"?

Another example is the Volokh Conspiracy's David Bernstein. Commenting on how the Treasury made recapitalization of the 8 biggest U.S. banks with public funds mandatory, Bernstein wrote, "If any of the relevant banks is already well-capitalized, I hope its CEO tells Paulson to take his capital injection and shove it up his you-know-what." If any of the relevant banks isn't well-capitalized, and they accept Paulson's capital injection while another bank rejects the government money, the market will know that the banks that took the government money are weak. Those banks' lenders will then run for the hills, potentially forcing the banks into bankruptcy.

Later, in the comments, Bernstein writes, "[A]pparently Paulson has decided that the issue is not banks that 'need' the money, but that the feds need to inflate the money supply, and pronto, and the mechanism to do so is by giving money to major banks." Say what? The TARP isn't about recapitalizing the banking sector, but is instead about inflating the money supply? Even if Paulson was really trying to inflate the money supply (and I'm quite certain that's not the true goal), there are much better ways to accomplish that goal. Inflating the money supply by recapitalizing the banking sector would be about as roundabout and ineffective as it gets.

So far, here's what we know about the U.S. recapitalization plan (with my commentary sprinkled in): Preferred Stock: The government will buy $250 billion of perpetual preferred stock in U.S. banks. $125 billion has already been committed to 8 large banks—$25 billion to BofA/Merrill, Citi, JPMorgan, and Wells Fargo, $10 billion to Goldman and MS, $3 billion to Bank of NY Mellon, and $2 billion to State Street. The other $125 billion "will be used to recapitalize other financial institutions around the country"—according to the WSJ, "potentially thousands of banks." The preferred stock "will carry a 5% annual dividend that rises to 9% after five years. ... [F]irms returning capital to the government by 2009 may get better terms for the government's stake."

  • Most people expect the preferred stock to be nonvoting, but will the government give itself back-door voting rights by making the stock noncumulative with contingent voting rights? I doubt it, but it's something to watch out for.
Executive Comp "Limits": "All of the banks involved will have to submit to compensation restrictions as mandated by Congress."
  • So basically, no meaningful executive comp limits.
Guarantee New Senior Unsecured Debt: The FDIC will "offer to temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts. This would apply to debt issued by June 30 with maturities up to three years." More FDIC Insurance: The FDIC "will offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses."
  • This is apparently "voluntary for banks," but without charging a fee for this guarantee (and no one is reporting that a fee will be required), every bank will presumably accept the FDIC's offer.
Goals of Recapitalization Plan: The Treasury is focused on "getting the participation of the firms most important to the financial system, according to people familiar with the matter. Treasury's main goal is to attract private capital."
  • My sense is that the Treasury wants to inject capital into healthy, solvent banks as much as possible, in order to: (1) avoid rewarding the most reckless and irresponsible banks, and (2) allow the banking sector to triage itself by allowing the prudent banks (e.g., Goldman) to start taking over failing institutions.
  • The word is that there's a lot of private capital sitting on the sidelines. I'm a bit skeptical that there's as much capital on the sidelines as some people claim, but I do think there's a lot. The Lehman CDS auction on Friday went well, so some of the cash that was being hoarded in preparation for the Lehman auction will undoubtedly go to work now. How much of Monday's surge was attributable to the Lehman CDS auction being behind us? We'll never know.
Favorable Terms for Everyone!
  1. WSJ: Terms Will Be Favorable for Banks: "To make sure private investors aren't scared away, it is expected to structure its investment on terms favorable to the banks and will inject capital in exchange for preferred shares or warrants, these people said."
  2. NYT: Terms Will Be Favorable for the Government: "The investments will be structured so that the government can benefit from a rebound in the banks' fortunes."
I'm guessing the Treasury won't be able to thread the needle on the preferred shares that well.

The Nikkei closed up 14.15%, the DJ Euro Stoxx 50 is currently up 10.7%, and futures indicate a 174-point gain in the Dow tomorrow morning. Technicians assured me that we would see modest gains, followed by a retesting of lows, and would crawl our way back to more reasonable levels in fits and starts. An L-shaped period would slowly morph into a U-shaped recovery, they insisted. I know it's only been 1.5 days, but this looks pretty friggin' V-shaped to me!

Sunday, October 12, 2008

Financial Crisis Jokes

My favorite joke floating around right now:

The financial crisis is worse than a divorce: I have half my money, but I still have my wife.

Tuesday, October 7, 2008

Chris Cox

It was obviously a political stunt, but John McCain was right. Fire Chris Cox. Right now. From Bloomberg:

An unedited version of the 137-page study [by the Inspector General of the SEC] posted to the Iowa Republican's Web site Sept. 26 showed that Bear Stearns traders used pricing models for mortgage securities that ``rarely mentioned'' default risk. ... The [SEC] removed a section of the publicly distributed report showing that the Division of Trading and Markets knew Bear Stearns's capital ratio had dropped to 11.5 percent in March from as high as 21.4 percent in April 2006. The ratio measures assets, adjusted for risk, relative to a firm's equity. Ten percent is the minimum standard under international banking regulations.

Monday, October 6, 2008


William Poole, writing in 1991:

[A]ny policymaker who is unwilling to play chicken with the markets on the issues will be conceding a lot in Washington infighting over policy. This is another reason why it is so important to change the incentive structure in private markets to promote stability. Government policy involves conflict, and conflict inevitably brings surprises and disappointments to the markets.
From The Risk of Economic Crisis (Martin Feldstein, ed., NBER 1991).

I apologize for the lack of posting. As I'm sure you can imagine, things have been beyond crazy for the past 3 weeks. My firm represents a large hedge fund, and I've been at the fund's headquarters in Connecticut for about 2 weeks now (I'm still in CT). Being in an office directly off the trading floor (and with a Bloomberg!) for the past 2 weeks, let me just say: things are very bad, and only getting worse. I'm honestly scared for the future of the financial system. How did we get here? There are lots of reasons, but to me, the most important reason is that traders, CEOs, and even risk managers all seem to have forgotten one extremely important thing: In a financial crisis, the correlations always go to one. From a legal perspective, I forgot how God-awful the ISDA's 1992/2002 Master Agreement and 2003 Definitions are (the standard contracts for credit derivatives). Seriously, I have summer associates who could draft better contracts. This legal clusterfuck will be working itself out for the next 20 years.

Thursday, October 2, 2008

Beware of Hackery

I see that Columbia Business School professor Chris Mayer is making the rounds on the op-ed pages (last week in the New York Times, and today in the Wall Street Journal). It's worth reminding people that at the height of the housing bubble, Mayer was prominently denying that a bubble existed at all. Here's what Mayer wrote in late 2005:

"Bubble Trouble? Not Likely," Wall Street Journal: "For the past several years, Chicken Littles have squawked that the sky -- or the ceiling -- is about to fall on the housing market. And it's tempting to believe them. ... "Yet basic economic logic suggests that this apparent evidence of a bubble is anything but. Even in the highest-price cities, housing is, at most, slightly more expensive than average."
Bear this in mind when reading Mayer's proposed solutions. A couple months ago I compiled a list of pundits/experts who were wrong on the housing bubble (which Mayer was on). Now that the financial crisis has reached a new level, it's worth re-posting the entire list: 1. Alan Reynolds, Cato Institute:
"No Housing Bubble Trouble,"Washington Times (January 8, 2005): "In short, we are asked to worry about something that has never happened for reasons still to be coherently explained. 'Housing bubble' worrywarts have long been hopelessly confused. It would have been financially foolhardy to listen to them in 2002. It still is." "Recession Fairy Tales," Townhall (October 5, 2006): "When it comes to homes . . . many people have spent the last four years fretting that the 'housing bubble' might end. That is, they worried that overpriced homes might become more affordable. This is not quite as nonsensical as worrying the price of oil might fall too much, but it's close."
2. Kevin Hassett, American Enterprise Institute:
New York Times (July 25, 2004): "Another bubble-skeptic is Kevin Hassett, director of economic policy studies at the American Enterprise Institute and co-author of the fabled 'Dow 36,000,' which was published in 1999 when the Dow Jones index was around 11,000. Mr. Hassett says there is an ideological component to the belief in bubbles. Liberals, who tend to believe that government must step in to protect people from market imperfections, will likely see more of them. Conservatives, who like their markets unfettered, will see less. ... "Mr. Hassett of the conservative American Enterprise Institute thinks housing prices will be pretty much O.K. He acknowledges there might be some bubble dynamics at play in some regions. But he argues that for the most part people are paying more for homes because their incomes are higher and interest rates are lower, reducing the cost to own a home. "Mr. Hassett expects that rising interest rates would raise this cost and home prices would then decline proportionately. But he sees no reason to expect a catastrophic decline. 'I don't think a catastrophe is very likely,' he says.
3. James K. Glassman, American Enterprise Institute:
"Housing Bubble?," Capitalism Magazine (May 24, 2005): "[W]hile such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up. ... "Even in places where prices are soaring, worries of a bubble could be overblown because higher prices appear grounded in good old fundamentals."
4. Jude Wanniski, journalist/hack:
"There is No Housing Bubble!!," The Conservative Voice (August 13, 2005).
5. Jerry Bowyer, author of The Bush Boom:
"Hate to Burst Your (Housing) Bubble: But there isn't one," National Review (July 5, 2006).
6. Nicolas P. Restinas, director, Harvard Joint Center for Housing Studies:
"More Than a Bubble Keeps Housing Prices Sky-High," LA Times (May 20, 2004).
7. Jim Cramer, host of CNBC's "Mad Money":
"House Beautiful," New York Magazine (December 8, 2003): "Housing bubble? What housing bubble? The signs are in place for a further run-up in real estate. Breathe easy, mortgage holders. There’s still no place like home."
8. Neil Barsky, Alson Capital Partners, LLC:
"What Housing Bubble?," Wall Street Journal (July 28, 2005): "There is no housing bubble in this country. Our strong housing market is a function of myriad factors with real economic underpinnings: low interest rates, local job growth, the emotional attachment one has for one's home, one's view of one's future earning- power, and parental contributions, all have done their part to contribute to rising home prices. ... "What we do have is a serious housing shortage and housing affordability crisis."
9. Chris Mayer, professor of real estate, Columbia Business School, and Todd Sinai, professor of real estate, Wharton:
"Bubble Trouble? Not Likely," Wall Street Journal (September 19, 2005): "For the past several years, Chicken Littles have squawked that the sky -- or the ceiling -- is about to fall on the housing market. And it's tempting to believe them. ... "Yet basic economic logic suggests that this apparent evidence of a bubble is anything but. Even in the highest-price cities, housing is, at most, slightly more expensive than average."
10. Jonathan McCarthy, senior economist, New York Fed, and Richard W. Peach, vice president, New York Fed:
"Are Home Prices the Next Bubble?," FRBNY Economic Policy Review (December 2004): "Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the U.S. economy. ... "A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates."
11. David Malpass, chief economist, Bear Stearns:
"So This is a Weak Economy?," Wall Street Journal (June 28, 2005): "[T]he litany against the U.S. economy is so ingrained and familiar that few disputed this spring's 'slowdown.' When strong data on income, employment, consumption and profits showed 3.5% first-quarter GDP growth and a continuation into the second quarter, the headlines shifted to other attacks -- adjustable-rate mortgages, a housing 'bubble,' the distribution of income -- rather than revising the slowdown story."
12. Steve Forbes, CEO, Forbes, Inc.:
Global Leaders Speakers Series (November 10, 2005):"[Forbes] maintained that there was no 'housing bubble' in the U.S. but there was an “oil bubble” driven by speculators."
13. Brian S. Wesbury, chief investment strategist, Claymore Advisors:
"Mr. Greenspan's Cappuccino," Wall Street Journal (May 31, 2005): "These nattering nabobs expect a housing collapse to take down the U.S. economy. But excessive pessimism is unwarranted: Fears of a housing bubble are overblown."
14. Noel Sheppard, economist, Business & Media Institute:
"Media Myths: The Housing Bubble is Bursting,"Business & Media Institute (Nov. 30, 2005): "The increase in real estate values the past five years has not resembled the rapid rise typically seen in a bubble."
15. Carl Steidtmann, chief economist, Deloitte Research:
"The Housing Bubble Myth," Economist's Corner (July 2005): "When you strip away all of the white noise around a housing bubble, what you find is a robust market for housing that is undergoing several profound changes all of which manifest themselves in higher home price indexes, none of which adds up to a housing price bubble."
16. John K. McIlwain, senior resident fellow for housing, Urban Land Institute:
"No Housing Bubble to Pop," Washington Post (March 2, 2005): "[T]he housing markets will cool as interest rates rise and as affordability declines, but they won't crash. Most markets will flatten for a while or increase at lower, more historical, rates. A few may decline for a year or two. But we won't have a crash."
17. Margaret Hwang Smith, professor of economics, Pomona College, and Gary Smith, professor of economics, Pomona College:
"Bubble, Bubble, Where's the Housing Bubble?,"Brookings Papers on Economic Activity (2006): "Our evidence indicates that, even though prices have risen rapidly and some buyers have unrealistic expectations of continuing price increases, the bubble is not, in fact, a bubble in most of these areas in that, under a variety of plausible assumptions, buying a house at current market prices still appears to be an attractive long-term investment."
18. Charles Himmelberg, economist, New York Fed:
"Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions," Federal Reserve Bank of New York Staff Reports (September 2005): "As of the end of 2004, our analysis reveals little evidence of a housing bubble. In high appreciation markets like San Francisco, Boston, and New York, current housing prices are not cheap, but our calculations do not reveal large price increases in excess of fundamentals."
19. Jim Jubak, investing columnist, MSN Money:
"Why There is No Housing Bubble," MSN Money (June 10, 2005): "Housing bubble? What housing bubble? With the 10-year U.S. Treasury bond yielding below 4% and 30-year mortgages available at 5.1%, there isnt a housing bubble."
20. James F. Smith, director, Center for Business Forecasting:
"There is No Housing Bubble in the USA: Housing Activity Will Remain At High Levels in 2005 and Beyond," Business Economics (April 2005): "There is no evidence of a housing 'bubble' in the United States and housing demand should stay strong for years to come."
21. Kathryn Jean Lopez, editor, National Review Online:
"Don't be Myth-Understood," National Review (December 21, 2005): "[T]he so-called housing bubble has yet to pop, and likely won't as long as home ownership remains a tax-advantaged event. Even the New York Times — no parrot of White House talking points — has had to admit that the economy is 'booming.'"
22. Samuel Lieber, president, Alpine Woods Capital Investors:
"Housing Bubble? The Market Won't Pop, Experts Predict," Wall Street Journal (April 12, 2006): "We don't see a bubble. Historically, home prices just don't go down nationwide unless we are in a significant recession. The last time home prices fell nationwide was in 1990. It's employment that really counts. The underlying fundamentals of real estate are still very positive. Job creation and household formation drive housing."
23. Mark Vitner, senior economist, Wachovia:
"There is No Housing Bubble, Says Senior Economist," The Virginia-Pilot (January 19, 2006): "'Everybody is looking for evidence of a housing bubble,' [Vitner] said. 'There is not a housing bubble. The supply had not kept up with demand.'"
24. George Karvel, professor of real estate, St. Thomas University:
"Housing bubble?," Minneapolis Star Tribune, October 4, 2005 (via LEXIS): "'There's no housing bubble,' said George Karvel, a professor of real estate at the University of St. Thomas. 'This is a media-induced frenzy. If I wanted to say there is a housing bubble, I'd have Time and Money magazine camped on my door. They've called, and I've told them there's no bubble. Panic sells." ... "There is absolutely nothing in any market in the country to indicate there'd be any kind of collapse in housing prices,' he said."