Economics of Contempt

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.)

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.

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.

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.

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.

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.

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.”

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.

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.

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.

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.

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: