Wednesday, April 29, 2009

Quote of the Day

"[O]ne dollar held by a particular bank at the beginning of the day changes hands around one hundred times during the course of the day."
From: Afonso & Shin, Systemic Risk and Liquidity in Payment Systems, New York Fed Staff Reports (March 2009).

When Goldman announced that it was raising capital to pay back its TARP money, there was a palpable outrage in the blogosphere. The main theme was that TARP money wasn't the only form of government aid Goldman received, so paying it back shouldn't free Goldman from the TARP restrictions (e.g., executive compensation, H1B visas). Josh Marshall said "the idea that simply paying back the TARP money means [Goldman is] back on their own is really a crock." Matt Yglesias said that it was "farcical" to think that "if Goldman Sachs repays its TARP money that it’s no longer a ward of the state." The main forms of government aid the critics focused on were the AIG bailout and the FDIC guarantee on new bond issues. Regarding the AIG bailout, for the eight millionth time, Goldman had hedged its exposure to AIG. The fact that AIG paid Goldman $13 billion after it was bailed out doesn't say anything about how much Goldman would have collected on its hedges had AIG been allowed to fail. This is a silly criticism. As for the FDIC guarantee, this was important, but it's not like a government guarantee on private sector loans is some new privilege available only to Wall Street banks. The SBA guarantees thousands of small business loans every year through the 7(a) loan program (and the guarantee was recently upped to 90%), but I don't hear any outrage over the small businesses in the 7(a) program benefiting from "government largesse." The government also guarantees well over $70 billion in student loans every year through the Federal Family Education Loan Program (FFELP), which includes Stafford loans, Perkins loans, and PLUS loans. Yet in contrast to TARP's restriction on the use of H1B visas, FFELP loans don't require beneficiaries to work for U.S. companies when they get out of school or anything like that. But again, I hear no outrage over the FFELP program—probably in part because a substantial portion of the blogosphere benefited from the "government largesse" of the FFELP program (I know I did). So let's not kid ourselves—the government guarantees private sector loans all the time. If you want to start demanding that government guarantees come with tough restrictions attached, that's fine. But you better be willing to follow that argument to its logical conclusion.

Monday, April 27, 2009

Treasury and "Least Cost Resolution"

It shouldn't surprise you to learn that I was not a fan of Gretchen Morgenson and Jo Becker's big profile of Tim Geithner in the NYT. As the late Tanta demonstrated time and again, Morgenson is an atrocious financial journalist. But I have neither the time nor the energy to highlight all of the errors and wildly misleading statements in the article. I do, however, want to highlight one ridiculous and nonsensical argument that Morgenson and Becker made in the article. They desperately tried to make something of the fact that the original template for Treasury's proposed resolution authority was a draft bill from Davis Polk & Wardwell, a large law firm that often represents Wall Street institutions. But the only argument they came up with doesn't even make sense:

[Treasury officials] point to several significant changes to that draft that "better protect the taxpayer," in the words of Andrew Williams, a Treasury spokesman. But others say important provisions in the original industry bill remain. Most significant, the bill does not require that any government rescue of a troubled firm be done at the lowest possible cost, as is required by the F.D.I.C. when it takes over a failed bank. Treasury officials said that is because they would use the rescue powers only in rare and extreme cases that might require flexibility. Karen Shaw Petrou, managing director of the Washington research firm Federal Financial Analytics, said it essentially gives Treasury "a blank check."
This is an absurd and incredibly ill-informed criticism. The "least cost resolution" provision (sec. 1823(c)(4)) requires the FDIC to use the resolution method that is least costly to the Deposit Insurance Fund. But there's a very famous exception to the least cost requirement known as the "systemic risk exception" (sec. 1823(c)(4)(G)), which, not surprisingly, provides that if there is a formal finding of "systemic risk," the FDIC doesn't have to use the least costly resolution method. A "systemic risk" finding requires written recommendations from the Fed and FDIC's boards of directors, as well as a determination of systemic risk by the Treasury Secretary after consultation with the President. (When the systemic risk exception was enacted in 1991, it was universally viewed as the formal adoption of a "too big to fail" policy.) This is precisely the situation Treasury's proposed resolution authority is designed for. Treasury's resolution authority would only kick in when there's a formal finding of systemic risk—that's why the bill is called, "The Resolution Authority for Systemically Significant Financial Companies Act of 2009." So of course the bill doesn't include a "least cost resolution" requirement. Right now the FDIC is bound by the least cost procedures when resolving a failed bank, except in cases of systemic risk. There is currently no equivalent to the systemic risk exception in the US Bankruptcy Code for nonbank financial institutions such as bank holding companies. The whole point of Treasury's proposed resolution authority is to extend the FDIC's systemic risk exception to the insolvency regime that governs large bank holding companies (e.g., Citigroup, BofA, JPMorgan, Wells Fargo). If there's no systemic risk finding, failed bank holding companies will still be handled by the bankruptcy courts. Treasury's proposal gives the government the same kind of discretion in cases of systemic risk that the FDIC has under the Federal Deposit Insurance Act. Any attempt to paint Treasury's proposal as somehow more Wall Street-friendly than the FDIC's insolvency regime because it doesn't include a "least cost resolution" requirement is based on a fundamental misunderstanding of the US insolvency laws.

From the FT:

The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve’s last policy meeting. The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation. A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent. Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorised at the last meeting, which included $300bn of Treasury purchases.
Could it be that most of the Fed's new facilities were implemented based on a desire to achieve effective monetary policy? No, because that doesn't conform to the media's narrative of the financial crisis, in which the Fed has been secretly bailing out its Wall Street fat cat friends.

Gillian Tett has an excellent column in today's FT on the implosion of the securitization markets:

What is imploding though is the securitisation world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds were sold in markets, and this year market issuance is minimal. ... But the longer that this drought continues, the bigger the policy issues become. After all, no politician wants to see the government buying mortgage-backed bonds forever; but nobody really believes that traditional, old-fashioned lending can take up all the slack. So either the system needs to find a way to restart securitisation or we face a world where credit will remain a highly rationed commodity for a long time to come.
Before the crisis, over a quarter of all consumer credit (non-mortgage) was funded through the securitization markets. While securitization's share of total lending will undoubtedly shrink in the medium- to long-term, it's just not possible to completely—or even substantially—replace such a large source of lending in a matter of months (and during an epic financial crisis to boot). So securitization it is. As Tett puts it in a great line at the end of her column:
The longer that politicians wail about the supposed “failure of banks to lend”, while ignoring the bigger source of the credit crunch, the harder it will be to wean the system away from government support.
I couldn't agree more. If you want banks to start lending again on a scale sufficient to fuel an economic recovery, then restarting the securitization markets should be one of your top priorities. You shouldn't be demonizing the entire concept of securitization, and you certainly shouldn't be calling for banks to increase lending while simultaneously criticizing the Obama administration for attempting to restart the securitization markets.

I'll give Simon Johnson one thing: he's great at knocking down straw man arguments. Today's straw man is Treasury's alleged "wait and see" policy on the banks. Johnson and Peter Boone claim on the NYT's Economix blog that Treasury's plan is to "look the other way on big banks' problems and hope an economic recovery brings them back to sustained profits." They then proceed to show why this "wait and see" policy is a bad idea. Clever! Too bad it's just not true. How any semi-informed commentator could describe Treasury's approach as "wait and see" is beyond me. Treasury has adopted a multifaceted approach to the major banks, which includes the Capital Assistance Program (CAP), as well as the Public-Private Investment Program (PPIP), which encompasses the Legacy Securities Program and the Legacy Loans Program. What do Johnson and Boone propose? Something eerily similar to what Treasury has already proposed:

We know there is a problem in the banks, just not how large it is. So why not do more than is absolutely necessary, in terms of forcing restructuring and recapitalization of the sector (ideally with private money)? Give everyone certainty that the problems are over once and for all.
Gee, that sounds an awful lot like Treasury's Capital Assistance Program, which is designed to determine how large the problem in the major banks is, and then force each bank to recapitalize — "ideally with private money," but if that's not possible, then with government money. As for forced restructurings, Treasury currently lacks the legal authority to do that, but it has already proposed a new resolution authority for large bank holding companies. (I personally don't think the proposed resolution authority can work, but you can't say that Treasury isn't trying to acquire the legal authority to force restructurings of major bank holding companies.) Oh yeah, and then there's the $1 trillion PPIP, which I hear is kind of a big deal. Whatever you may think of Treasury's approach to the banks, it's hardly "wait and see."

Wednesday, April 22, 2009

Wall Street Pay

Like Justin Fox, I was struck by this passage in Gabriel Sherman's New York magazine piece about Wall Street pay (but for an entirely different reason):

A few weeks ago, I had drinks with a friend who used to work at Lehman Brothers. She had come to Wall Street in the mid-eighties, when the junk-bond boom spawned a new class of globe-trotting financiers. Over two decades, she had done stints at all the major banks—Chase, Goldman, Lehman—and had a thriving career directing giant streams of capital around the world and extracting a substantial percentage for herself. To her mind, extreme compensation is a fair trade for the compromises of such a career. “People just don’t get it,” she says. “I’m attached to my BlackBerry. I was at my doctor the other day, and my doctor said to me, ‘You know, I like that when I leave the office, I leave.’ I get calls at two in the morning, when the market moves. That costs money. If they keep compensation capped, I don’t know how the deals get done. They’re taking Wall Street and throwing it in the East River.” Now, a lot of people in New York have BlackBerrys, and few of them expect to be paid $2 million to check their e-mail in the middle of the night. But embedded in her comment is the belief shared on Wall Street but which few have dared to articulate until now: Those who select careers in finance play an exceptional role in our society. They distribute capital to where it’s most effective, and by some Ayn Rand–ian logic, the virtue of efficient markets distributing capital to where it is most needed justifies extreme salaries—these are the wages of the meritocracy. They see themselves as the fighter pilots of capitalism.
Sherman's takeaway from the former Lehmanite's story—that Wall Streeters "see themselves as the fighter pilots of capitalism"—isn't at all what I took away from the story. To me, the former Lehmanite was simply expressing a well-worn sentiment in the financial sector: yes, compensation is extremely high, but it's not like working on Wall Street is all champagne and caviar. The hours are insane, the lifestyle is brutal, the pressure is never-ending, etc., etc. This, to most Wall Streeters, is justification enough for their exorbitant compensation. I don't buy this argument, but this is the way they think about it. Yves Smith—not one to sympathize with Wall Street, mind you—summed this mindset up well (in what was probably the last thing I agreed with her on):
You do not know how hard you can work, short of slavery, unless you have been an investment banking analyst or associate. It is not merely the hours, but the extreme time pressure. Priorities are revised every day, numerous times during the day, as markets move. You have numerous bosses, each with independent demands and deadlines, and none cares what the others want done when. You are not allowed to say no to unreasonable demands. The time pressure is so great that waiting for an elevator is typically agonizing. If you manage to get your bills paid and your laundry done, you are managing your personal life well. Exhaustion is normal. One buddy stepped into his shower fully clothed. And exhaustion and loss of personal boundaries is an ideal setting for brainwashing, which is why people who have spent much of their career in finance have such difficulty understanding why their firm and their world view might not be the center of the universe, and why they might not be deserving of their outsized pay.
Lawyers generally get paid a fraction of what investment bankers take home, so I've had this argument with friends on Wall Street too many times to count. And their argument always seems to come back to some form of: "Well, working on Wall Street is a miserable, miserable life, so you don't get to criticize my compensation." I don't think that justifies their exorbitant compensation (especially when a lot of what makes Wall Street jobs miserable is needless hazing), but that's generally their argument.

Saturday, April 18, 2009

William K. Black is an Idiot

William K. Black has been making the rounds lately, and has been drawing a lot of attention (from people who want to hate the Geithner plan) by claiming that the Obama administration is "refusing to obey the law" by not seizing the major banks. On Bill Moyers' show, Black stated:

I think, first, the policies are substantively bad. Second, I think they completely lack integrity. Third, they violate the rule of law. This is being done just like Secretary Paulson did it. In violation of the law. We adopted a law after the Savings and Loan crisis, called the Prompt Corrective Action Law. And it requires them to close these institutions. And they're refusing to obey the law.
This is patently untrue. Prompt Corrective Action (PCA) does not require the government to close any of the major banks. PCA requires the government to take certain actions as an FDIC-insured bank's capital cushion declines. But even when a bank becomes "critically undercapitalized," PCA requires the government to either place the bank in receivership or "take such other action as the agency determines ... would better achieve the purpose of [PCA], after documenting why the action would better achieve that purpose."So Black is misrepresenting the law. Moreover, none of the major banks' FDIC-insured subsidiaries are even close to "critically undercapitalized" under the Prompt Corrective Action Law. In fact, they're all considered "well capitalized" under PCA. To be considered "well capitalized" under PCA, a bank must have (1) a total risk-based capital ratio of 10% or higher; (2) a Tier 1 risk-based capital ratio of 6% or higher; and (3) a leverage ratio of 5% or greater. A bank isn't considered "critically undercapitalized" until its ratio of tangible equity to total assets falls below 2%. Here are the relevant ratios for the FDIC-insured subsidiaries of Citigroup, BofA, Wells Fargo, and JPMorgan. (Select "Performance and Condition Ratios.") As you can see, all of them have capital ratios well above those required to be considered "well capitalized" under PCA. Now, you can argue that these capital ratios don't represent the true condition of the banks, but that's a different argument. The issue here is whether the Obama administration is "refusing to obey the law" by not seizing the banks under PCA. Clearly they're not. So not only is Black misrepresenting the Prompt Corrective Action Law, he's also badly misrepresenting the condition of the banks under PCA. What a dishonest hack.

I wrote a long post for The Atlantic's business blog the other day about the idiocy of the whole "too big to fail, too big to exist" idea, which is sadly catching on in the blogosphere. And it's showing no signs of slowing down. Matt Yglesias wrote this about Goldman Sachs:

So instead of [the issue] being "if they want taxpayers to save them, then they have to take fewer risks and become smaller" it's given that taxpayers will save them, then have to take fewer risks and become smaller.
Oy. First of all, Matt ignores the fact that Goldman subjected itself to stricter regulation when it converted to a bank holding company—including tighter controls on leverage. (In a slightly related point, it amazes me when people who have been paying somewhat close attention to the financial crisis assert that the Obama administration wants to "turn the clock back to 2006" in the financial sector. Honestly, what planet are these people living on? Everything has changed. It wouldn't be possible to go back to the financial sector circa 2006 even if the Obama administration wanted to—and it doesn't.) Second, Matt falsely assumes that the solution to the too big to fail (TBTF) problem is for Goldman to "take fewer risks and become smaller." As I noted in my Atlantic post, this is an absurd idea. TBTF has always been a misnomer—the issue is whether a financial institution is "too systematically important to fail." Yes, Goldman is too systematically important to fail, but it's silly to suggest that the solution is to force Goldman to "become smaller." The reason Goldman, JPMorgan and the rest are too systematically important to fail is that the Bankruptcy Code, which governs the resolution of failed bank holding companies (and most other nonbank financial institutions), can't facilitate the orderly resolution of systematically important financial institutions. The fact that bank insolvencies are fundamentally different from regular corporate insolvencies is the whole reason we have a separate insolvency regime for commercial banks and thrifts, which is run by the FDIC rather than bankruptcy courts. If we had an insolvency regime that was capable of resolving large complex financial institutions (LCFIs) without causing a financial crisis, then no LCFI would be "too systematically important to fail." Some LCFIs would still be systematically important, but the point is that with an effective insolvency regime, regulators would no longer fear the broader consequences of letting them fail. Thus, they would be systematically important, but not too systematically important to fail. How to design an effective insolvency regime for systematically important financial institutions is what the debate in the TBTF literature is all about. There are lots of ideas on how to design an effective insolvency regime for systematically important financial institutions—my favorite being the NewBank concept, which involved the creation of a dormant bank that is available for activation to clear and settle government securities, should one of the two banks that provide such services (Bank of New York and JPMorgan) ever fail. I won't pretend to have all the answers on how to design an effective insolvency regime, but this is fundamentally what the TBTF debate is about. Notice, however, that a new insolvency regime for nonbank financial institutions does away with the need for a definition of "too systematically important to fail" (which is impossible to define ex ante anyway). But nowhere in the TBTF literature have I ever seen a proposal to force systematically important financial institutions to "become smaller." There's a reason for that: it's a really, really stupid idea.

Thursday, April 9, 2009

The Purpose of the CAP

Matt Yglesias badly misunderstands the purpose of the Treasury's Capital Assistance Program (CAP):

I thought the point of the [stress] tests was to open up the possibility that a minority of banks would be shut-down, while the others would be proclaimed healthy (as in actually healthy rather than "healthy given a government guarantee") and we could shift out of the implicit guarantee phase.
You thought wrong. That is not, and has never been, the purpose of the CAP. In fact, that's the exact opposite of the stated purpose of the CAP:
The purpose of the CAP is to restore confidence throughout the financial system that the nation's largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. Under CAP, federal banking supervisors will conduct forward-looking assessments to evaluate the capital needs of the major U.S. banking institutions under a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, banks will have an opportunity to turn first to private sources of capital. In light of the current challenging market environment, the Treasury is making government capital available immediately through the CAP to eligible banking institutions to provide this buffer.
So, clearly, the whole point of the CAP is to avoid having any of the 19 largest U.S. financial institutions fail in the near-to-medium term. How does "avoiding the shut-down of major U.S. banks" become "open[ing] up the possibility that a minority of banks [will] be shut-down"?

Wednesday, April 8, 2009

More AIG Counterparty Nonsense

ProPublica has ridiculous article titled, Does AIG Really Need to Pay Its Counterparties in Full? Yes, AIG really has to pay its counterparties in full. The whole point of rescuing AIG was to keep it out of bankruptcy, and short of bankruptcy, there's no mechanism for forcing AIG's counterparties to take a haircut. But the ProPublica article really goes off the deep end when it says:

Another option is to break the contracts and let the counterparties -- many of which are themselves beneficiaries of federal bailouts -- sue the federal government, if they dare. ... Such a suit may not fare well in court because some legal questions swirl around whether the bulk of credit default swaps are legally enforceable. Some of the swaps function like insurance policies on corporate bonds. Purchasers of such credit default swaps know that even if the bond issuer defaults, they will limit their losses. But many other swaps are more like bets (akin to buying "insurance" on another person's house), and it is unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable.
Wow. First of all, it's simply not true that "legal questions swirl around whether the bulk of credit default swaps are legally enforceable." Standard credit default swaps are enforceable. The credit default swaps that AIG wrote are enforceable. If the government breaches the contracts and refuses to pay, the counterparties will sue, and the government will lose. The author clearly shows that she has no idea what she's talking about when she says that it's "unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable." Credit default swaps are not insurance contracts, so there doesn't need to be an insurable interest! CDS are like insurance contracts, but there are key differences. Just because a CDS contract doesn't fit the statutory definition of an "insurance contract," doesn't mean that it's not enforceable. Honestly, the complaints about AIG paying its counterparties get more idiotic by the day.

Tuesday, April 7, 2009

PIMCO: Just lucky, I guess

One of the most important aspects of the ISDA's recent overhaul of the credit default swaps (CDS) market — known in the market as the "Big Bang" — is the creation of a Credit Derivatives Determinations Committee. Starting tomorrow, the Determinations Committee will make binding decisions on a range of issues, the most important of which include whether a "credit event" has occurred, and which obligations will constitute "deliverable obligations" in a settlement auction. Representation on the Determinations Committee is obviously important, and to combat the fact perception that it's heavily biased toward the major dealer banks, the ISDA agreed to give the buy-side a voice on the Determinations Committee. The 5 buy-side Committee members are supposedly "selected at random" — you know, to ensure fairness. In what I'm sure was a tightly controlled, double blind-like random selection, do you know who the ISDA just so happened to pick as a buy-side Committee member? That's right, the biggest bond player in the world, PIMCO! I'm sure PIMCO's selection had nothing to do with the fact that it's one of the new ISDA board members, or that it's the 800-pound gorilla in the bond markets. Nope, it was just the luck of the draw.

That seems to be the argument in this paper by Harvard's Joshua Coval and Erik Stafford and Princeton's Jakub Jurek, which is being touted as evidence that Treasury is wrong to believe that the toxic assets are underpriced. The introduction states:

On March 23, 2009, the Treasury announced that the TALF plan will commit up to $1 trillion to purchase legacy structured credit products. The government's view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals. ... The main objective of this paper is to determine whether fire sales are required to explain prices currently observed in credit markets.
Sounds like the paper is going to examine the prices of the toxic assets that the Treasury is planning to buy, right? Wrong. Instead, the authors examine investment grade corporate credit risk, using the CDX.NA.IG index. But ABS and CDOs backed by investment grade corporate bonds are not eligible for either the TALF or the PPIP. In other words, investment grade corporate bonds aren't considered "toxic assets." The authors conclude that market prices of investment grade corporate credit risk are accurate—which isn't surprising, seeing as the CDX.NA.IG is the most liquid contract in the CDS market. Amazingly, however, the authors use this to conclude that the Treasury's plan to buy up the banks' toxic assets is misguided:
Policymakers are rapidly moving towards using TARP money to purchase toxic assets—primarily tranches of collateralized debt obligations (CDOs)—from banks, with the aim of supporting secondary markets and increasing bank lending. The key premise of current policies is that the prices for these assets have become arti…cially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer refect their true hold-to-maturity value. By purchasing or insuring a large quantity of bank assets, the government can restore liquidity to credit markets and solvency to the banking sector. The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals.
Are they serious? The Treasury is arguing that the prices for mortgage-related securities are artificially depressed because of illiquidity and fire sales. No one is arguing that investment grade corporates are underpriced due to illiquidity and fire sales. That's why ABS and CDOs backed by investment grade corporates aren't eligible for the TALF or the PPIP. The fact that prices for tranches of CDOs backed by investment grade corporates are accurate is completely irrelevant to whether prices for mortgage-related securities are accurate. To repeat: the fact that the prices for non-toxic assets are accurate does not mean that the prices for toxic assets are accurate. What's the deal with the ivory tower recently? Did everyone decide to take extra-strength stupid pills?

Paul Krugman says that Jeff Sachs's worries "need to be taken seriously." I think people need to stop taking academics seriously on the bank rescue. Sachs claims that banks like Citi can game the PPIP by partnering with the government to buy their own toxic securities at inflated prices. No, professor, they can't. The terms of the PPIP explicitly prohibit this:

A Fund Manager may not, directly or indirectly, acquire Eligible Assets from or sell Eligible Assets to its affiliates, any other Fund or any private investor that has committed 10% or more of the aggregate private capital raised by the Fund.
All the hoopla over the banks possibly "gaming" the PPIP is overblown. It's true that some of the investment banks (e.g., Morgan Stanley, Goldman) have explored the possibility of buying toxic securities under the PPIP, and repackaging them for sale to new investors—in effect creating a new CDO market. But this will never happen. If it ever got that far, Treasury would kill the idea. Regulators have repeatedly stated that "healthy banks" will be able to buy toxic assets in the PPIP program. That obviously doesn't include Citi or BofA, and there's no way regulators would let either of them participate on the investment side. The reason Treasury hasn't ruled out TARP recipients en masse is that hundreds upon hundreds of banks have received TARP money, and their degree of health varies considerably. Some regional banks that received TARP money are no doubt healthy enough at this point to participate in the PPIP. These determinations are best made on a case-by-case basis, which is why Treasury hasn't issued a blanket prohibition on TARP recipients participating in the PPIP on the investment side.

Saturday, April 4, 2009

Tyler Cowen Is Very Wrong

Tyler Cowen has a truly bizarre column in this morning's New York Times. He argues that there's "a big hole" in the Obama administration's proposals to reform financial regulation: "the new proposals immunize the creditors and counterparties of [firms like AIG] by protecting them from their own lending and trading mistakes." He goes on at length about how the administration's proposals "neutraliz[e] creditors," and thus risk "creating a class of institutions whose borrowing is, in effect, guaranteed by the government." This is 100% untrue. The Treasury's proposals specifically included a proposed resolution authority for systematically significant finanancial companies like AIG, modelled on the FDIC's resolution authority. And like the FDIC's resolution authority for insured banks and thrifts, the Treasury's proposal gives the FDIC the power to impose pain on creditors—which is exactly what Cowen criticizes the Obama administration for failing to propose! Specifically, the FDIC would have its traditional powers of avoidance, as well as the power to repudiate "burdensome" contracts. This undercuts Cowen's entire column. I honestly don't know how he could have missed this—the proposed resolution authority was the most talked about aspect of Treasury's proposed financial regulations. What's even more amazing is that the NYT's editors let Cowen's column go to press. I guess they don't read their own paper.

Along with executive pay and bank size, I propose that we cap the number of adjectives Glenn Greenwald is allowed to use in a given post. Substantive issues aside, his writing is atrocious. It's a legitimate public health issue at this point.

Martin Feldstein is generally supportive of the Geithner plan, but he says it needs to be expanded in three ways to ultimately succeed. The odd thing is, the Treasury has already announced two of his three proposed expansions. Feldstein writes:

First, the Treasury must be prepared to inject capital into the banks that agree to sell mortgages. Without additional capital, the banks may not be willing to sell the mortgages that are causing their lack of confidence.
Umm, providing the banks with additional capital is exactly what the Treasury's Capital Assistance Program (CAP) is for:
Should [the bank stress test] indicate that an additional capital buffer is warranted, banks will have an opportunity to turn first to private sources of capital. In light of the current challenging market environment, the Treasury is making government capital available immediately through the CAP to eligible banking institutions to provide this buffer.
Feldstein continues:
Second, cleansing the banks' balance sheets will also require much more Treasury money for equity investments and loans. The current plan to remove $500 billion of impaired assets will not be enough to cleanse the banks' balance sheets to a point where they can be confident enough about the remaining assets to resume lending.
The Treasury has already stated that the PPIP "will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time." It's almost as if Feldstein hasn't been paying attention. Very odd.

This behind-the-scenes account of the financial crisis by Phillip Swagel, the former Assistant Secretary for Economic Policy at Treasury, makes for absolutely fascinating reading. Swagel takes academic economists to task for their failure to understand the very real legal constraints on policymaking. This is something I've emphasized with regard to the ridiculous debate over "nationalization" or "managed receivership" of money center banks. As Swagel writes:

A lesson for academics is that any time the word "force" is used as a verb ("the policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest.
Preach it, brother. Similarly, Swagel shoots down Luigi Zingales's widely-cited (but comically impractical) proposal to force banks' bondholders into a debt-for-equity swap:
As Zingales (2008) notes, debt-for-equity swaps could "immediately make banks solid, by providing a large equity buffer." All that would be required, according to Zingales, would be a change in the bankruptcy code. A major change to the bankruptcy law was enacted (for better or for worse depending on one’s point of view) with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, but this was the culmination of years of legislative debate. The idea of a further instantaneous change in the bankruptcy code was unrealistic. Indeed, efforts to make such changes in the middle of the crisis would have re-opened the debate over the 2005 Act along with controversial provisions such as the mortgage cram down. The simple truth is that it was not feasible to force a debt for equity swap or to rapidly enact the laws necessary to make this feasible. ... [T]he idea … that there should be a forcible capital injection [is] pure ivory tower, unfettered by the practicalities of legality, enactment, or implementation.
This same critique applies to Simon Johnson's absurdly unrealistic suggestion that the Treasury could use its proposed resolution authority for large financial institutions to deal with the current financial crisis. Most nationalization/receivership proponents seem to think that major changes to the U.S. legal code occur instantaneously, which betrays a stunning ignorance of the legislative process. Swagel also pushes back against the criticism—advanced most prominently by TARP watchdog Elizabeth Warren—that Treasury overpaid for its equity stakes in the banks:
An important consideration with regard to the terms of the capital injections was that there is no authority in the United States to force a private institution to accept government capital. This is a hard legal constraint. ... In order to ensure that the capital injection was widely and rapidly accepted, its terms had to be attractive, not punitive. ... The terms of the CPP were later to lead to reports that the Treasury had "overpaid" for its stakes in banks, which of course is the case relative to the terms received by Warren Buffett. But this was for a policy purpose: to ensure broad and rapid take-up.
Read the entire essay. It's well worth the time.

Thursday, April 2, 2009

"Stress Test" Scenarios

The Obama administration has taken a good deal of heat for the less-than-catastrophic assumptions in its bank stress tests. In the "more adverse" scenario, average unemployment is 8.9% in 2009 and 10.3% in 2010, while housing prices fall 14% in 2009 and 4% in 2010. While the adverse scenario may indeed be overly optimistic, it's important to note that in constructing the baseline and adverse scenarios, the administration largely relied on the average projections of professional forecasters. In particular:

The "more adverse" scenario was constructed from the historical track record of private forecasters as well astheir current assessments of uncertainty. In particular, based on the historical accuracy of Blue Chip forecasts made since the late 1970s, the likelihood that the average unemployment rate in 2010 could be at least as high as in the alternative more adverse scenario is roughly 10 percent. In addition, the subjective probability assessments provided by participants in the January Consensus Forecasts survey and the February Survey of Professional Forecasters imply a roughly 15 percent chance that real GDP growth could be as least as low, and unemployment at least as high, as assumed in the more adverse scenario. ... Based on the year‐to‐year variability in house prices since 1900, and controlling for macroeconomic factors, there is roughly a 10 percent probability that house prices will be 10 percent lower than in the baseline by 2010.
The administration was, no doubt, trying to maintain a certain level of objectivity in constructing the stress test scenarios, which, given Treasury's limited resources, was probably a good idea. So whatever you may think about the stress test scenarios, they weren't, as Dean Baker suggests, "rigged" in any way.

Wednesday, April 1, 2009

Joe Stiglitz, Mainstream?

In his op-ed in this morning's NYT, Joe Stiglitz ends up just regurgitating all the superficial mainstream arguments about the Geithner plan: it's a backdoor bailout for banks, Treasury wants investors to "overpay" for toxic assets, nationalization is the solution, yada, yada, yada. I never thought I'd see the day that Joe Stiglitz, of all people, sounded downright bland. Luckily, as if to confirm his authorship, Stiglitz throws in some of his trademark fudging of the facts. He writes:

[T]he F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later).
Whoa, a "few years" later? It took the FDIC seven years to get rid of Continental Illinois. Hardly a model of successful bank nationalizations.

I've actually changed my mind somewhat on mark-to-market (MTM) accounting during the financial crisis. At first I was strongly against relaxing MTM—the banks' complaints about MTM sounded way too much like the bogus complaints I had grown accustomed to hearing from banks over the past 15 years. But I spent a good deal of time either on or right off a few trading floors in the manic weeks after Lehman's failure, and it's safe to say that the intrinsic value of securities was the furthest thing from most traders' minds. (Liquidity and getting net flat to the market were the only things traders seemed to care about.) To the extent that banks are still marking assets at prices set in the immediate aftermath of Lehman's failure, MTM accounting is a legitimate problem. Even in normal times, though, MTM accounting has never lived up to its billing. It's the most accurate valuation method we have, but that doesn't make it accurate. Ultimately, I share Kevin Drum's general ambivalence toward MTM accounting. It's just hard to get worked up about moving from one inaccurate and unreliable valuation method to a slightly less accurate and slightly less reliable valuation method.

Casual Wednesday! (Explanation here.)