Thursday, December 31, 2009

Annoying Myths on the Bailout

Since I missed my connection and I'm spending New Year's in an airport hotel, I figured I'd take this time when everyone is out celebrating to point out something I know is unpopular, but which still annoys me.

Joe Stiglitz, writing at the New Deal 2.0, echoes the conventional wisdom on the bailouts:

We are accustomed to thinking of government transferring money from the well off to the poor. Here it was the poor and average transferring money to the rich.
But was it really? It was the government transferring money to the rich, that's for sure. But where does the government get its money? Mostly from....the rich. According to the Tax Policy Center, the top income quintile pays 67.2% of all federal taxes; people who make over $100K/year pay 73% of all federal taxes. When it suits their argument, pundits like Stiglitz suddenly forget that we have a progressive tax system.

I'm not saying the bailouts weren't unfair (they were), or that the middle class hasn't suffered for the mistakes of others (they have). I'm just saying, let's stop pretending like the majority of the bailout is being financed by Sally Schoolteacher. It isn't.

Tuesday, December 15, 2009

The Lynch Amendment: Bizarre and Confused

The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:

[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.
This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal. Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.) Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That's what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they're going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse's risk management practices. A dealer is unlikely to trade through a clearinghouse if it's prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it's exactly the kind of aligning of economic interests that we're looking for! The Lynch amendment would effectively prevent a given clearinghouse from having more than 2 or 3 dealers as clearing members. This would make the clearinghouse much less effective in mitigating the systemic risk of OTC derivatives. When a clearing member defaults, the clearinghouse can generally transfer big chunks of the defaulting member's open positions to other clearing members—like the FDIC does when it resolves commercial banks—minimizing the disruption to counterparties and preventing contagion from spreading. If a clearinghouse only has 2 or 3 dealers as clearing members, and one of those dealers defaults, the clearinghouse wouldn't be able to transfer most of the defaulting member's open positions to other clearing members, because there would only be a couple other clearing members who, under the best of circumstances, have the balance sheet capacity to assume significant chunks of the defaulting member's derivatives book. This would greatly increase the strain on the clearinghouse's guaranty fund. By contrast, if all of the dealers are clearing members and one of the dealers defaults, there's a good chance the clearinghouse will be able to transfer most of the defaulting member's derivatives book to other clearing members, smoothing the resolution of the defaulting dealer and minimizing the strain on the guaranty fund. Another major problem with the Lynch amendment is its potential effect on the liquidity of cleared OTC derivatives. As the name implies, "swap dealers" are the market-makers in OTC derivatives. There's already a question as to whether a lot of standardized OTC derivatives are liquid enough to be centrally cleared. I personally think they are, but the Lynch amendment would make it a very close call. You have to think about why clearinghouses only accept liquid derivatives for clearing — in order to collect the right amount of collateral (or "variation margin") from counterparties, cleared derivatives need to be liquid enough to accurately mark-to-market every day. If mark-to-market prices aren't available, a clearinghouse won't be able accurately value the contract, and it won't know how much collateral to demand from counterparties. If a clearinghouse only has 2 or 3 dealers as clearing members — which, again, would be the ultimate effect of the Lynch amendment — then its access to the (real-time) pricing information it needs to accurately set mark-to-market values will be severely constrained. A clearinghouse needs several dealers to be clearing members (at least 7 or 8) in order to accurately mark-to-market standardized OTC derivatives on a daily basis. Finally, Rep. Lynch is wrong to say that the clearinghouses "are being created to police the big banks in their derivatives trading." Uh, no Congressman, they're not. There's a reason we often say that standardized derivatives should be forced onto "regulated clearinghouses" — it's because the clearinghouses would be "regulated" by the CFTC and SEC! The CFTC and SEC will be the ones policing the OTC derivatives markets, as they'll have nearly unfettered access to clearinghouse data, as well as the authority to impose pretty much whatever standards they want on the clearinghouses. A regulated clearinghouse can only make rules for its members within the confines of CFTC/SEC regulations. Warning that the big banks will be allowed to police themselves without the Lynch amendment is a pure straw man. Let's hope the Senate takes a second to think through the Lynch amendment before it takes up financial regulatory reform.

Thursday, December 3, 2009

Changing My Mind on Bernanke

I think it's pretty obvious that I'm a big supporter of the Obama administration, and particularly of the Geithner Treasury. But I'm surprised at how little I find myself caring about whether Bernanke is reappointed. If you had asked me a month ago, I probably would've given Bernanke my full-throated support. The only thing that's changed in the past month is that I started to think more carefully about how Bernanke, personally, has performed. I still strongly believe that the Fed has performed admirably ever since the Bear Stearns failure, opening wide the money spigots and helping to avoid a second Great Depression. In some respects, Bernanke deserves credit for not repeating the mistakes the Fed made during the Great Depression. But let's be honest: no Fed-Chair-worthy economist would have repeated the mistakes of the Depression-era Fed. The Fed, as an institution, is very much in the middle of mainstream economic thought, and no mainstream economist thinks the Fed acted wisely during the Depression. The Fed has seen itself as institutionally-committed to intervening in a financial crisis for a few decades now. What about all those "creative emergency lending facilities" like the PDCF and the CPFF that the Fed implemented, and that Bernanke is always getting so much credit for? Those were in reality designed largely by the NY Fed's Markets Group (headed at the time by William Dudley, who's now the NY Fed President), not Bernanke. More on that later. If you think about it, two of the decisions that Bernanke actually did have significant influence over were in hindsight pretty terrible decisions: 1. The emergency 75-basis point rate cut when Asian and European markets were tanking due to SocGen unwinding rogue trader Jerome Kerviel's trades — that wasted 3 of the Fed's bullets in one fell swoop. Awesome. It's not like the Fed could've used those bullets later or anything. And the emergency rate cut was definitely Bernanke's call. Here's how David Wessel described it in In Fed We Trust (emphasis mine):

"Flexing his muscles as he had rarely done before, Bernanke won the FOMC’s backing for what — for the Fed — was a king-size rate cut: three-quarters of a percentage point, with a strong hint of more to come at the FOMC meeting scheduled for the following week." (pg. 93)
2. The unreal decision NOT to cut rates on the Tuesday after Lehman's failure. Hoocoohanode that the largest bank failure in world history — 13 months into a still-worsening financial crisis, no less — would've had an effect on interbank lending? Yeah, the interbank markets probably didn't need any help on Sept. 16-17, 2008, and the markets definitely didn't need a confidence boost. Or something. I'm reminded of Paul Krugman's description of Greenspan's emergency rate cut after LTCM's failure (from The Return of Depression Economics):
"It is important to realize that even now Fed officials are not quite sure how they pulled this rescue off. At the height of the crisis it seemed entirely possible that cutting interest rates would be entirely ineffectual—after all, if nobody can borrow, what difference does it make what the price would be if they could? And if everyone had believed that the world was coming to an end, their panic might—as in so many other countries—have ended up being a self-fulfilling prophecy. In retrospect Greenspan seemed to have been like a general who rides out in front of his demoralized army, waves his sword and shouts encouragement, and somehow turns the tide of battle: well done, but not something you would want to count on working next time." (pp. 135-136)
Bernanke didn't even ride out in front of his army. Ultimately, I think these two bad decisions raise questions about Bernanke's "feel for the market" — his understanding of market psychology (hugely important), his ability to interpret market signals that are important to Fed policymaking, etc. A Fed Chair absolutely needs to have a good feel for the market. Greenspan, for all his faults, actually did have a remarkably good feel for the markets during crisis-type situations. Does Bernanke? I'm not sure, but I'm skeptical. Bernanke deserves at least some credit for being willing to sign-off on the "creative emergency lending facilities" that took the Fed into uncharted waters. On the other hand, I don't think he (or the other Fed Governors, for that matter) had much of a choice. As I said before, the Fed sees itself as institutionally-commited to intervening to ease a financial crisis, and there were unquestionably intervention-worthy problems in the credit markets in 2007-2008. For example, Bear's failure vividly demonstrated how important it is, in terms of financial stability, for large investment banks to have access to stable sources of liquidity. After Bear Stearns, any Fed Chair would've seen that the sudden failure of a large investment bank could threaten the stability of the financial system. Since the Fed's traditional emergency lending facility (the discount window) isn't available to investment banks, anything the Fed did to address this problem was necessarily going to take the Fed into uncharted waters. So Bernanke didn't have much of a choice on the Primary Dealer Credit Facility (PDCF) — everyone, and I mean everyone, knew that the Fed had to get involved, and the only real way to do that was with something like the PDCF. Ultimately, I'm not against Bernanke's reappointment. I'm ambivalent on Bernanke personally, and I'm rooting for the Senate to confirm Bernanke just so the Obama administration doesn't take a huge hit to its credibility (I'm also rooting for him because it's effectively a done deal now, and everyone likes to root for a winner). Do I wish that the Obama administration had nominated someone other than Bernanke? In retrospect, yes, I probably do. But now that they've re-nominated Bernanke, I don't want to see him get rejected, and then have the administration forced into accepting someone that Chris Dodd "suggests" can easily get confirmed. The devil you know, and all that. To be clear: I don't think Bernanke will be a bad Fed Chair in his second term by any means, but I don't think he'll be a particularly great Fed Chair either.

In my earlier post on TBTF policy, I started to discuss why "prompt corrective action" (PCA) is the key to making TBTF policy work, and I want to expand on that here. Done right, I really do think PCA could be the glue that holds TBTF policy together. The resolution authority is clearly the most important aspect of TBTF policy, since "too big to fail" just means "too systematically important to put into Chapter 11." Give us a resolution authority that can wind down systematically important nonbank financial firms without causing a financial crisis, and suddenly no firm would be TBTF anymore — the TBTF problem would instantly vanish. The trick is obviously to design such a resolution authority. Easier said than done. One of the biggest problems is that there are no trial runs — we won't know whether the resolution authority we end up with actually works (i.e., allows regulators to wind down systematically important financial firms without causing a financial crisis) until we use it during a crisis, which policymakers will be loath to do the first time because it'll still be untested. But that's where PCA should come in. PCA can act as "foam on the runway" for the resolution authority (to borrow a phrase from Geithner). In the earlier post, I argued that one of the PCA triggers should be contingent on the tenor of a financial institution's overall liabilities—that is, the Fed should be required to take prompt corrective action once a large financial institution allows the tenor of, say, 20% of its overall liabilities, or 50% of its daily funding requirements, to drop below one week (again, I just pulled those numbers out of the air). In other words, the new PCA regime should be focused more on a large firm's liquidity ratios than on its capital ratios. What sort of "corrective action" should a financial firm that runs afoul of this or other similar PCA triggers be forced to take? Broadly, I'd say that the PCA regime needs to force a firm to secure a certain amount of medium/long-term financing for its capital markets activities (e.g., $X >30 days, $Y >100 days; "medium-term" and "long-term" are relative terms here, since we're most talking about capital markets positions). The key is to make sure that a systematically important firm's survival or failure is not contingent on its ability to obtain ultra short-term financing. As a firm relies more and more on overnight repos and rehypothecated collateral and prime brokerage accounts to fund its positions, its balance sheet gets exponentially more chaotic and confusing — securities are being pledged overnight all over the place, the firm is rehypothecating all the collateral it can (and some that it can't), etc., etc. If the firm ends up failing, this makes a smooth resolution 100 times harder, in part because of the inevitable delay required to figure out where everything is. Lehman was still transferring assets in between its various European and North American branches at a furious pace right up until its bankruptcy filing. As a result, a lot of hedge funds and other investors were very surprised to discover that their assets were not in segregated accounts in Lehman's North American unit, but in fact had been transferred to Lehman Brothers International (Europe) and then rehypothecated. This was a huge source of uncertainty in the days following Lehman's bankruptcy filing. It was also the main reason why hedge funds all started pulling their prime brokerage accounts from Morgan Stanley and Goldman, which both investment banks had relied on to some extent for short-term financing (the so-called "free credits"). The new PCA regime should aim to prevent this kind of thing from happening by making a large firm's survival or failure contingent on its ability to obtain medium/long-term financing for its capital markets positions, or by giving the Fed the authority to restrict transactions between affiliates once a large firm passes a certain PCA trigger. If we can use PCA to ensure that a large firm doesn't rely more and more on ultra short-term financing as it edges closer to failure, then a successful resolution under a new resolution authority is very realistic. The point is that PCA needs to be a way to force both the financial institution and the regulators to start getting their ducks in a row in preparation for a resolution. If PCA can ensure the conditions necessary for a smooth (i.e., non-catastrophic) resolution of a large financial institution, then we'll have a legitimately "successful" resolution authority for large nonbank financial institutions, and the problem of TBTF will be no more. Of course, I've been through more than enough rounds of financial regulatory reform to know that it's highly unlikely it'll actually happen that way. But getting a framework in place that could get us to that point isn't out of the question, so long as the fairweather populists can be kept in check.