Economics of Contempt

Chris Dodd has now formally dropped a free-standing Consumer Financial Protection Agency (CFPA), instead pushing for a new Treasury-housed "Bureau of Financial Protection." Per Bloomberg:

Senate Banking Committee Chairman Christopher Dodd abandoned the Obama administration’s stand- alone consumer financial agency and is proposing a bureau in the Treasury Department, seeking to overcome Republican opposition to legislation overhauling Wall Street regulations.

The Bureau of Financial Protection would be run by a director appointed by the president, have power to write rules for companies offering financial services and be funded mainly through industry fees, according to a two-page summary the Connecticut Democrat circulated this weekend.

This is a mistake, but not in the way you'd think. I was talking to a friend about this the other day, and he was lamenting the fact that the left has made the CFPA into a litmus test for whether Democrats are serious about financial reform — essentially making it the "public option" of financial reform. A free-standing CFPA never had a chance in hell of making it through the Senate (really, a 0% chance), so setting the CFPA up as a litmus test just guarantees that the left will end up angrily denouncing Senate Dems as sellouts.

I suggested that since Dodd clearly knows that a free-standing CFPA is out of the question, he should push for whatever he can get in terms of a new division dedicated to consumer protection inside Treasury, but should make absolutely sure that it's called the "Consumer Financial Protection Agency." The vast majority of progressives don't really care about the details of the CFPA, nor could they tell you what specifically they want the CFPA to do (and be able to do). They just want a CFPA. If the new Treasury division is called the CFPA, then a lot of progressives will be happy. It doesn't give journalists — who know even less about the substance of the CFPA — the chance to easily label one proposal as "bad" and the other as "good," but will instead force them to distinguish the proposals by, you know, actually describing the differences (which will likely be minimal). And it'll definitely reduce the likelihood of a free-standing CFPA becoming progressives' next big "line-in-the-sand hissy fit." (Memo to progressives: the time you need to draw a line in the sand is when the DSCC is recruiting candidates for the next Senate races. But once you've let them fill the caucus with Blanche Lincolns and Evan Bayhs, you can't profess to be outraged(!) when we can't push something like a free-standing CFPA through.)

Since I'm talking about political strategy, I should also address Matt Yglesias and Felix Salmon's argument that we should hive off the CFPA from the larger financial reform package, and try to pass a CFPA bill separately. Hiving off the CFPA is a total non-starter — it would be the fastest way to guarantee that nothing resembling the CFPA ever gets passed into law. Now, Salmon is a self-professed political neophyte, but Yglesias has been paying close attention to politics for long enough that he should know this. And I almost spit out my coffee because I was laughing so hard when I read this part of Yglesias' argument:

If Corker doesn't want to vote for a CFPA then let's write a different bill to create a CFPA, have everyone go on TV and talk at rallies about how awesome it is, and maybe a Collins or a Snowe or a Brown will feel compelled to vote for it and it'll pass or maybe they'll all vote no and it won't pass.

This is a true fairyland and pixie dust strategy. If we could just explain why creating a free-standing CFPA is such good policy, then Men of Good Will in the Republican Party — known the world over for their intellectual honesty — would agree that we're right and vote for the CFPA bill. (Followed by a Kumbaya sing-along on the Senate floor.) Yeah, because that's absolutely how it works.

Look, there are no Republicans in the Senate who would vote for a free-standing CFPA. That's just a reality. Perhaps you weren't paying attention to the health care and stimulus debates? The CFPA is a partisan, left vs. right issue now (partly because progressives have been stomping their feet so loudly about a free-standing CFPA). Even if there was a Republican who was willing to break ranks on this issue, there are still several pussies moderate Dems who almost certainly won't vote for a free-standing CFPA. Ben Nelson, Evan Bayh, Blanche Lincoln, Claire McCaskill, just to name a few. You better believe Ben Nelson's going to extract his usual pound of flesh on this issue. Hell, we're still not sure if Tim Johnson will vote for the CFPA, so it might have trouble just making it out of committee (if Johnson and Bayh both vote nay).

Progressives really do need to face reality here: a free-standing CFPA absolutely, positively cannot pass the Senate. If Corker is willing to go along with Dodd's "Bureau of Financial Protection," and provide (crucial) cover to the moderate Dems to also support it, then progressives should consider that a huge victory. And it would be a huge victory.

As to Yglesias' argument that even if the bill didn't pass, it would at least "clarify who's for it and who's against it," I would ask: are you interested in getting a federal office dedicated to consumer financial protection, or are you just interested in knowing who's for the CFPA and who's against it? Knowing who's for it and who's against it would be the worst consolation prize ever. Honestly, which consolation prize would you rather have:

(a) a new division in the Treasury Department that's only slightly weaker than the House-passed CFPA, can be strengthened/expanded in the future without a huge public fight, and will protect consumers for years to come; or

(b) the knowledge of which Senators are for a free-standing CFPA and which are against it.

Hiving off the CFPA would be tantamount to choosing option (b). If that's what progressives want, then so be it.

Gretchen Morgenson has yet another article about credit default swaps in today's NYT. I don't have time to debunk all of the myths or point out all of the false statements (of which there are many) in her article. Suffice to say that at several points she confuses currency swaps with credit default swaps, which is pretty goddamn hard to do. But one statement jumped out at me, because while it's not terribly important, it's an indisputably false statement, and provides a pretty clear example of the kind of lazy and uninformed analysis that Morgenson brings to the table. She writes:

The Office of the Comptroller of the Currency reported that revenue generated by United States banks in their credit derivatives trading totaled $1.2 billion in the third quarter of 2009.

No, Gretchen. The OCC does not report trading revenue by instrument. The OCC report she's referring to is the latest Quarterly Report on Bank Trading and Derivatives Activities. She got that $1.2 billion number from the chart accompanying graph 6A (on page 16), which I've reproduced here:


These numbers do not represent banks' derivatives trading revenues. Look at the title of the table: "Cash & Derivative Revenue." Right there in huge font. Notice also the note accompanying the table:

The trading revenue figures above are for cash and derivative activities.

So it should be very clear to anyone who can, you know, read words, that U.S. banks did not generate $1.2bn in revenues from credit derivatives trading in Q3-2009. That Morgenson somehow missed this is simultaneously astonishing and not at all surprising. (I don't know what newspapers' policies on corrections are, but shouldn't provably false statements at least be corrected online? So that you're not continuing to knowingly mislead your readers?)

In fact, most of the trading revenue figures in the OCC report are considered unreliable. The trading revenue figures are taken from Schedule RI of banks' call reports, which directs banks to determine the appropriate risk exposure category for trading revenues the same way they make that determination in other financial reports. But banks usually don't break out revenues (or fair values) by these five risk exposure categories in other financial reports, so they're basically left to use their own internal system to make this determination. And that's where things get messy and unreliable, because every major dealer bank organizes their trading floors differently. The "credit desk" at one bank may not trade the same instruments as the credit desk at another bank. Rates desks at some banks trade derivatives and pretty much every cash instrument under the sun, while other rates desks trade only interest rate derivatives. So the way the banks break out revenues internally, by desk/division rather than by instrument, differs substantially. The end result is that the category-specific trading revenue figures in the OCC's report are basically useless.

Also useless: Gretchen Morgenson.

People tend to use the label "Wall Street" very loosely. Once upon a time — that is, in the Pre-Lehman Era — people would go to comical lengths to be included in the definition of "Wall Street." In the Post-Lehman Era, of course, "Wall Street" has become a pejorative in the media, and people in the financial industry are walking sideways away from the label. Unfortunately, commentators now simply use the term "Wall Street" to refer to any financial company they don't like, or that they're trying to paint in a negative light. If the SEC fines some random boutique brokerage in California, it's now evidence of "Wall Street corruption." All hedge funds are apparently part of Wall Street now too. Basically, if it's in the financial industry and it's being criticized, it's part of Wall Street.

Given all of this confusion, I thought it would be useful to clarify who exactly I'm talking about when I refer to "Wall Street." I'm not saying that this is the One-and-Only Definition of Wall Street; this is just my definition. Nonetheless, I do think it fairly represents the commonly-used definition within the financial industry.

In general, when I talk about "Wall Street," I'm referring to the major dealer banks (both domestic and foreign) and the two big custodian banks. Specifically, I'm referring to the following institutions:

1. Goldman Sachs
2. Morgan Stanley
3. JPMorgan
4. Deutsche Bank
5. Barclays
6. BofA-Merrill Lynch
7. UBS
8. Citigroup
9. Credit Suisse
10. SocGen
11. BNP Paribas
12. RBS
13. Wells Fargo/Wachovia Securities
14. Nomura
15. HSBC
16. BNY-Mellon
17. State Street

(It's possible that I forgot someone here — it's hard for an old guy like me to keep all the recent reshufflings straight.)

When you hear people in the industry say things like, "the Street is short 2YR swaps," they're generally talking about these institutions. They're not talking about hedge funds, or PIMCO, or boutique firms that have offices in lower Manhattan. It's really just a relatively small group of major dealer banks.

Anyway, I hope this clarifies things a bit.

An interesting research note on the labor market from Goldman:
Goldman Sachs: The Labor Market: Crawling Out of a Deep Hole

After reading John Taylor and John Cochrane's analyses Lehman's failure, I'm beginning to understand how it's possible for economists to say that "we're still arguing about the causes of the Great Depression." It's generally hard to come to an agreement when one side simply lies, or refuses to acknowledge undeniable facts.

I've already dealt with John Taylor's ridiculous claim about Lehman's derivatives counterparties. John Cochrane's "analysis" of Lehman's failure is equally fictitious:

Why would Lehman's failure cause a panic? Why, after seeing Lehman go to bankruptcy court, would people stop lending to, say, Citigroup, and demand much higher prices for its credit default swaps (insurance against Citi failure)? Nothing technical in the Lehman bankruptcy caused a panic. The usual "systemic" bankruptcy stories did not happen: We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses. Most of Lehman's operations were up and running in days under new owners. Lehman credit default swaps (CDSs) paid off. Sure, there was some mess — repos in the United Kingdom got stuck in bankruptcy court, some money market funds "broke the buck" and had to borrow from the Fed — but those issues are easy to fix and they do not explain why Lehman's failure would cause a widespread panic. What is more, Lehman's failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.

This is just mind-boggling nonsense. It's genuinely frightening that a prominent professor of finance can be so utterly clueless about modern financial markets.

Let's start with Cochrane's claim that there wasn't a secondary wave of failures after Lehman's bankrtupcy. First of all, that's not even true. Plenty of hedge funds failed as a result of Lehman-related losses. However, since they were generally structured as LLPs, they went into pre-defined liquidation procedures rather than filing for bankruptcy. But that doesn't make those failures any less real. Second, Cochrane, like Taylor, inexplicably ignores the fact that Lehman's biggest counterparties — the other dealers — were virtually all bailed out by their governments.

Next, let's take Cochrane's bizarre attempt to minimize the importance of the obvious knock-on effects from Lehman's bankruptcy — namely, the problems at Lehman's European broker-dealer (LBIE), and the run on the money markets. Contrary to Cochrane's assertion, it wasn't just "repos in the United Kingdom" that were affected by LBIE's failure. In addition to the 140,000 failed trades, over $40bn in prime brokerage client funds and assets were frozen by LBIE's administrator. That's $40bn that was suddenly and unexpectedly unavailable to hedge funds — and when you consider that hedge funds use their prime brokers to lever up, the end result is that LBIE's failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn't be able to access their funds if either of the prime brokers failed. Investment banks used clients' prime brokerage accounts for funding (which is why prime brokerage accounts are called "free credits"), so when hedge funds started pulling their prime brokerage accounts, that was the equivalent of having counterparties stop lending to them.

And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, "broke the buck" because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn. So the run on the money markets was directly attributable to Lehman's bankruptcy. As to why the run on the money markets would cause people to stop lending to banks like Citigroup, there are several reasons. The biggest reason the run on the money markets affected Citi's (and other banks') wholesale funding was that to meet the massive redemptions, money funds all drew down their backup lines of credit with banks at the same time. Institutional investors knew this, and started to pull back aggressively from the big banks in the wholesale funding markets. And then there were all the asset firesales by money funds...

(Cochrane's claim that these two problems were "easy to fix" further demonstrates how detached from reality he is. The vast majority of the prime brokerage client assets frozen by LBIE's administrator still haven't been returned yet. Not only was that problem not "easy to fix," but it still hasn't been fixed yet! Also, the money market funds never borrowed from the Fed. I know the structures of the Fed's various financing facilities are a bit complicated, but Cochrane is supposed to be a professor of finance at a prestigious business school, is he not?)

Finally, there's Cochrane's point that "[m]ost of Lehman's operations were up and running in days under new owners." Well, yes, Barclays did buy Lehman's core US units, and Nomura bought some of Lehman's Asian and European units — minus those pesky liabilities, of course! I'm not sure Cochrane knows this, but in a bankruptcy, the debtor's liabilities tend to be kinda-sorta important in determining how large an effect the bankruptcy has on non-debtors.

John Cochrane and John Taylor are both prominent economists, and they will no doubt convince legions of starry-eyed grad students that Lehman's bankruptcy was really only a minor event. John Taylor, at least, will no doubt also convince these grad students that the real problem was the government's handling of the bailout. And 80 years down the road, economists will be saying, "We're still arguing about the causes of the Financial Crisis of 2008."

The biggest news of the day was that Sen. Bob Corker (R-TN) has agreed to break ranks and negotiate with Chris Dodd on a financial reform bill. This comes five days after Dodd said he and Sen. Shelby—the ranking Republican on the Senate Banking Committee—had reached an "impasse" on financial reform.

Let's be clear: Corker is taking a massive political risk here. He's a first-term Senator, and he's publicly replacing his ranking member at the negotiating table on the biggest, most important piece of legislation that the Senate Banking Committee has seen in a long time. And he's not crossing any ranking member, he's crossing Richard Shelby—the most vindictive, ruthless Senator this side of Tom Coburn. (As I said the other day, what you have to realize about Shelby is that he would literally bomb Oregon if it meant an Alabama company would get the contract to build the bomb.)

Now, even with Corker at the negotiating table, there's still no way we're going to get an independent Consumer Financial Protection Agency (CFPA). That was the main sticking point in Dodd and Shelby's negotiations. No matter how much consumer advocates push, an independent CFPA is off the table in the Senate. The votes simply aren't there: the Dems don't have a supermajority anymore; Ben Nelson always takes his pound of flesh; and "centrists" Evan Bayh and Blanche Lincoln are both in cycle right now. So the Dems are at least four votes shy on this issue. Corker won't agree to an independent CFPA, because even if he did, the Dems would still be at least three votes short, the bill wouldn't pass, and he'd get tons of heat from within his own caucus for having supported it in the first place. But let's be honest: the CFPA is largely a political sideshow in the context of the larger financial reform bill.

What consumer advocates need to do is start thinking about what specific powers and directives they want a consumer financial regulator to have, and then start pushing for a division within an existing agency to be given those powers/directives. Or they can keep stomping their feet and insisting on an independent CFPA, which I absolutely, 100% guarantee will end in massive disappointment. Your choice.

And, I have to point out (since it's my blog, after all), I was ahead of the curve on Corker. After a committee hearing almost a year ago, I wrote: "Am I crazy, or did the most articulate and useful questions for Bernanke in the Senate Banking Committee hearing really come from Bob Corker?" I usually leave important hearings on in the background while I work, and after the first round of questions, when all the members have done their grandstanding and all the ADD journalists have left, there are occasionally some members who stick around and ask serious questions. Corker's questions in that hearing a year ago were almost shockingly well-informed (for a Senator), and were couched in a very non-partisan way. Corker seemed genuinely interested in talking with Bernanke about the nitty-gritty of financial reform. I've since asked around on the Hill about Corker, and the consensus feeling is that while Corker is still a largely unknown entity politically, he's really, really interested in the details of financial reform.

I wouldn't say that I'm a fan of Corker—I still disagree with him on policy. I think of Corker like I think of Hank Paulson: while I think Paulson made a lot of mistakes in the financial crisis, and I disagree with him philosophically, he was clearly acting in good faith, in that he did what he thought was best for the country. You can't say that about many modern-day Republicans.

I'm getting so tired of people who refuse to read financial reform proposals before dismissing them as woefully inadequate. This time it's James Kwak, who writes (quoting a senior administration official during the background briefing on the Volcker Rule):

“The basic authority is provided in Chairman Frank’s legislation, for regulators to break apart major financial firms or to address problems with risky activities to the extent that they cause the firm to act in an unsafe or unsound manner that threatens the financial system. So we worked very closely with Chairman Frank on that already.”

Not exactly. The “basic authority” referred to must be the Kanjorski Amendment, which allows regulators to take action regarding a specific firm because it is a danger to the system (not just because it is a danger to itself). I don’t recall the Kanjorski Amendment being in Treasury’s initial regulatory proposal. (The Kanjorski Amendment is also hemmed in with all sorts of restrictions, like needing Tim Geithner’s approval for any action affecting more than $10 billion in assets.)

Or, more precisely, the answer is technically correct–they are claiming that they worked with Frank on the Kanjorksi Amendment, which may be true–but it dodges the spirit of the initial question, which was “Why didn’t you do this back in June?”

I know that administration officials have a tough job when they have to go out and spin new policies that (a) are significant changes from past policies and (b) may turn out not to be serious anyway. But that doesn’t mean I have to give them a pass.

This is 100% false. I know James is still a law student, but that doesn't mean I have to give him a pass either (especially since both he and Simon Johnson like to pass themselves off as experts on financial reform).

Both Treasury's initial proposal and Barney Frank's discussion draft contain the "basic authority" to prohibit specific firms from engaging in activities that regulators consider a threat to financial stability. Kwak clearly didn't bother to read either Treasury's proposal or Frank's discussion draft, which is sad because he just co-authored a book on financial reform.

Frank's discussion draft very clearly contained this "basic authority," in Section 1104(a)(5):

(5) MITIGATION OF SYSTEMIC RISK.—If the Board determines, after notice and an opportunity for hearing, that the size of an identified financial holding company or the scope or nature of activities directly or indirectly conducted by an identified financial holding company poses a threat to the safety and soundness of such company or to the financial stability of the United States, the Board may require the identified financial holding company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities, or to impose conditions on the manner in which the identified financial holding company conducts one or more activities. (emphasis added)

It doesn't get much clearer than that. And it's not like this provision was buried hundreds of pages into the discussion draft — it was on page 19. Of course, admitting that this provision was in Frank's discussion draft — which was the product of lengthy negotiations between Frank and Treasury — would go against Kwak's little narrative, in which Treasury is in the pocket of the Evil Wall Street Banks.

What's more, Treasury's initial proposal, which they released last Jun, also gave the Fed a couple of ways to prohibit activities that threaten financial stability. First, Treasury's proposal gave the Fed the authority to order Tier 1 financial holding companies (i.e., large complex financial institutions) and their subsidiaries to terminate "conduct, activities, transactions, or arrangements that could pose a threat to global or United States financial stability." Treasury's proposal also gave the Fed the authority to prohibit risky activities at Tier 1 FHCs through its Prompt Corrective Action (PCA) provisions. Essentially, Treasury's proposal allowed the Fed to treat even Tier 1 FHCs that are technically "well capitalized" under the law as "undercapitalized" for purposes of PCA, which would've then allowed the Fed to order Tier 1 FHCs to terminate or restrict risky activities.

What self-proclaimed "reformers" probably don't realize is that the Kanjorski Amendment significantly reduced the likelihood that a financial institution will be ordered to terminate activities that threaten financial stability. Under Frank's discussion draft, the Fed had the authority to prohibit activities that "pose a threat to financial stability." Under the Kanjorski Amendment, however, the activities have to pose a "grave threat to financial stability" before regulators can order a financial institution to terminate the activities. The Kanjorski Amendment also shifted the authority to prohibit risky activities from the Fed to the Financial Services Oversight Council (meaning multiple regulators have to sign off on the action), and added a whole bunch of cumbersome procedural requirements to boot. This is just terrible policymaking, which is why the Kanjorski Amendment was such a bad idea.

And yet for some reason, people who like to think of themselves as reformers cheered the Kanjorski Amendment on, and patted themselves on the back when it passed. This is what the financial reform debate has come to.

I think it’s safe to say that Yves Smith and I don’t see eye-to-eye on much. But on Paul Volcker’s latest op-ed, we largely agree: Volcker simlpy doesn’t get it. I have the utmost respect for Volcker, but he seems to be fighting old battles. He emphasizes the importance of — and the need to extend the safety net to — depository institutions like commercial banks. He contrasts commercial banks with "capital market institutions," which he does not believe should have access to the safety net. Capital market institutions, Volcker believes, should "be free … to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail."

I’m sorry, but were we watching the same financial crisis? The clear lesson from the financial crisis is that certain capital market institutions are every bit as important to the day-to-day functioning of the modern economy as commercial banks. That’s a positive statement, not a normative one. Lehman Brothers was not a commercial bank, and yet its failure had catastrophic consequences for the global economy.

If anything, Volcker is not advocating enough government intervention. Capital market institutions need to be given access to the safety net — but just as with commercial banks, access to the safety net has to come with stringent regulation to limit the amount of risk that capital market institutions can take on. As Yves says:

The world has evolved so that many market making activities are now as essential to commerce as deposit gathering and lending. Those activities are de facto backstopped; there is simply no ready way back here (trust me, even if there were, it would take twenty years, and we’d still need an interim solution). We need to regulate those activities aggressively, including requiring much more capital to support them, and strict limits as to how much and what type of credit these firms can extend to hedge fund and other speculative investors.

If you accept that certain capital market institutions have become just as important to the day-to-day functioning of the modern economy as commercial banks — and given what we witnessed in September 2008, I don’t see how that could be seriously disputed — then how can you justify extending the safety net (with stringent regulations, of course) to commercial banks, but not to those capital market institutions? Volcker essentially wants to implement a resolution authority for capital market institutions, and then send them on their way (leaving them "free to innovate, to trade, to speculate, to manage private pools of capital"). While I think a resolution authority is the most important element of financial regulatory reform, I certainly don’t think it’s sufficient. We need to extend the formula for commercial bank regulation (safety net access + stringent regulation) to capital market institutions. Volcker seems to be pretending that the lesson of the financial crisis is that we just need to clamp down harder on commercial banks. I think that’s misguided.