Archive for January, 2010|Monthly archive page

Query re AIG

According to the NYTimes:

The debate within the Fed centered on which part of the government could provide the guarantee, according to the documents. Staff at the Board of Governors told Fed officials in New York that a Fed guarantee “was off the table,” according to an e-mail message to Mr. Geithner and others on Oct. 15 from Sarah Dahlgren, the New York Fed official overseeing the A.I.G. rescue.

“We countered with questions about why it was so clearly off the table and suggested, as well, that perhaps this was something that Treasury could do,” Ms. Dahlgren continued.

Supporters of the plan considered a guarantee a good option because A.I.G.’s debt rating was at risk of a downgrade by the credit rating agencies and the company would then have to post more collateral with the banks.

“If a ratings downgrade happens at any time in the next three weeks or afterward, we will need this to protect any value in the insurance companies and, importantly, to avoid a disorderly seizure,” Ms. Dahlgren wrote.

The New York Fed pursued the guarantee option with the Treasury, the documents indicate. But by Oct. 23, the Treasury had refused to provide the guarantee, according to an e-mail message sent by Ms. Dahlgren to Mr. Geithner. In early November, the Fed decided to make the counterparties whole on their insurance contracts.

How does Treasury explain its decision not to provide a guarantee to the AIG CDOs that were absorbing so much collateral?  This would clearly have saved taxpayer money in the short-run — and would be unlikely to end up adding to taxpayer losses in the long-run.  (As far as I can see, the only situation in which Maiden Lane III is a better choice for Treasury than an outright guarantee of the same assets is if Blackrock manages to pull off an extraordinarily well timed sale of the CDOs, thus transferring yet to be realized losses to someone in the private sector.)

On “proprietary trading” and commercial banks

“I fully understand the desire to implement a situation where commercial banks do not engage in proprietary trading.  However, the real problem isn’t proprietary trading – it’s leverage – it’s actual risk.” — Kid Dynamite

Well, precisely.  What is a bank, but leveraged finance?  When commercial bank deposits are used to finance prop trading, the leverage is about 20:1, so any substantial position that loses more than 5% can provide a serious hit to a bank’s equity capital and create a headache for regulators.

And it’s a fact that the rehypothecation of prime brokerage collateral played a role in both Bear Stearns’ and Lehman’s collapse — and while holding collateral is clearly essential to client services, it seems to me that that when a broker chooses to use clients’ collateral in order to finance the broker’s business, this rehypothecation is proprietary trading.  Ergo proprietary trading played a large role in the financial crisis.  — And don’t tell me that there were no prime brokers supported by commercial banks that failed, because we all know that without a government bailout Citigroup was bankrupt.

Radical ideas on deposit insurance

Raghuram Rajan proposes doing away with deposit insurance for large banks.  I can think of few more effective ways of eliminating large commercial banks.

On another note, I heard on the grapevine (i.e. this may not be accurate) that the FDIC is not allowing new banks to be chartered unless the the new bank is willing to buy the assets of an old bank.  If this is true, it is such a total perversion of market principles, that maybe the FDIC really is an important part of the problem.  If the truth is that the FDIC and its fellow regulators have let the banking system deteriorate to such an extent that they can’t afford to allow new, sound banks to form, then maybe we are better off doing away with the FDIC and should allow the NCUA to be the only insurer of deposits.

A solution to the EU’s Greek problem

Goodhart and Tsomocos have a very creative solution to the need for deflation in Greece:  a dual currency regime.

The estimable TED gets this one wrong

TED argues that bankers are “men of action” and that they could care less about the causes of the financial crisis:

Men of thought like Mr. Krugman analyze, dissect, and theorize about such conundra as the causes of the financial crisis and the proper size of banks in the economy. Investment bankers take such things as given, and then try to make the most of them. Investment bankers are men of action.

… Investment bankers have well-justified confidence in their ability to turn new regulations to their advantage. It’s just that, being in an industry that is constantly creating, reinventing, and destroying itself, investment bankers have a very healthy respect for change. You might even say we fear it.

So yes, Mr. Krugman, you are basically right. Don’t look to investment bankers for answers on how we got here. We don’t know and we don’t care. We take the world as we find it and try to make money.

This unfortunately is, at least when we’re discussing the Goldman Sachs and JP Morgans of the world, extremely well written nonsense.

TED is likely right that investment bankers don’t spend much time thinking about the optimal structure of the financial world, but they have a very long history of talking about the optimal structure of the financial world — especially when there’s a Congressman listening.  In fact, I seem to remember investment bankers testifying in 1999 in support of changes to existing law:  If Congress would just remove the regulation of derivatives from the jurisdiction of the CTFC and from exposure to state gambling laws, risk would be optimally allocated using derivatives and the economy would be able to perform even better than it had in the 90s.

Hmm, I wonder how that turned out.

Volcker’s economics

Rajiv Sethi has found a piece by Paul Volcker on the credit cycle — which sounds a lot like 19th and early 20th century economists.  No wonder he was such a good central banker!

Are the big banks criminal enterprises?

James Kwak’s post on banker “incompetence” reminded me of a recent experience.

I went in to my bank (one of the big five) and inquired about the fees for a service I was interested in.  I was directed to a customer service representative, who gave me the fee schedule and then offered to check whether there was an account that would give me a discount.  He then offered me a “no fee, no minimum” checking account with a linked savings account for overdraft protection.  Knowing that the big banks don’t offer “no fee, no minimum” checking accounts, I said “What’s the catch?”  He said “There is no catch.  Switch accounts and you’ll have no fees with no minimum.”  I said:  “It’s a joint account, so give me a brochure for the account and we’ll think about it.”

He printed some spec sheets from the web and handed them to me.  When I read them, I went through the roof.  The customer service representative had lied.  The account had a monthly fee that was waived if you met a complex set of conditions that I couldn’t understand.   One of the ways for the fee to be waived involved minimum monthly deposits that were more than double the amount that my current account required as a minimum account balance to waive the fee.  Furthermore, the linked savings also had a monthly fee (savings account with monthly fee? WTF?) — and one of the conditions for waiving this fee was that you maintain a balance almost double the balance needed in my current checking account to waive the fee.

If I didn’t have a deep seated suspicion of sales representatives, I might have switched from an account on which I have not incurred a fee in more than ten years to an account that was likely to be expensive.  In order to get me to make a switch that would allow the bank to gain at my expense (that is, charging new fees without giving me any additional services that I valued), the sales representative had no compunction whatsoever about misrepresenting the product he was selling by deliberately hiding the fact that there were many circumstances in which I would be charged high fees — unlike the simple terms of my existing account.  Of course, the lies were all made in a face-to-face verbal exchange so I can’t prove anything.  Welcome to the modus operandi of the modern American super-sized bank.

I haven’t closed my account yet, but as soon as someone recommends a good local bank, I’ll go.

My question for the bankers

In response the request for additional questions for the Too Big to Fail bankers from Bill Thomas of the FCIC, I emailed the following:

Did anyone at your firm ever market a synthetic or hybrid CDO investment as a bond?  Please provide any emails, presentations, brochures or other marketing literature that your firm produced that indicates that a synthetic or hybrid CDO can be treated by investors as bonds.  Also indicate any disclosures that clarify for investors the substantial differences between derivative markets and bond markets.

If the answer to the first question above is not “No”, please disclose who authorized the marketing of derivatives as bonds.  Also please explain what justification was given within your firm for asking investors to put money that was earmarked for the bond market — where at the initial offering of the contract both sides of the trade expect to benefit — into a derivative-backed position — where it is known from the date of the initial offering of the contract that there would be significant losses for one or more of the parties to the contract.  That is, please explain why you encouraged managers of funds destined for the bond market to indirectly take derivative positions — which were expected to perform extremely poorly according to the analysis of sophisticated clients of your firm (that is, by counterparties to the trade) — and thereby encouraged these managers to divert their funds from the bond market to the derivative markets.

The Knightian uncertainty meme is back …

The Knightian uncertainty meme is back.

[During the asset backed commercial paper crisis of 2oo7] Knightian uncertainty took over, and pervasive flight to qualities plagued the financial system. Fear fed into more fear, and caused reluctance to engage in financial transactions, even among the prime financial institutions

In response to this let me just quote an old post of mine:

Apparently the reason for this abrupt outbreak of Knightian uncertainty is that bankers have suddenly realized that there is a difference between reality and their models. As long as the world behaves according to model, bankers want to claim that they are earning profits from managing “risk,” and as soon as their models fail, risk becomes uncertainty and necessitates a government bailout.

In short whenever you read that bankers can manage risk, but uncertainty requires government intervention, you should hear: “Privatize the profits and socialize the losses.”

The truth is that bankers always have to price assets in the face of Knightian uncertainty, they have just chosen to spend the last decade pretending that this was not their job.

In response to the view that the government should insure the financial system against systemic tail risk:

… the main failure during the crisis was not in the private sector’s ability to create triple‐A assets through complex financial engineering, but in the systemic vulnerability created by this process. It is important to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events).

I will refer readers to an earlier post that distinguished between systemic liquidity risk and systemic credit risk.

Should default be a business decision?

John Quiggin asks:

Bankruptcy is once again as common as divorce. … And, as with divorce, we must soon be reaching the point where most people who take out loans will do so in the knowledge that default is an option. The question is – can the consumer credit system survive this?

But I think his more interesting point is:

Lowenstein’s key point is that businesses (including those owned or controlled by the banks themselves) treat default as a straightforward business decision, to be adopted whenever it is profitable to do so. … To be fair, it’s only in the last thirty years or so that such ethics have become dominant in the corporate sector, to the point where a board that rejected profitable opportunities to stiff their creditors would now be regarded as having violated its fiduciary obligations to shareholders

This recalled to mind Brad de Long’s work on the early years of the stock market.  Or actually a comment on that work, published with the paper in Temin’s book to which I don’t have a link.  In this comment Charles Sabel argued that in fact the first duty of any firm whose stock issue was underwritten by Morgan was to make sure that creditors were repaid.  That is, the author argued that in order to maintain their reputation, the first duty of Morgan’s Men was to protect the bond-holders.

So I think there’s another question here is:  How long can the bond market survive in a world where default has just become a business decision?

Update:  In fact as I read Mark Thoma (“you have to ask (and understand) why securitizers were so willing to take this paper from the loan originators”) I think that maybe there’s a sense in which this question explains the whole of the crisis.

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