Banks repaying TARP is good

While I agree with commentators like Ed Harrison that the economy and the banks are far from recovery, I don’t understand the claim that banks should not have been allowed to repay TARP money.

Of course, the big banks would be better off with more capital — and some of them are sure to either fail or do more capital raising in the near future.  TARP did provide capital to the banks, but, as the CIT failure demonstrated, it did so in the worst way possible — as a direct transfer from taxpayers to the financial system with nothing close to a fair exchange of assets.

The fact is that reversing TARP is one of the best things the Obama administration has done — especially if there’s another outbreak of financial instability in the next few years.  Given the public’s anger about bailouts, any future government aid to banks is likely to be in the form of DIP lending — which is how TARP should have been structured in the first place.  I say good riddance to a profoundly flawed bailout program.

How to increase the ranks of the Big Four auditors

After reading Francine McKenna on PwC, I have a proposal that would be of extraordinary value in helping shareholders understand the meaning of financial reports — if the structure of the accounting industry doesn’t change to avoid such disclosure:

Require auditors to publicly report the variation in valuation of identical financial instruments on the books of their clients (probably limiting disclosure to instruments over a threshold market or notional value).

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.)

Was TARP a failure?

Brad DeLong is arguing that the government’s actions since the Lehman failure have been good — and thus that TARP was not a failure because it saved the financial system.  I think the issue is this:

If we ask the question:  Given that passing a resolution authority was impossible, was TARP a failure?  Then I think the answer is no.  If you take the best solution out of the set of possibilities, then the Treasury and the Fed did what they could given the constraints they faced.  In other words TARP was better than using the bankruptcy process as it is currently structured to resolve the crisis.  (Note:  Steve Lubben is proposing that a modified Chapter 11 process would be a superior alternative to a resolution authority.)

However, if you simply ask the question:  Was TARP a failure?  Then you have to take into account the fact that passing a resolution authority in September/October 2008 was a possibility. The sense in which TARP was a failure was that a conscious decision was made to transfer funds from the taxpayer to the financial system in a way that all but ensured that a large chunk of the money would be lost (see CIT bankruptcy).  This was necessary because there was no resolution authority and no way for the government to provide DIP financing (as it did for the GM and Chrysler).  Thus, the responsibility for TARP’s “failure” lies with whoever took the possibility of passing a resolution authority off the table.

Dudley explains why TBTF firms need to shrink

William Dudley claims that there are two sources of instability inherent to financial intermediation.  The first is universally recognized: maturity transformation.  The second is not:

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent as shown in Figure 1. But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line, as shown in Figure 2, because the liquidation value is lower than the firm’s value as a going concern.

In his analysis Dudley fails to ask one very important question:  When is there a big difference between the liquidation and the “going concern” value of financial firms?

I would posit that for old-fashioned banks that hold loans on the balance sheet and take deposits the difference between the liquidation and the “going concern” value of the bank is not necessarily large.  Simple loans are relatively easy to value.  Branches can be sold off.  Key employees who know the borrowers and have relationships with large depositors can be kept on by the firm that purchases a branch.

Almost certainly too big to fail firms have much higher liquidation costs than old-fashioned banks.  Complex asset portfolios are harder to liquidate than simple loan portfolios and are likely to be particularly hard-hit when markets are unstable.  Furthermore too big to fail firms are frequently too large to be managed well even when they are going concerns and thus must be split in many, many pieces in liquidation.  The process of selling off divisions will inevitably lead to some loss of information as employees with broad experience must go in one direction or another.

I read Dudley’s second source of instability as a reason to protect the financial system from oversized financial supermarkets.

On TARP and tragedy

I had the rather traumatizing experience of running into a professor this weekend.  A man whose early work was brilliant, but who did not pursue it and ended up devoting his life to justifying why economic theory does not need to change.  Basically, someone who inhabits an alternate reality constructed to protect his self-image.  True to form, he is still justifying the failure to act by viewing the world as just fine as it is:  he genuinely believes that the financial system has been saved.  I challenged this view and pointed out that only a complete failure of analysis could lead one to conclude that the financial system was sound, but I didn’t really expect him to process what I had to say.  With some people communication is simply impossible.

The world we live in is one where a lot of people desperately want to believe that everything is okay.  Facing the possibility that the foundations of our economy are deeply unstable, that the authorities have a mammoth task before them and that it is possible that our political system does not have the strength to pass the necessary legislation is frightening.

People want to believe that the disaster that was the TARP program did good things for the economy.  For this reason, voices like Steve Waldman’s and Haldane and Alessandri‘s are extremely important.  Steve Waldman makes the key point about TARP:  Everybody knew after the Bear Stearns debacle that a resolution authority was necessary — and Treasury chose instead to write up a bill that was designed to give taxpayer money away to the banks.  Given that after the Bear Stearns collapse it was clear that none of the investment banks had a viable business plan in a crisis (unless you consider running to the Federal Reserve for a handout a plan) and thus that the whole industry was on the short-list for resolution, Henry Paulson’s close ties to Goldman Sachs almost certainly affected his judgment on this matter.  (Remember that, if resolution was an option in September 2008 the Fed might not have extended additional support to the investment banks via the repo market and the conversion to bank holding companies.  These actions were taken because there were no alternatives.)

Now, we all need to admit that Paulson’s failure was an extremely human failure — that none of us can actually know whether we, having spent the whole of our working lives at a firm and then finding ourselves handed the job of drafting the law that would in all probability dissolve that firm, would not also have balked at the task and failed.  But the fact that a playwright could turn Henry Paulson’s career into a classical tragedy, doesn’t change the fact that TARP was a failure.

As Waldman observes, it is important to state clearly that the policy decisions taken in 2008 were a failure, and that they were a failure because they were shaped by people with close ties to the financial industry.  The old saw is still true:  “The first step in recovery is admitting you have a problem.”

Amusing quotes of the day

Quote 1

Because the FDIC does not provide insurance for the liabilities of a non-bank financial company, the super powers contained in the bank insolvency statute are inappropriate when applied to non-bank financial companies, regardless of whether a systemic risk determination has been made.

Timothy Ryan of Sifma argues that creditors to “too big to fail” firms should be granted the protections of the Bankruptcy Act in the law that acknowledges that these creditors will never be subject to the discipline imposed by the Bankruptcy Act.  The basis for this view is apparently that there is no government guarantee for “too big to fail” firms.  Hmm.

Quote 2

part of being a bank is trying to hedge as much of your [credit] risk as possible

Dan Indiviglio is just stating a fundamental principle of 21st century “too big to fail” banking.  For centuries  banks were viewed as playing an important role in the process of credit allocation precisely because the asset side of a bank’s balance sheet was full of loans that only the bank had the information to value correctly — that is, a bank’s job was to evaluate and carry credit risk for the rest of the economy.  So just what is it that modern “too big to fail” banks are supposed to be contributing to the economy nowadays?

On “too big to fail” financial markets

Yves Smith is confused by the fact that the securitization industry wasn’t carefully following legal procedure as it sold mortgages from one bank to another and then into the securitization trust.

But it isn’t surprising that judges are plenty unsympathetic, and in cases, outraged. The law is all about sanctity of process, both the underlying law and court proceedings. Cases typically revolve around disputes of fact or grey areas of the law. This isn’t grey (whether a party has standing to file a suit is fundamental) and the law in this area is well established. Basically, the securitization industry tried creating rules outside any established legal framework and judges are having none of it.

She and anybody else who’s confused about the financial industry’s modus operandi when it comes to the law over the past few decades needs to read Kenneth Kettering’s Securitization and its Discontents.

Kettering makes a simple point:  Whether you’re talking about repos or standby letters of credit or any of a number of financial practices of questionable legality, the financial industry has found that the best way to get the law rewritten in their favor to create a “too big to fail” market in the contract.  Once the market is so big that enforcing the law will create large scale disruption in financial markets, each judge is left with a choice — made explicit in “friend of the court” briefs written by financial players — enforce existing law and risk causing a financial collapse or create some pretext for claiming that what the financial industry says is the law is in fact the law.

According to Kettering the huge securitization industry, built on dubious legal foundations, is just the continuation of a long standing process used by the financial industry to overturn centuries of legal precedents and generate precedents and laws that favor the financial industry.

Why wasn’t a resolution authority an integral part of TARP?

Remember that the TARP proposal was made after the first rescue of AIG.  It was clear at this time that the real problem in the economy was the fact that regulators did not have the authority to manage a controlled resolution of firms like AIG (i.e. of non-bank financial institutions).  I can understand that regulators would need a big line of cash to aid them in resolving the AIGs of this world, but I can’t understand how the cash is useful – even today – without the legal authority to perform the resolution.

Some might say that the reason that a resolution authority wasn’t included in TARP was that nobody thought it would be necessary before AIG and things were simply happening too fast to create a proposal of that magnitude on the fly.  There’s a huge problem with this argument:  Bear Stearns.  After Bear Stearns’ sudden collapse in March, one of the first priorities should have been to draft a resolution authority for taking over a firm in a similar situation.

Thus, the question remains:  Why didn’t Hank Paulson insist that Congress create an authority to resolve insolvent non-bank financial institutions in September 2008?

Also of note Tim Ryan, CEO of SIFMA, in a FT commentary titled “Wall Street is a willing partner in financial reform” carefully omits support for the one tool that would make it possible for the government to get the too big to fail problem under control.  The message the financial industry seems to be broadcasting loud and clear is this:  we’ll submit to more regulation, but we really, really don’t want to ever have to face the consequences of competing in a real free market environment.