Economic Dreams - Economic Nightmares

American Oligarchs and their Minions, take 2

Last Friday, Bill Moyers sat down for an hour with Simon Johnson and James Kwak (authors of The Baseline Scenario and 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.) Watch it in two parts here. The topic of the day was (and will continue to be for the next month or so) financial regulation in the wake of financial meltdown. Among other arguments, Johnson and Kwak make the case for breaking up America's big banks  financial oligarchy. They, with Bill Moyers ever-thoughtful-guidance, help us better understand the the deeds, misdeeds, and too-often blind ideological missteps that brought us to the edge of the abyss, and that keep us in bondage to those who ought have been more concerned with our collective progress than with lining their own pockets with gold.

I continue to be somewhat agnostic on setting up a "size rule" for large financial institutions, but Johnson and Kwak have me leaning in their direction right now.  Here is a snip (from the transcript) arguing for breaking up the big banks:

SIMON JOHNSON: . . . [I say] to all my Republican friends: on Fannie Mae and Freddie Mac, you were right. They became too big to fail. They captured Congress. They were known as some of the most formidable financial lobbyists in the 1990s. They argued for the rights to take on these kinds of risks, okay?

And the Republicans were right. The Republicans called them on this. But now it's the big private banks that have the same incentive structure. That have bulked themselves up so big that you can't let them fail. That's what we saw in September 2008. Hank Paulson looked at his options. And they are all pretty awful. And I'm not a big fan of Hank Paulson, but I think the moment where he looked at it, he was right. That if you let JPMorgan Chase or Goldman Sachs fail, the consequences would have been devastating, because they're so big. It's a Fannie May and Freddie Mac structure come to Wall Street, come to the top guys on Wall Street. And our Republican colleagues and friends should recognize this, they should acknowledge it. And then we can all fix this together.

I also found this commentary on the hedge fund "Magnetar" particularly interesting. It foreshadows what may yet be revealed about many others in the financial industry:

JAMES KWAK: Magnetar is a hedge fund which means that other people gave them money to invest. And their job is to make as much money as possible. And these were the smart guys in the room. They saw that the system was broken. And they found a specific way to exploit it. And they knew that they could go for example, they could go to Wall Street banks and the banks would collaborate in making these extremely toxic securities. Because they knew what the bankers incentives were. They knew that the banker's incentives were to do the deal, to do the transaction, to get the fees up front. And they knew that there was nobody watching out for the investors. There was nobody watching out to make sure that securities they manufactured were actually good securities. But essentially what they were doing is they wanted to short the housing market. And they shorted the market in such a way that they actually made the problem worse, because what they did is they encouraged they tried to create these very toxic securities explicitly so that they could then short those securities. And that's why in a sense, they were they were shorting the American Dream. But what the real story of Magnetar, I think, is that they were exploiting a system that was deeply broken.

So, we like to think that the financial system we have in Wall Street are set up so that as people try to make lots of money they are they are indirectly helping the economy by making sure their capital goes where it's needed most. What the Magnetar story shows us that this is a casino, where you can make money you can make money exploiting the weaknesses in the casino. And it has nothing to do with the American Dream. It has nothing to do with making sure that capital goes to the places where it's needed most.

 Watch the rest of the story. I'll try to update this post as (or if) I see others commenting on on the Moyers, Johnson, Kwak tale.  American Oligarchs and their Minions, "Take One" is here.

Power Corrupts: Goldman Sachs, US Congress

The old saying, "Power tends to corrupt, and absolute power corrupts absolutely," rings true once more as we see ever-more-clearly what Goldman Sachs has been up to recently, whether it be the Greece mess or their center-stage presence in the US financial implosion, with the latest chapter being Friday's SEC charge of fraud. Who among us doubts that Goldman Sachs is too powerful.

But the old saying also rings true as we ponder why it was that the US Congress in the run-up to our current financial mess, with the blessings of the Clinton Administration, allowed firms to bet on impending tragedies of others without adequately weighing the consequences that such behaviors might have on financial markets. Here is what Lynn Stout had to say Friday in the NY Times "Room for Debate Blog" about the the US Congress and their lack of foresight in marking up The Commodities Futures Modernization Act of 2000:

In one dramatic move, [the Commodities Futures Modernization Act] eliminated a longstanding legal rule that deemed derivatives bets made outside regulated exchanges to be legally enforceable only if one of the parties to the bet was hedging against a pre-existing risk.

This traditional derivatives rule against purely speculative derivatives trading has a parallel in insurance law, because insurance, like derivatives trading, is really just a form of betting. A homeowner’s fire insurance policy, for example, is a bet with an insurance company that your house will burn down.

Under the rules of insurance law, you can only buy fire insurance on a house if you actually own the house in question. Similarly, under the traditional legal rules regulating derivatives trading ….

By eliminating this centuries-old rule in the name of “modernization,” Congress created enormous problems of moral hazard in the off-exchange derivatives market. Imagine, for example, if we allow the unscrupulous to buy fire insurance on other people’s houses; the incidence of arson would rise dramatically.

The US Congress may not be too powerful, or maybe it is, but all we have to do is to ponder their approval ratings to wonder whether we Americans are being well-served by our Congress. On the other hand there were very few who were ready to "take to streets" to protest the Commodities Futures Modernization Act when it passed in 2000. Too bad Brooksley Born didn't fare better when she tried to challenge the likes of Alan Greenspan, Larry Summers, and Robert Rubin back in 1998.

Oh well.  At least Born is now a part of the Financial Crisis Inquiry Commission and we all get to watch the ongoing show between now and Memorial Day (end of May) as the US Congress gets down to the business of righting the wrong that it gave us with financial deregulation and the Commodities Futures Modernization Act.

Financial Regulatory Reforms: Neither easy nor politically palatable

Months ago I promised to keep tabs on financial regulatory reform measures. Well, I've tried but it is not easy — and I've been distracted (and generally depressed by American US culture and politics).  Today I begin anew, and renew my promise by referring readers via "snips" to two of my favorite bloggers. Steve Randy Waldman explains why financial reform efforts are not going to be easy, and The Epicurean Dealmaker reiterates and expands his proposal for reform. To Waldman, Capital Can't Be Measured (4/3/2010):

Simon Johnson and James Kwak are absolutely right. Sure, "hard" capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. Large complex financial institutions report leverage ratios and "tier one" capital and all kinds of aromatic stuff. But those numbers are meaningless. For any "large complex financial institution" levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish "well capitalized" from insolvent banks, even in good times, and regardless of their formal statements.

Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% "tier one" capital and very conservative "net leverage". On September 25, 2008, Lehman declared bankruptcy. Despite reported shareholder's equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than "going concern" value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible "franchise" value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from "tier one" capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

So Lehman misreported its net worth, right? Not according to the law. . . .

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even "hard" capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein "Schrodinger's Banks" are simultaneously alive and dead until some politically-shaped "measurement" by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like "confidence intervals surrounding measures of bank capital are greater than 100%, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much "capital" we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely "true" model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional "space" of defensible models by which capital might be computed. When we "measure" capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we'll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank's capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no "one-size-fits-all" model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, "innovative" banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we'll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. "Banks’ internal risk models" or "internal valuations of Level 3 assets" don't cut it. They are gateways to regulatory postmodernism.

Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.

So what is to be done? The Epicurean Dealmaker gives us fleeting hope in Poachers Turned Gamekeepers (3/16/2010), but there may be a political flaw in his reasoning. The problem is that the proposed solution requires very highly paid, highly skilled, 'seasoned' regulators. That may not fly in the US where we expect our "civil servants" to be moderately paid as per the usual GS pay-scale or even the moderately higher Senior Executive Service pay-scale. Still, his ideas of general regulatory rules that allow for regulatory discretion (by competent government regulators) seems much better than overly complex government legislative and/or administrative "rules". I wish that the highly debated healthcare reform could have been effected that way.  To the "dealmaker":

. . . [I]nspired by readings among several of the more rational and composed voices in said bloggy peanut gallery, including David Merkel, Mike Konczal, and Felix Salmon. . . .

Like Felix, I agree with David that "dumb regulation"—or, in less pejorative language, simple and relatively inflexible regulation—is far more likely to do the trick than the kind of complex, encyclopedic, tick-all-the-boxes regulation exemplified by the bloated pig currently wending its way through the legislative python in Congress. But I also agree with Felix (and, so it would seem, with David) that simple regulation will only work if it is overseen, enforced, and modified as necessary by extremely intelligent and motivated regulators.

I have argued in these pages before that delivering regulations which are comprehensive, detailed, and complex only encourages the institutions being regulated to immediately try to engineer their way around them. Simple, broad-brush regulations have a much better chance to operate as a set of principles which are well understood by both regulator and regulatee alike. But having such principles-based regulation is not enough. They must be enforced, as financial collapse in the face of a decidedly principles-based regulatory regime in the United Kingdom amply demonstrated. Not only does this mean, in Felix's example, that regulators must have the authority to make up rules, tests, and procedures on the fly on behalf of preserving systemic stability, they must also have the balls to take that phone call from Dick Fuld. And, moreover, to tell him in no uncertain terms to go fuck himself if he doesn't like it. . . .

[R]egulators [should] get hired from Wall Street banks, big law firms, and elsewhere. An effective wholesale financial regulator ¹ should be comprised of forensic accountants, corporate and securities lawyers, investment bankers, derivative structurers, and the like. They should all be paid market rates for their services, which will make their compensation much, much closer to that of the people they regulate. They should be prohibited from accepting positions in private financial industry—and, most especially, at any individual firm they ever directly or indirectly regulated—or firms working for financial firms (law firms, accountancies, etc.) for a minimum of at least three years after they leave government service. Five would be preferable.

While individually expensive, I don't believe you would need to hire many such people to make this kind of regulatory regime work. Given that you really only need high-powered regulators for the very biggest institutions, I am guessing you could get away with fewer than 100 to start. In fact, it might be less, because you really only need these people to direct and train their junior staff, and to interface directly with senior executives of the regulated entities. Fully loaded, I imagine you could fund a financial regulatory SWAT team like this for less than $150 million per year. That's a drop in the bucket compared to the financial losses these supposedly regulated institutions have already inflicted on the American taxpayer, not to mention in comparison with the normal run rate of your average stodgy, inefficient, and ineffective government bureaucracy.² Even better, you could fund such an agency with a levy indexed to the size of each financial institution under its jurisdiction. The larger and more complex a bank, the more fire-breathing, table-throwing, nail-spitting investment bankers and lawyers you could afford to throw at it. Talk about an incentive to shrink your balance sheet.

* * *No plan is without its drawbacks, however, and I knew I could rely on my intelligent and well-meaning interlocutors on Twitter to supply some. Among the more cogent of these, Graeme Hein noted that "Smart regulators can always make more money in [the] private sector." This has always been true, and always will be so, but my plan could be structured to minimize this defect. For one thing, you do not need "the best" investment bankers, traders, or lawyers—whatever that's supposed to mean—on the regulatory case. All you really need is good ones, and there are plenty of those. A certain doggedness, and a commitment to preserve systemic stability and enforce rules and regulations regardless of the wealth, prestige, or lung power of their charges would be necessary as well. Remember, you are not looking for the best traders, or the best M&A advisors, or the best derivatives structurers out there; you are looking for people who can understand what those people do and who can stand up to their counterparts across the negotiating table.³

For another, while pay should be very attractive, and likely many multiples of current front-line regulators' salaries, it does not need to equal that of industry practitioners. It can be paid 100% in cash, which dramatically shrinks the gap with nominally much bigger pay packets stuffed to the gills with unvested, restricted funny money. It can also be far less volatile than industry pay, since it should not depend on the vagaries of market performance the way real investment bankers do. Add to that the psychic compensation from working at a powerful, elite organization which generates fear and respect among its regulatees, and you will have a potent package. You might just be surprised how many top flight industry professionals apply for the job.

Now some people might object to the prospect of a federal agency staffed with lots of employees pulling down half a million dollars or more a year, as loadeddice observed. But the answer here is simple: for socially critical functions, money has never been an object when it comes to government spending. Just look at the military. By the same token, I would find it very easy to argue that the cost of a several dozen government employees earning more than the President of the United States is a very reasonable price to pay for financial and economic security. Unlike the military, however, you don't need to spend millions or billions on hardware to do the job. Instead, you spend millions on the software walking around in wingtips and Gucci loafers.

The most frequent objection among those who deigned to comment, however, was simply that—regardless of the attractiveness of my proposal—such a radical change "would never happen." Perhaps these naysayers are right. It certainly would ruffle a lot of feathers, both in the finance industry itself and in Washington, D.C. But I tend to think that is a good thing, and a reliable indicator of the value and importance of the plan, rather than a defect.

At the end of the day, I do believe most Americans actually prefer their government bureaucrats to be slow, bumbling, and ineffective. It reassures them they can stay one step ahead of City Hall, which, as we all know, you ordinarily should not try to fight. Smart, aggressive, and committed government employees terrify most people, because they have so many natural advantages without such personal qualities. The only solution to this, of course, is constant oversight, which is a sine qua non of my proposal.

¹ "Wholesale" means big commercial, investment, and universal banks, and any other systemically important financial entity. As opposed to retail oriented firms, which should be regulated by the CFPA or whatever bastardized, emasculated entity the political meat grinder decides to come up with. My focus here is on institutions which can bring the system down, not on the ones trying to screw Grandma out of her last $50,000.
² Even less in comparison to the tens of billions of dollars in compensation the systemically important financial institutions pay their own employees. A pittance, I tell you.
³ Sadly, given the revelations coming out of the Lehman examiner's report and other sources, this may actually be a very low bar. Perhaps we need regulators who are better than the "best" investment bankers.