Monday, March 30, 2009

Samuelson: Assets Just Need Some Love-erage

Count Robert Samuelson among those who insist that "there are no bad assets; only misunderstood assets". Per Samuelson:
"Deleveraging" has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject more leverage into the economy -- not to previous giddy levels but enough to reverse the panic-driven price collapse.
But has the collapse in assets prices been the result of panic or fundamentals? One study has shown that some CDOs are actually worth even less than what many pessimists thought. To counter the notion that the fundamentals justify the current depressed prices, Samuelson cites
one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.
Unfortunately, this description omits two key details: are the borrowers underwater on their mortgages, and do the mortgages reset in the near future? If borrowers owe substantially more than their homes are worth, then they have a powerful incentive to post jingle mail, and walk away from their mortgages, even if they could afford to pay it. And as the real economy continues to deteriorate, with unemployment rising and wages lowering, increasing numbers of underwater borrowers will likely be under greater financial strain; paying off a mortgage that dwarfs the value of one's house will make less and less sense. Likewise, if these are option ARM mortgages, then they will likely reset within the next year. Borrowers who can make their payments today may not be able to make the higher, reset rates. If either of these scenarios is the case, then discounting this particular mortgage bond 40% seems fairly reasonable.

Samuelson does hedge a bit, admitting that these current lows "may be as unrealistic as previous highs." Perhaps he realizes that losses in mortgages, in commercial real estate, and in credit card debt are all real. There is nothing panic-driven about these losses. And unfortunately, the wizards of Wall Street multiplied these losses several times over with synthetic CDOs and CDS bets. No, our major banks are very insolvent. And no amount of financial engineering - no matter how clever - will change that.

AIG Money Laundering Made Banks Profitable in Q1?

AIG is the scandal that never dies. There was the first bailout for $85 billion. The second bailout for $65 billion. The third bailout for $30 billion. The $165 million in bonuses to the employees in the Financial Products division responsible for bankrupting the company. And, of course, the revelation that AIG has been the conduit for a backdoor bailout of its creditors, particularly Goldman Sachs. However, the latest report concerning AIG is even more outrageous. AIG has not been simply paying its creditors back in full - it has essentially overpaid them on purpose. This is looting.

Remember when Citigroup CEO Vikram Pandit proclaimed his bank had been profitable through the first two months of 2009 in an "internal" memo released to the press? Bank of America CEO Ken Lewis and JP Morgan CEO Jamie Dimon followed suit the next day, claiming that they too had been profitable through February. While some dismissed these pronouncements as misleading at best, the beleaguered markets took off, rebounding from twelve year lows at any hint of good news. This rally has continued for nearly three weeks now, despite Jamie Dimon and other bank CEOs admitting that March has been "a little tough" - read: they are losing money hand over fist again.

What changed between February and March? According to an email financial blogger Zero Hedge received from a trader at a major bank, the explanation is that in the first two months of the year, AIG unwound trades on extremely favorable terms for the banks. In other words, AIG deliberately overpaid on what it owed. According to the trader
During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent - these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades - ever"....

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period."
That AIG's counterparties have been made whole at taxpayers' expense was scandalous enough. After all, companies took a risk when they entered into CDS contracts with AIG that AIG would not be able to make good on the payments. Why should taxpayers foot the entire bill for Wall Street's mistakes? (That's a rhetorical question - the obvious answer is that the financial sector controls the levers of power inside the Beltway). But words fail when AIG more or less launders money directly onto bank balance sheets. As Zero Hedge summarizes
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam....

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.
Our democratic system is in jeopardy. Sadly, this is not hyperbole. The pernicious influence of Wall Street - which has spent some $5 billion over the last decade lobbying both parties for increased deregulation - has made the government responsive to the moneyed interests rather than to the people. As MIT professor and former IMF chief economist Simon Johnson argues, we risk turning into Argentina or Russia, in the sense that crony capitalists have captured the government, and are blocking reform after crashing the economy. Demanding transparency in the bailouts, and an honest accounting of where our money is going is the first step towards reclaiming our government. Absent such clarity - and replacing bank CEOs and boards - Congress should not authorize any further bailouts, because, clearly, Wall Streeters paying off their pals with public money cannot be acceptable. Hopefully, President Obama will realize that a little populist rage is warranted, and is actually not such a bad thing. His presidency may depend on it.

Math Can Do Anything?

Can math better predict financial markets? IBM seems to think so. Maybe they've missed this whole global financial meltdown thing. Or haven't had time to read Nassim Taleb's Black Swan. If they had, maybe they would have noticed that an over-reliance on financial models that turned out to have little predictive value played a key role in helping traders justify the insane bets they were making both to themselves and to their shockingly negligent risk managers. Floyd Norris nails it: this commerical makes IBM look really stupid.

Sunday, March 29, 2009

Is There Even Demand For New Debt?

If only we could just get banks lending again, we could go back to those heady pre-Lehman days of credit-fueled consumption growth - that seems to be the rationale animating the Geithner banking plan. If we get these toxic assets - er, I mean "legacy assets" - off of banks' balance sheets, then they'll be sound enough to extend credit again. Economic recovery will follow soon thereafter. But can we return to the status quo ante? Or has the deleveraging process gathered such momentum that even if households could take out new loans, they'd choose not to, as they instead try to pay off their existing onerous debt obligations?

Count James Galbraith among those skeptical that even a successful bank bailout would reverse the economy's death spiral. Rather, restoring household solvency is the key issue. Indeed, in a piece in the Washington Monthly, Galbraith makes the case that until households are made creditworthy again, lending will not resume at anything close to normal levels. Galbraith begins by noting that:
For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years.
Simply put, American households are drowning in debt. As unemployment rises, wages fall, and option ARM mortgage rates reset to higher levels, increasing numbers of households will not be able to service their debts. Furthermore, now that the game of debt musical chairs is over, and many households have by and large lost access to credit, they must save more to pay off their debts. This means less money for consumption. Businesses in turn will face declining profits, necessitating further layoffs and wage cuts. And of course, all of these losses will reverberate on bank balance sheets, since they hold securitized mortgages, credit card debt, auto loans, student loans, etc. And on and on it goes. Throughout this downward spiral, only debt levels do not fall, posing a rising real burden. This is debt deflation - or a "d-process".

Making the banks solvent again is necessary but not sufficient to resume normal credit expansion. If banks remain de facto insolvent, as the credit losses pile up in both the real and financial economies, then the creditworthiness of American households will be irrelevant - there will be no lending. But this is not to say that fixing the financial system will remedy this collapse in credit. If there is a dearth of creditworthy borrowers, or creditworthy borrowers lose their appetite for new debt - either because they want to pay off their old debts or economic uncertainty makes new business investments seem risky - then the soundness of the banks will be irrelevant. In short, credit depends on both lender and borrower. Both must be solvent and willing to extend or accept a loan for normal credit expansion to occur. But this simple point often gets lost in policy discussions about the banking system. Galbraith points out that
In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal....But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank.
The obvious question is whether there is any reason to expect American households to fix their balance sheets in the near future so that they are creditworthy?

Unfortunately, the answer seems to be no. The wealth effect of vanishing stock portfolios and plummeting housing values not only makes households less willing to spend, but it also leaves them with no collateral with which to take out a loan. Indeed, creditworthiness depends on
a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans.
Here, the especially pernicious effect of falling house prices becomes clear. And unhappily, housing prices still have roughly another 20% to fall from their peak just to revert to historic norms, as the following chart shows.

With foreclosures flooding the market, compounding the problem of a housing glut, the chance that housing prices will overshoot on the downside - and possibly stay there for a prolonged period - is very real. Most American households simply will not have the collateral to secure a loan for quite a few years at the least.

There is also the question of "animal spirits" - will creditworthy individuals want to take out loans? Again, the answer seems to be no. The psychology of this crisis has frozen economic activity. As consumer spending has collapsed, there is little incentive to invest in expanding business operations. The future seems so uncertain that people only want to hold cash or liquid assets like Treasuries. Fear rules the scene. A recent New York Times profile of individuals and businesses in Portland, Oregon captures this sentiment well. Writing about the local Portland economy, the New York times reports that
Even banks that are eager to lend find some of their best customers reluctant to extend themselves.

“The problem is trying to get qualified people to borrow,” said Raymond P. Davis, president and chief executive of Umpqua Bank, a regional lender based in Portland....

“The people that want the money don’t deserve it, and the people that deserve it don’t want it,” said John B. Satterberg, president of Community Financial Corporation. “Everybody’s sitting on the fence.”
This is a liquidity trap. The bank-centric economic rescue plans oftentimes lead us to think of a liquidity trap as a supply problem; the banks will not lend because there is no incentive to lend. As Paul Krugman explains
Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.
This could be certainly be true, and perhaps even was true early on in this crisis, but as fear has gripped the real economy, and households scramble to save every penny they can in guaranteed assets - i.e., cash and Treasuries - it seems clear that there is no longer any demand for debt. This situation will likely continue until insolvent households fix their balance sheets, at which point they will be creditworthy again, and already solvent households will stop putting off taking out new loans, as the fear strangling the economy subsides.

What is to be done to hasten recovery? Absent government intervention, the economy will eventually recover, to be sure. As households cut back, saving to pay down their debts, pent up demand builds throughout the economy. Once households reestablish their financial footing, this pent up demand will cause a new credit expansion and virtuous circle of economic growth. As Paul Krugman explains, this is how nineteenth century panics resolved themselves. The problem is that this can take years - or longer. Economic growth can stagnate for decades, as it did between 1873 and 1897, when the economy was in recession more often than not. An economy depressed over the mid-to-long term means lower tax revenues, and consequently likely increased deficits (absent large spending cuts, which would only exacerbate the downturn). Given that deficits will increase even without aggressive action, the case for proactive deficit spending to get us out of this economic slump becomes strong. But what should our priorities be?

Fixing balance sheets. That is the short answer. Banks and households. Doing one without the other is pointless. Regarding the banks, Nouriel Roubini has made a convincing argument that the Geithner plan is appropriate for solvent but illiquid banks, but not for outright insolvent ones. Of course, distinguishing between illiquid and insolvent banks can be quite difficult. But paying insolvent banks for toxic assets will be like AIG bailout fiasco on a grand scale: black holes sucking in taxpayer money across the economy. For truly hopeless banks, FDIC-style receivership and restructuring is the best answer. This means bondholders, who have heretofore not taken any losses, will not be made whole. Taxpayers will still be on the hook for enormous losses, but they will get all of the upside from selling these institutions back to private investors, and the total bill will be less, since bondholders will chip in. This is not, however, a free lunch. It is fraught with risk. Bondholders could panic, and pull their money out of banks. But it is the least bad option at this point. Just like banks, households need financial restructuring as well. This means writing down debts, particularly the principals on underwater mortgages. Roubini has proposed reviving the Depression-era HOLC, with the government buying up mortgages, and then renegotiating the principal owed, not just the interest payments as the Obama Administration has already done.

Aside from restructuring bank and household balance sheets, we must increase the buying power of the middle class to boost aggregate demand. This means creating jobs and strengthening social safety nets. The stimulus bill is a good first step towards putting the unemployed back to work, but the talk of cutting Social Security or Medicare benefits out of a sense of "fiscal discipline" seems dangerously wrongheaded. Again, from Galbraith
The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
We must not confuse reforming the health care system - expanding coverage and lowering costs - with reducing benefits. Stronger safety nets ensure everyone a minimum living standard, and act as automatic stablizers in a downturn. The challenge Obama faces is incorporating the best aspects of the welfare state, without importing the rigidity in the labor markets that European countries face. This is a fundamental pivot away from the deregulatory, private-sector mania of the last thirty years, and instead imagining a system where not just the rich and connected win, but all share in the benefits; where the government does more to reduce economic uncertainty without choking off economic opportunity. It means creating an economy that grows from the bottom up, rather than the top down. Let us hope Obama is sufficiently bold to meet these opportunities.

Hey Paul Krugman

It's a good question: why aren't people who saw the housing bubble and the financial crisis developing - Krugman, Roubini, Shiller, Stiglitz - in the Obama Administration? And what does it say that someone on Youtube has to point this out, rather than the media?

Kristof Calls for Expert Accountability

A few weeks ago I lamented the disturbing lack of accountability among our political and media elites. For the supposed experts who hyped WMDs in Iraq and the bubble economy of the last decade, there have been precious little consequences. They are mostly still treated as serious commentators - at least by their fellow elites - and seem to feel no sense of chagrin over their manifest errors. Bill Kristol is the poster child for this phenomenon.

Nicholas Kristof at least deserves credit for bringing this issue to the forefront. From the New York Times:
The marketplace of ideas for now doesn’t clear out bad pundits and bad ideas partly because there’s no accountability. We trumpet our successes and ignore failures — or else attempt to explain that the failure doesn’t count because the situation changed or that we were basically right but the timing was off.

For example, I boast about having warned in 2002 and 2003 that Iraq would be a violent mess after we invaded. But I tend to make excuses for my own incorrect forecast in early 2007 that the troop “surge” would fail.
This is obviously but a single column, but raising this issue of the unaccountability of our often wrong experts is a good first step. Of course, this is not to say that if someone makes a bad prediction they should be barred from offering their opinions. Rather, that chronically bad prognosticators - some might say propagandists - should be discredited, and not continued to be treated as Serious People due to the clubby nature of elite media.

Friday, March 27, 2009

AIG Bonus Outrage=Fascism?

We have a winner for most hyperbolic defense of AIG: Holman Jenkins of the Wall Street Journal. While many Very Serious People in the establishment media have taken to print and the airwaves to lecture the public on how pointless, unproductive, and even counterproductive rage over the retention bonuses paid to AIG's Financial Products employees (some of whom no longer even work at AIG), Holman Jenkins is the first to nearly break Godwin's Law. At the conclusion of his jeremiad chronicling the veritable slings and arrows of outrageous fortune befalling AIGFP's employees, Jenkins informs us that Andrew Cuomo's investigation into AIG reminds us that "It can happen here." This is a reference to Sinclair Lewis' 1935 work It Can't Happen Here, imagining a fascist takover of the United States at the hands of a charismatic Huey Long-style pol. So anger over the employees of a bankrupt company on government life support receiving millions of dollars of bonuses in taxpayer money is the first step on the road to serfdom? Will Andrew Cuomo ask President Obama to set up FEMA concentration camps in the AIG building? And could the right wing be any more detached from reality?

Kinsley: Obfuscation is the Point of the Geithner Plan

Finally, someone from the establishment media (aside from Paul Krugman) speaks the obvious truth about the Geithner giveaway-to-banks-and-hedge-funds-and-private-equity-at-taxpayers'-expense-orgy: it is deliberately opaque, so as to mask how large a subsidy it is to the financial sector. Just as our erstwhile wizards on Wall Street seem to create intentionally abstruse financial instruments in order to keep the masses from questioning their financial hanky panky, Kinsely argues that the difficulty in deciphering the exact workings of the Geithner public-private plan seems similary motivated: to keep the public out. Indeed, Geithner has merely recycled Paulson's TARP idea of buying up toxic assets, which was rejected for being too transparent a giveaway to bankers, and added an extra step - launder the money through hedge funds and private equity firms. Perhaps the success of keeping the identity of AIG's counterparties secret for six months inspired this new scheme. Geithner has explained that partnering with these financiers will tap into the "expertise of the market" in pricing these so-called toxic assets, when in fact, this amounts to passing out lottery tickets to hedge funds and private equity firms, as they siphon off a percentage of any potential gains from the bailout. And, of course, public money will continue to flow into the banks, except this time via hedge funds and private equity firms instead of through AIG. This is the coup de grace of our kleptocratic system: everyone on Wall Street wins, and everyone on Main Street loses.

Of course, once it becomes clear that already rich financiers are becoming even richer thanks to the largesse of the Treasury, there will be public outrage that could potentially dwarf the AIG bonus flap. Maybe then our political class will pay more than lip service to the righteous anger spewing over the transfer of wealth from the masses to the politically connected who have brought the system down.

Wednesday, March 18, 2009

Fair and Mentally Unbalanced

These reports that Glenn Beck is a neo-Nazi vampire-zombie who feasts on the blood of illegal immigrants - I'm tired of hearing about them. I wanted to debunk them. Well, I've now for several days done research on them. I can't debunk them.

See how difficult it is to prove a negative? It's impossible, really. Maybe that's why Glenn Beck is having such a hard time debunking the absurd talk of FEMA camps around the country (or maybe it's because Glenn Beck is an idiot playing to the tinfoil hat crowd). For those of you not keeping up with your right-wing conspiracies, Beck is referring to the rumor that Obama is using FEMA to set up concentration camps across the country where political dissidents will be sent. Sane conservatives like David Frum are reduced to saying WTF?

With the nation facing the economic equivalent of war, the Republicans - who still have enough votes to block major initiatives/bailouts due to the unreliability of Evan Bayh's Blue Dogs - are going off the deep end. Of course, Glenn Beck is just an entertainer - but he's the highest rated talking head on the Republican channel. And as we've seen with Rush Limbaugh, the Republican leadership is unwilling to stand up to the crazy folks in their base. So if Glenn Beck tells his viewers to call their representatives and tell them to boycott any Obama economic agenda, because it's the first step on the road to serfdom...well, you can guess what John Boehner, Eric Cantor and the rest of the A-Team will do. Now they'd almost certainly obstruct Obama's agenda regardless, but having a minority party that has clearly lost its mind that can still block legislation is a tremendous obstacle to getting the right policies in place. At a time of national peril, the Republicans are arguing about realities that only exist within their heads. Bush would be proud.

Clawbacks, Taxes and Prosecution: Oh My!

Angry Bear captures the zeitgeist of the moment: we need prosecutions of Wall Streeters. Put insolvent firms into pre-packaged bankruptcy, and go after past bonuses as fraudulent conveyance. Or pass punitive, retroactive taxes on all firms that received TARP funds. It could just be the fixed income idiots who spawned this crisis (they accounted for nearly half of Wall Street profits at the peak of the bubble). Or, if Andrew Cuomo is really ambitious, start going after these firms with RICO cases. Get creative. Make arrests. Put the worst of them in jail, where they belong. Show them they are not above the law.

A Modest Proposal: Jim Baker to Treasury

If Paul Volcker can serve as an economic advisor at the ripe old age of 81, then Jim Baker should be more than spry enough to reprise his role as Treasury Secretary for a year. At this point, it only seems like a matter of time before Tim Geithner gets canned/decides to spend more time with his family. Geithner's stunning inability or unwillingness to use the government's leverage over AIG to prevent them from paying out absurd bonuses is the final straw. The larger issue is his failure to come up with a bank rescue plan that doesn't amount to a giveaway to the bankers. Apparently, nationalization is too unthinkable or scary (picking on Geithner is like hitting a ball off a tee, but Harold Meyerson hits one out of the park with his latest column).

To his credit, Baker recognizes that we face a crisis of solvency, not of liquidity. He has called for FDIC-style receivership of insolvent banks, so that they can be closed and sold back to private investors. This would admitedly be a difficult process, fraught with risk, but it is much, much better than the alternative of creating zombie banks. If anyone can pull this off well, it is Baker; throughout his career he has demonstrated a knack for simply getting things done. He is a doer. Most appealingly, he is a Republican - and one with close ties to Reagan to boot. If he were to be in charge of temporarily nationalizing the banks, it would insulate Obama from any political heat Republicans might gin up about him being a "socialist" for taking over the banks. This would be a political and policy coup. What are the odds of it actually happening?

Tuesday, March 17, 2009

AIG: All Your Billions Are Belong To Us (And Our Counterparties)

This is the definition of looting. It would be one thing if employees who had good years despite AIG's implosion were receiving bonuses. Even that is hard case though. After all, taxpayers don't want their money going to pay for bankers/insurers' bonuses; the point of the bailouts was to stabilize the financial system, not bankers' lifestyles. But AIG is an entirely different story. They're giving $150 million to the wizards at Financial Products responsible for burning down the house (or, at the very least, pouring gasoline onto the burning house) - and by house, I mean the global financial system.

AIG has, of course, offered up all sorts of specious arguments about why they need to dole out these "retention" bonuses. The oldie-but-goodie is that the world will end if we don't give them every cent they demand. This is simply extortion. It is sociopathic behavior. The other spurious defenses of these payments - which Aaron Ross Sorkin the New York Times bought hook, line, and sinker in his column yesterday - are that if the government begins abrogating contracts, our entire system of rule of law will crumble, bringing - once again - the world to an end; as well as the claim that AIG needs to keep its supposedly in-demand employees in house to unwind their CDS positions. Here's Sorkin on Hardball reiterating his position.

However, as John Carney notes, there are holes in these arguments large enough for any half-clever lawyer to push Rush Limbaugh through. AIG would not exist today were it not for its taxpayer-financed bailout, and if AIG had been allowed to go into bankruptcy, its employees, as unsecured creditors, certainly would not be receiving any bonuses. Renegotiating the bonus contracts in this case would not be an abrogation of contracts, but merely reflect the changed status of AIG as a ward of the state. As to the assertion that AIG needs to pay out these bonuses to retain its "top talent" - well, as Andrew Cuomo points out, paying "retention" bonuses to people who no longer work at AIG makes a mockery of that claim.

While the public has attached onto the bonus issue, the real outrage, of course, has been the billions funneled into AIG through the frontdoor going out the backdoor to Goldman Sachs and the rest. Eliot Spitzer nails it: why are taxpayers on the hook to make counterparties whole - especially at a time when people on Main Street are all taking a little bit less so that everyone can get by? That Goldman CEO Lloyd Blankfein was the only bank executive in the room when Paulson and Geithner decided to bail out AIG always reeked of pure cronyism, but amidst the warpspeed nature of the crisis in September, it did not receive the scrutiny it deserved. But in an environment where a senator suggests AIG executives should commit seppuku, perhaps we'll finally begin to demand the type of transparency we should have had from the beginning. We can only hope.

Saturday, March 14, 2009

Is Harvard A Hedge Fund?

Harvard has problems. Billion dollar problems. Exactly how many billions of dollars remains in dispute. What is beyond dispute, however, is that Harvard has lost around a quarter of its endowment in the last nine months, and a large part of the remaining funds are tied up in illiquid investments. This is quite a reversal. Indeed, only a year ago endowments at Harvard and other elite schools had swollen to such gargantuan sums that they were busy devising ways to spend enough to maintain their tax-exempt statuses. There was even talk of using the endowment to make Harvard free for all students. Ah, those heady pre-Lehman days. Of course, it is hardly surprising that Harvard's endowment has not been immune to the global financial turmoil. Markets everywhere have cratered. But the nature of Harvard's losses illustrates the extent to which the university has aggressively moved into nontraditional investments - "real" assets like forests and oil, as well as stakes in private equity. Harvard has become a hedge fund. But why did Harvard transform itself, as Jim Manzi wryly opined, into a "tax-free hedge fund with a very large marketing and PR arm called Harvard University"? And what does this tell us about how the bubble economy skewed our perspectives, and created perverse incentives to join the speculative crowd?

Because it was lucrative. Very lucrative. This is the short answer to why Harvard began managing its endowment like an amped up Wall Streeter trying to max out just before bonus season. This is not hyperbole. Ex-Wall Street alums ran the endowment, and were compensated along the same bonus system (although the Harvard Management Corporation did wisely include clawback provisions). As Edward Jay Epstein notes, they moved out of the types of assets endowments had traditionally held, such as Treasuries and other bonds, and into a broad range of often obscure, illiquid investments. After all, there were oversized fortunes to be made in these exotic bets. And Harvard made them. Under Jack Meyer's stewardship, Harvard's endowment ballooned from $4.7 billion in 1990 to $22.6 billion in 2005. Aggressive management accounted for at least $12 billion of this growth; 15% annual returns will do that.
Of course, it was not simply a Scrooge McDuck hoarding instinct that motivated this shift in investment strategy. The scorched earth competition that is elite higher education demanded it. As colleges entered an arms race in the last fifteen years to attract the best faculty and students, costs skyrocketed. There was an education bubble. And even a school with as strong a brand as Harvard could not afford to let its near peer institutions outspend it on research facilities, dorms, and professors. As former Citigroup CEO Chuck Prince remarked nearly two years ago about the credit boom (in a statement that retrospectively highlights the collective cluelessness of our erstwhile financial titans), "as long as the music is playing, you've got to get up and dance." So Harvard danced.

Harvard needed little cajoling to get up on the metaphorical dance floor. This unreserved jump into heretofore abstruse markets hints at the final dimension of the Harvard endowment's metamorphosis into a speculative enterprise: the school's changing culture. Beginning in the 1980s, increasing number of Harvard graduates flocked to Wall Street to get rich. According to Harvard economists Claudia Goldin and Lawrence Katz, the number of graduates going into finance grew from 5% in 1970 to 15% in 1990. A survey of the class of 2007 revealed that 20% of the men were headed for Wall Street. And who could blame all these wannabe Masters of the Universe - alumni in finance earned on average three times more than their former classmates in other fields. What explained this explosion in financial sector salaries? No one is quite sure. If anyone could explain, it would almost certainly be business journalist Michael Lewis, who had a firsthand view of the genesis of this brave new financial world while at Salomon Brothers. However, even he is slightly flummoxed. As Lewis explains in Liar's Poker, the money was just there. In terms of supply and demand it made little intuitive sense. Some confluence of new freedom from regulatory strictures and a generational forgetting of the toxicity of excess debt created a frenzied era of seemingly exponential growth for Wall Street. It certainly seems that by the early 1990s, recent alums and current students had so bought into the Wall Street way that maximizing the endowment's returns seemed obvious; following a conservative strategy would be an inefficient use of capital, after all. Now it is certainly possible that the changing career choices of Harvard alums had little or no impact on the investment strategy of the HMC. The fact that hosts of grads descended on the investment houses and the endowment reoriented towards higher-yielding (read: riskier) assets could both merely have reflected the immense profitability of the Great Bull Market.

Without large parts of the Harvard community internalizing the Wall Street ethos, it seems unlikely that the HMC would have been able to justify its shift in investment philosophy. Indeed, even this was not enough once HMC remuneration peaked in 2004. To some alumni who came of age before the go-go 1980s, the outsized paychecks HMC handed out to the endowment's managers were disquieting. Several members of the class of 1969 began a letter-writing campaign, and ultimately succeeded in pressuring the administration to establish pay caps. The student newspaper the Harvard Crimson, however, was not impressed. They told alumni to "stop calling for salary cuts" and end the "excessive scrutiny" of HMC - otherwise the university would be unable to retain its top financial talent. Besides, HMC did not pay its employees nearly as much as a hedge fund with identical returns would receive. Don't kill the goose that laid the golden nest egg.

They had a point. While paying a combined $70 million to two bond traders in 2004 stoked outrage, this was a pittance compared to what Harvard would have had to pay to an outside firm for the same results. However, arguing that capping pay was short-sighted presupposed a key issue: that Harvard was a hedge fund. During the boom years, this might have seemed a pedantic point, but the current downturn has demonstrated the downside of running an endowment like George Soros runs his hedge fund. Like colleges everywhere, Harvard has instituted a hiring freeze, halted construction on new projects, and fired staff to cut costs in response to the global financial crisis. These austere measures have prompted a torrent of criticism. Despite its losses, Harvard's endowment still dwarfs those of other schools; indeed, Harvard has lost more than most ever had. Given the university's relative wealth, shouldn't they use the endowment to maintain services? Some contended the university was acting as if capital preservation mattered more than the students. Such are the dangers of turning a university into an investment vehicle.

Harvard is hardly alone in transforming itself into a hedge fund. The trend began with Wall Street itself in the 1980s. It is easy to forget now, but investment banks did not always trade on their own books. They advised companies on mergers and acquisitions; they underwrote securities; they executed trades for clients. But as Michael Lewis chronicles in Liar's Poker, the trading culture quickly spread from Salomon Brothers throughout Wall Street once it became clear what kinds of fortunes stood to be made. Institutional investors - university endowments, pension funds, and insurance companies - followed suit. Big ticket manufacturers - GE and GM - got in on the act as well, turning their financing arms into cogs in the larger banking system. At the bubble's peak, entire countries - yes, that means you Iceland - effectively leveraged themselves up and became de facto private equity firms and hedge funds. Why did everyone and their aunt borrow to speculate in the markets? Because they were afraid of being left out. They saw their relatives and neighbors and rivals making a quick buck, and they didn't want to be the sucker who didn't get rich. They let social pressure cloud their judgment. Their early "successes" in the markets only reinforced these pressures, and warped their values, sending them into self-congratulatory fits about how brilliant they were for doing so well.

But now that the age of leverage is over, never to return in our lifetimes, we must all go back to doing what it is that we did before the markets made us crazy. Iceland needs to go back to fishing; GE and GM need to go back to building wind turbines and cars; pension funds and insurance companies need to invest in safe, boring assets; and Harvard has to go back to just educating its students. A new age of responsibility is most certainly upon us.

Friday, March 13, 2009

Welch: Ignore Everything I've Ever Said (Except For This)

Remember maximizing shareholder value? Remember beating quarterly earnings expectations being the be-all-and-end-all of a CEO's job? Well forget it - at least according to Jack Welch, the deified former GE CEO credited with ushering in the shareholder value gospel. From the FT:
Jack Welch, who is regarded as father of the "shareholder value" movement, has said the obsession with short-term profits and share price gains that has dominated the corporate world for over 20 years was "a dumb idea"....

"On the face of it, shareholder value is the dumbest idea in the world," he said. "Shareholder value is a result, not a strategy...your main constituencies are your employees, your customers and your products."
Now he tells us. No doubt Welch feels chagrined about the sorry state in which he left GE. While Welch managed to leave near the top, the accounting gimmicks he regularly employed to beat quarterly earnings expectations - particularly with the opaque GE Capital - have shredded investor confidence in GE's financial statements today. Oops.

It's worth noting that not everyone has bought into the shareholder value gospel. In the Washington Post, Harold Meyerson calls attention to the stakeholder model in Germany, where workers have meaningful representation on company boards, and long-term goals are prioritized over short-term ones, since German companies rely on retained earnings and banks rather than the markets for funding. It might be a model worth copying.

Down Goes Cramer! Down Goes Cramer!

Here's the video of Jon Stewart completely eviscerating Jim Cramer last night. Cramer truly got crossfired. Hopefully reporters around the country took notes on what real journalism looks like. Glenn Greenwald hits all the right notes about the financial media's complicity in hyping the bubble mirroring the national media's obsequious "reporting" in the run-up to the Iraq War. Sadly, the proliferation of media has reduced the quality of journalism. Reporters worry so much about losing access to their sources that they never ask the tough questions. Landing the big interview, rather than breaking the big story, has become the measure of a journalist. And sadder still, a comedian has to show them how it should be done.

Thursday, March 12, 2009

Markets Forcing Nationalization?

Will the bond markets force the administration's hand when it comes to nationalizing banks? Bloomberg reports that:
Citigroup Inc. and Bank of America Corp.’s bond prices are sliding on concern that owners of debt issued by U.S. financial firms will be forced to swallow losses if the industry needs another bailout.
While there has been speculation for some time now that unsecured bondholders might take a loss in any future bailout, analysts are now openly questioning just how safe supposedly ultrasafe senior debt is as well. Again from Bloomberg:
“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” Mehernosh Engineer, a London-based strategist at BNP Paribas SA, said this week. “There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”
James Kwak over at Baseline Scenario observes that
this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.
There is the potential for this fear to become self-justifying. Since Citi and BoA are more or less insolvent, loans to them are only worth as much as investors think the government will guarantee. If investors become convinced that some sort of government receivership is inevitable, despite the government's protestations to the contrary, then not only will bank bonds trade at distressed levels, but the banks themselves will have a harder time raising private capital than they already do. Cut off from private capital, the government will then be forced to nationalize the banks.

The risk, of course, is that a panic develops beyond merely Citi and BoA, and that solvent banks find themselves unable to finance themselves, as investors flee from all bank debt. To avoid this, the government must decide who needs to be nationalized rather than the markets. To this point the Treasury has tried to encourage private capital to flow back into the banks to no avail. It has not worked. The markets are not buying it. Treasury needs to finish its stress tests, determine which banks cannot be saved, and then nationalize them all at once. It will be messy and enormously challenging. But it's better to proactively address the problem, rather than have policy reacting to panic.

They Say It Like It's a Bad Thing

According to the Wall Street Journal, "the exodus" out of finance is in full force. As politicians have tried to attach more strings to bailout packages to appease angry voters, and anemic (if that) earnings have drastically cut into Wall Street bonuses, more and more bankers are leaving the business. What a shock - investment bankers were only it for the money. But the Wall Street Journal says this as if it were bad. It is not. Just as there was massive misallocation of capital into bubbles over the last decade and a half, there has been massive misallocation of human capital into banking. If our best and brightest physicists and MBAs turn their attention to solving real problems rather than inventing new ways to pile leverage on top of itself, I think our society will manage to keep going. We might even prosper again, as opposed to merely creating an illusion of wealth. Indeed, the sooner we can turn our top minds towards developing green tech or making healthcare more efficient, and away from mastering market manipulation, as Jim Cramer explains below, the better we will be.

Wednesday, March 11, 2009


What happened to accountability? There's a disturbing lack of it among our elites today. If you're a politician or pundit who told the public we'd be "greeted as liberators" or needed to go to war in Iraq so that Arabs would learn to "suck on this," then you are still considered a credible commentator - by other elites - on what we should do in Iraq today. If you're a bank executive and you've mismanaged things so badly that your bank needs a bailout to avoid bankruptcy, then you are just the person to navigate your firm back to health (while still shelling out million dollar bonuses to yourself and employees, of course). If you're a financial news channel that constantly hyped up the bubble and had its anchors simply repeat whatever CEOs told them, then you are still considered the first stop for financial analysis.

And if you're a conservative think tank that touted countries that embraced the type of laissez-faire reforms you champion, only to watch those countries self-immolate two years later...then you are still the go-to source on economic policy for Republicans. From Krugman:
And wide-open, loosely regulated financial systems characterized many of the other recipients of large capital inflows. This may explain the almost eerie correlation between conservative praise two or three years ago and economic disaster today. “Reforms have made Iceland a Nordic tiger,” declared a paper from the Cato Institute. “How Ireland Became the Celtic Tiger” was the title of one Heritage Foundation article; “The Estonian Economic Miracle” was the title of another. All three nations are in deep crisis now.
If you thought Iceland, Ireland, and Estonia were model economies, why should anyone take your economic advice seriously? It would be as if liberals hyped the success of central planning in communist 1988.

Greenspan: Don't Blame Me; Blame China

Alan Greenspan takes to the pages of the Wall Street Journal today to defend whatever is left of his tarnished legacy. His message: the housing bubble wasn't my fault; it was China's. Of course, there is a savings glut, and it certainly contributed to the credit and asset bubbles in large part. But doesn't this miss the point? Greenspan could have raised short-term interest rates to higher levels; if the 2004 hikes did not bring down long-term mortgage rates, Greenspan should have continued to raise rates (if he was truly worried about the housing bubble). It strains credulity that there was nothing the Fed could have done to pop the bubble. Doing so obviously would have meant sending a weak economy into recession - likely even a fairly nasty one - but in retrospect, it would have been better. It's easy to fall into hindsight bias, but Greenspan's own understanding of the role of the Fed as designated driver surely prevented him from taking action that at the time seemed reasonable.

Dean Baker does a good job laying out the case for the Fed targeting asset price stability in addition to its historically understood role of managing inflation. Alan Greenspan, are you listening?

Friedman: Toxic Assets Just Need Some Love

Another day, another gem from Thomas Friedman. While Friedman correctly identifies fixing the banking crisis as fundamental to turning the economy around, he seems to have embraced the "toxic assets are not bad; they are simply misunderstood" fallacy. From the New York Times:
we need to get a market going that would bring fair value and clarity to the "toxic assets" crippling the balance sheets of our major banks. This will likely require some degree of government subsidy to private equity groups and hedge funds to get them to make the first bids for these toxic assets by guaranteeing they will not lose.
Who told Friedman this was a good plan? Could it have been...private equity guys and hedge fund managers? And what is "fair value" for the so-called toxic assets? Is it the price at which selling them will make banks solvent? Friedman has adopted the transparently untrue belief that toxic assets still have some fundamental value, but are being artificially depressed because of panic. Unfortunately, our Treasury Secretary seems to believe this as well. But facts are stubborn things. And the facts indicate that toxic assets are worth even less than what pessimists have projected. This is a solvency crisis. Insolvent, too-big-to-fail institutions need to be put into receivership, broken up into smaller pieces, and sold back to private investors. This will pose numerous technical challenges. It is not a free lunch. But it's the most cost effective way to create public trust that the financial system is healthy.

Tuesday, March 10, 2009

Black Swan Bait

This piece in the New York Times on the rise of quants on Wall Street seems a bit too kind. Of course, it contains the now obligatory Nassim Taleb quote - he never misses an opportunity to herald the dangers of financial models - but this sentence misses the point:
Another consequence is that when you need financial models the most - on days like Black Monday in 1987 when the Dow dropped 20 percent - they might break down.
No - they will break down. This is Taleb's point. Models only work when you don't need them. And, as we have seen, in the hands of unsophisticated traders, these models become the intellectual justification for taking on unknown risks. So to recap: financial models do not help traders anticipate future shocks, but they do give traders a false sense of confidence. Why exactly is Wall Street in a rush to hire ever more quants now?

Repeat After Me: It's A Solvency, Not A Liquidity, Crisis

Give Russell Roberts and Arnold Kling credit for at least being able to identity the current crisis as one of solvency rather than one of liquidity.

A liquidity crisis means assets lose value because of panic and distressed selling. The assets themselves are still inherently valuable, and given enough capital to tide the banks over, they should be able to survive and sell off the assets at something close to full value once the "market dislocation" ends. A solvency crisis means assets are actually worthless, or close to it. Insolvent banks become black holes (see Citi and AIG, which is a quasi-bank), as they pour capital into the gaping holes in their balance sheets. FDIC receivership is the best option for insolvent banks.

This is a distinction our government officials have apparently been unable to make. Bernanke and Geithner have both publicly stated that our financial system is suffering from a lack of liquidity. If this were true, the unprecedented liquidity the Fed and Treasury have injected into the system over the last six months would have ended the crisis.

I see three possible explanations for Bernanke and Geithner's apparent disconnect from other informed observers when it comes to assessing the banks: 1) they have honestly misdiagnosed this as a liquidity crisis, 2) they are afraid of the politics of nationalization, or 3) they wish to extinguish all alternatives before turning to nationalization because of the technical challeneges it poses. If the first explanation is true, they should both be replaced. If the second is the case, then David Axelrod should explain that given that conservatives from Alan Greenspan to Lindsey Graham have endorsed some form of temporary nationalization, there is more than enough political cover. And if the third is true, then I have two questions: why will the TALF work better than the TARP, and how much more expensive will nationalization be in six months time than it is now?

Shanty Towns

As foreclosures continue to devastate communities, and unemployment mounts, it seems like more stories like this one from the Today show about the rise of shanty towns - or Bushvilles - in Sacramento, Seattle, Reno, and Nashville will become more commonplace.

Any governor who has threatened to reject any stimulus money, particularly extended unemployment benefits, should be forced to go visit these encampments.

Now what can we do to prevent these settlements from exploding in size? Creating jobs is the obvious first step. Hopefully, the stimulus and the benefits aimed at the most at risk within society will help. But we also need debt reduction for insolvent households, primarily by writing down the face value of mortgages to reflect current prices. With so many borrowers underwater on their mortgage - and many more likely to find themselves there over the next few years, as housing prices most likely still have 20-30% to fall - there will be a terrible incentive to do jingle mail, and simply walk away. This will cause housing prices to overshoot on the downside. Reducing mortgage debt will not only mitigate foreclosures, but boost aggregate demand. Nouriel Roubini has long called for a reincarnation of the HOLC of the Great Depression to buy up mortgages, in order to refinance/renegotiate the terms. Roubini elaborated on this point on CNBC yesterday.

Why can't we find a job in the Treasury department for Roubini? And Krugman, Stiglitz, Shiller, and Simon Johnson as well, for that matter?

Monday, March 9, 2009

Can the Government Stimulate the Economy?

If two conservative economists discussed whether fiscal stimulus can ever work, and one exposed the debate as irrelevant to our current crisis, would the other even notice?

The answer seems to be no. Russell Roberts gives what he apparently believes is a deep and philosophical critique of Keynsian spending, arguing that government spending (G) effects consumption (C) and investment (I), such that an increase in G will lead to a decrease in C and I; they are more or less zero sum. Robert's argument rests on the assumption that an increase in G necessitates higher taxes, which individuals and businesses will factor into their spending and investment decisions, offsetting the effect of any higher government spending. This is recycled Treasury view masquerading as insight.

But then Arnold Kling exposes one of the fundamental flaws of the Treasury view: it assumes something close to full employment. When the economy is near full capacity, government deficits more or less would crowd out private investment. But when resources are being unemployed, this does not apply. And today we certainly have idles resources, between private capital sitting on the sidelines, pouring into short-term Treasuries, and unemployment itself rising above the equilibrium level.

Roberts seems oblivious to the implications of Kling's argument. The Dark Ages are quite dark, indeed.

Buffet Channels Taleb

In another segment of his never-ending interview on CNBC, Warren Buffet gave advice Nassim Taleb would be proud of: don't stress about the day-to-day changes in the markets.

Who would have guessed - the key to investing for the long term is identifying well-performing businesses. Forget the quotes; look at the business. Or, in other words, look at companies that create real wealth, not those that merely seem like good speculative bets. Or, to rephrase once again, invest in companies Paul Graham of Y Combinator would endorse - companies that make something people want.

The Banking Lobby

The banking lobby is digging in to make sure that we learn nothing from this crisis, so they can keep playing their heads-we-win-tails-you-lose game. From Bloomberg:
Alan “Ace” Greenberg, the former Bear Stearns Cos. chief executive officer, said he sees a “very small” chance the Great Depression-era Glass-Steagall Act that separated banking and investment banking could be reinstated.

“Practically you can forget about it, it’s not going to happen,” Greenberg, 81, said today in an interview on Bloomberg Television. “The people who lobbied so extensively for the extinction of Glass-Steagall are still around.”
This is why Simon Johnson talks about the only obstacle to effectively fixing our financial system, since most economists agree temporary nationalization is the best option, is the power of the banking lobby. They really do control the levers of government. If the seemingly endless stream of cash Wall Street has siphoned off from the taxpayers isn't going to be a total waste, we need to put preventive measures in place to guarantee this type of crisis never happens again (at least in our lifetimes, until our children and grandchildren forget our lessons, as we did with the lessons of the Greatest Generation).

Buffet Hints at Geithner's Plan

During a marathon interview on CNBC this morning, Warren Buffet had a surprisingly upbeat take on the banks.

Buffet claimed that banking has never been more lucrative than it is now do to historically low interest rates and wide bond spreads. While he admitted some of the worst capitalized banks will likely not make it through this crisis, Buffet did say he expected most banks to earn their way out of the holes they are in.

And this is essentially the Geithner plan: give banks enough capital to keep them alive, and hope that they can earn their way back to health. Of course as a major shareholder in Wells Fargo, Buffet favors letting the, according to its own fair-value accounting, insolvent bank try to rebound. But why is Geithner apparently so willing to just cross his fingers and hope for the best? The politics would certainly be easier if the banks did not require massive injections of capital, but instead just needed enough to tide them over till they returned to profitability. But what about banks' increasingly toxic balance sheets makes this likely? Even if banks return to robust earnings, a whole host of mortgages, commercial real estate loans, auto loans, student loans, and credit card loans made at the peak of the bubble that have yet to go bust threaten to overwhelm any new revenue streams, and send banks further into insolvency. This seems like a repeat of Japan.

Alan Blinder: Clueless or a Liar

Yves at Naked Capitalism says most of what needs to be said about this Alan Blinder op-ed in the New York Times. But it's worth reiterating just how much Blinder misrepresents the terms of the debate. The most glaring example is when Blinder writes that:
Another argument is that banks’ dodgy assets are hard to value, making it impossible to know how much capital they need — and probably very expensive to provide it. True again. But nationalization doesn’t make these problems disappear.

If the government takes over a bank, the taxpayers tacitly acquire its assets, thereby inheriting all the uncertainties over valuation. And if a bank has negative net worth when it is nationalized, who do you think fills the hole?
This is patently untrue. The entire point of temporary nationalization is that regulators don't have to price toxic assets; they can simply buy the bank, and then split it into good and bad halves. This is why Alan Greenspan came out in favor of putting insolvent banks into receivership. The good half can be sold back to private investors rather quickly. The bad assets can be held indefinitely, and sold to investors, hopefully as the market for them recovers, like was done with the RTC during the S&L crisis. Of course, if these assets really are worthless, as seems likely, then the taxpayers will end up eating the losses. But at least the taxpayers will have gotten the upside from selling the good half of the bank, and we won't have merely subsidized bankers by giving them cash for trash.

Alan Blinder either does not know what he is talking about, or is intellectually dishonest. Which is worse?

Creditanstalt II?

Over the weekend in the New York Times, Liaquat Ahamed sounded the alarm on Europe's potential for catastrophe. Quick version: Eastern Europe borrowed huge sums in foreign currencies from Western European banks; once lending died in September, Eastern European countries found themselves with massive short-term liabilities they could no longer roll over; the exodus of capital from Eastern Europe, in conjunction with massive current accounts deficits, has caused currency crises across the region, raising the real cost of debts; because of difficulties organizing collective action, particulalry on the part of France and Germany, Western Europe has been unable to agree on a bailout of its Eastern neighbors despite the risks Eastern European defaults pose to Western Europe's banks.

Ahamed concludes:

The response of the American government to the financial crisis has been criticized for being too slow and inadequate. But at least we have a federal budget, the national cohesion and the political machinery to get New Yorkers and Midwesterners to pay for the mistakes of homeowners in California and Florida, or to bail out a bank based in North Carolina. There is no such mechanism in Europe. It is going to require leadership of the highest order from officials in Germany and France to persuade their thrifty and prudent taxpayers to bail out foolhardy Austrian banks or Hungarian homeowners.

The Great Depression was largely caused by a failure of intellectual will. In other words, the men in charge simply did not understand how the economy worked. Now, it is the failure of political will that could lead to economic cataclysm. Nowhere is this danger more real than in Europe.
I couldn't agree more.

Volcano Insurance

Let's say you live next to a volcano. Let's also say you run an insurance company. You make all sorts of bet with all sorts of people, collecting premiums. You do well. Then one day you come up with a way to make huge profits: you'll sell volcano insurance. After all, the volcano hasn't erupted in ages. This is money for nothing - right?

Fast forward three years. The volcano erupts. You're on the hook for hundreds of billions in insurance policies you have no way of paying. And your clients will go bankrupt themselves if you don't pay them. In this case, you're AIG, the volcano insurance was CDS, and your clients were major US and European banks. Now you go hat in hand to the government, telling the Feds that if they don't bail you out, the world will end. From Bloomberg:
What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means. Insurance is the oxygen of the free enterprise system. Without the promise of protection against life's adversities, the fundamentals of capitalism are undermined.
This is extortion. And what is the point of indirectly bailing out AIG's counterparties? Why not do so explicitly? Many of them are European banks, and we would certainly stop bailing them out. As for the American banks, if they are so desperate for capital that taking a hit on their payout from AIG would push them into insolvency, then they should probably be in some form of government receivership. AIG should go through an orderly bankruptcy where creditors agree to write down debts to some levels to make a continuing bailout at least a little cheaper. The taxpayers should not simply pump money into the system to make Goldman whole.

Ken Lewis: We're Not Insolvent! We Promise!

Ken Lewis takes to the Wall Street Journal to tell us to pay no attention to that man behind the curtain.

Lewis assures us that "the vast majority of banks will weather this storm" and that nationalization is misguided, because its "announcement would undermine confidence in the financial system and send shudders through the investment community."

Undermine confidence in the financial system? Really? As Paul Krugman would ask, what's the weather like on his planet? Trillions of dollars of credit losses worldwide has destroyed confidence in the financial system. Paying billions of dollars for the right to absorb Countrywide and Merrill Lynch's billions of dollars of losses has crippled confidence in Lewis's BoA. Nationalization only raises the specter that creditors won't be made whole. That could create a renewed panic among holders of unsecured bank debt, but if there's an orderly process it should be a tractable problem. At this point, nationalization might be the only way to convince the public that banks are actually healthy.

So nice try Ken. But you're not distracting anyone from the real question at hand: why do you still have a job?

What Does Nationalizing the Banks Mean?

Here's Chuck Schumer and Lindsey Graham on Meet the Press talking about possibly nationalizing insolvent banks.

Schumer does a good job explaining the differences between what he calls "good" and "bad" nationalization. Good nationalization is essentially FDIC receivership on steroids - the government seizes the bank, separates good and bad assets, sells the good parts back to private investors quickly, and holds the bad assets to sell back over a longer time frame. This is more or less what the government did during the S&L crisis. Bad nationalization means the government permanently running the banks, with political connections determining who does and does not get loans. It is crony capitalism. Think Mexico in the 1980s.

Schumer did neglect one key, though technical, question: what to do with unsecured bondholders? Within any corporation, the capital structure flows up from common stock to preferred stock to unsecured debt to senior debt. If the government puts a bank into receivership, the common stock is automatically wiped out (not that the markets haven't more or less done that to troubled banks already). But who else should take a loss? Simon Johnson has argued that CDS spreads on financials peaked last week in response to the government converting its Citigroup preferred stock to common. Johnson speculates that the markets have interpreted this action as the harbinger of a move up the food chain to eventually include unsecured debt. If there were debt-for-equity swaps, or even outright haircuts, there could be a run on unsecured bank debt. This is the nightmare scenario Bill Gross of PIMCO describes. While Gross obviously is obviously not impartial on this issue, his point is valid. While forcing bondholders to share some of these losses with taxpayers certainly makes the package cheaper, it must be done transparently and simultaneously so that there is not a generalized panic.

Still, even without addressing these thornier issues, it's certainly encouraging to see a bipartisan consensus emerging around temporary nationalization (or receivership or pre-privatization if the N-word is still too taboo). Of course, the administration is still dragging its feet on a banking fix, preferring instead to put lipstick on a pig, and trot out TARP 2.0. But the fact that Wall Street's senator himself admits that putting failed banks into receivership might be our best option should prod Geithner and Summers to reconsider their non-plan plan.

Update: E.J. Dionne and Paul Krugman both summon the appropriate level of concern over the Obama administration's timidity in dealing with the economic crisis.


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