Sunday, May 10, 2009

SNL Nails "Stress" Tests

When it comes to the stress tests, I think SNL's Tim Geithner might have been a tougher negotiator than the real Tim Geithner.

Saturday, May 9, 2009

Stress Test "Negotiations"

When is a stress test not a stress test? If you said when the most "adverse" scenario in the stress test is not as bad as current economic conditions, you would be correct. If you said that the regulators relied on the bankers to report on their firms' financial health using the same models that failed to alert the banks to the impending financial apocalypse, you would also be correct. And if you said when the bankers negotiate with the regulators over how much capital they need to raise due to the stress tests, you would be triply correct. From the Wall Street Journal:
The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.

At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.

At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.

The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.
Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.

A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.

"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.
This is exactly backwards. Throughout this sham of a process, regulators have bent over backwards, making sure not to offend bankers' sensibilities. Whether bankers are happy with the results of the stress tests is irrelevant - what matter is whether the numbers are accurate. Why would anyone have confidence in these numbers if banks lobbied for them? (Saying that what they were doing was not lobbying is a dead giveaway that they were).

This final nugget from the WSJ piece reveals the underlying problem with the stress tests - the regulators confused the ends and means. From the WSJ:
With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.
The purpose of stress tests should be to reduce opacity. Increased confidence should be a byproduct of this increased transparency. Lying about banks' balance sheets to create a short-term confidence boom in the banks simply puts off the problem, as the administration hopes the banks can earn themselves back to health. And if the banks are still insolvent six months from now? Will we finally get some sort of pre-packaged bankruptcy for systemically important financial firms? Or will we get Tim Geithner to come back and tell us everything is still fine...the banks just need another $500 billion or so.

Wednesday, May 6, 2009

More Stress: Wells Fargo Needs $15 Billion

Bloomberg reports that Wells Fargo will need to raise $15 billion in additional capital as a result of its stress test. If Wells is allowed to play the same accounting games as Citi and BoA, they can simply convert some of the $25 billion of preferred shares the government owns from the TARP to common shares and be done with meddlesome capital requirements. Of course, Wells Fargo may not want the government to be one of its biggest voting shareholders, if not the biggest, so actually issuing new common stock is not out of the question. And, of course, Wells Fargo plans on getting out from under its government shackles by earning its way back to solvency - soon! From Bloomberg:

Chief Executive Officer John Stumpf said last week that Wells Fargo will pay back $25 billion to the Treasury’s Troubled Asset Relief Program and restore its dividend as soon as possible.

“We earn our way out,” Stumpf, said at the company’s annual shareholders’ meeting in San Francisco April 28. “This company has a great capacity to produce wonderful results. That will be the driving force.”

The stress tests were designed to incorporate potential earnings in their assessments of banks’ capital needs.

Translation: with all the direct and indirect government subsidies to banks, even the idiots who ran their firms aground cannot lose money. If new revenues equal losses on "legacy" assets - and there are still huge time bombs on banks' balance sheets like CRE loans- then the banks should not require too much more help. Whether banks can survive and thrive without government training wheels is entirely another question, though.

But forget those concerns. Happy days are back again - right? At the very least, maybe Warren Buffet's favorite banks should unveil a new slogan: Wells Fargo - Not As Crappy As Citi or BoA.

Stressed: BoA Needs $34 Billion

The New York Times reports that Bank of America needs to raise $33.9 billion in additional capital according to the regulators who conducted the stress tests. BoA can either issue new common stock, or convert some of the non-voting preferred shares the government received for the TARP into common shares. And, of course, it's vital to keep in mind that economic conditions today are worse than the most "adverse" scenario regulators used for 2009 in the so-called stress tests. So if Geithner & Co. say BoA needs $34 billion, the actual hole in their balance sheet is likely much, much larger. From the New York Times:
The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank.

If the bank is unable to raise the capital cushion by selling assets or stock, it would have to rely on the government, which has provided $45 billion in capital through the Troubled Asset Relief Program.

It could satisfy regulators’ demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock.

But that would make the government one of the bank’s largest shareholders.

Executives at the bank, one of the largest being examined, sparred with the government over the amount, which is higher than executives believed the bank needed.

But J. Steele Alphin, the bank’s chief administrative officer, said Bank of America would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock.

“We’re not happy about it because it’s still a big number,” Mr. Alphin said. “We think it should be a bit less at the end of the day.”

The government’s determination that Bank of America doesn’t need as much capital as it has already received from taxpayers is an indication that even some of the most troubled banks may not need more government money than has been allocated to them.
None of the banks may need more capital from the taxpayers - if their bondholders convert debt-to-equity, or otherwise take a haircut on what they are owed. That does not mean the banks are healthy, merely that policymakers finally realize that it is not sustainable for the public to subsidize Bill Gross's portfolio any longer. Also: how reliable is this $34 billion figure if officials from BoA allegedly "sparred" with Treasury officials over this number? Back to the article:
Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own.

“There are several ways to deal with this,” Mr. Alphin said. “The company is very healthy.”

Bank executives estimate that the company will generate $30 billion a year in income, once a normal environment returns.
Here's the crux of Geithner's plan: hope something approximating a "normal" environment returns quickly so that banks can earn their way back to health without requiring any further restructuring or government bailouts. This is more or less how the Reagan administration dealt with de facto insolvent banks in 1982. While this approach could work, we won't know for several months. And if banks cannot earn their way back to health, the costs of bailing them out will only rise.

Tuesday, May 5, 2009

Will Fewer Have Jobs When The Economy Is At Full Employment After Recovery?

Some economists are reconsidering what will constitute "full employment" - the unemployment rate at which the inflation rate does not change positively or negatively - after this slump ends. From Bloomberg:
Post-recession America may be saddled with high unemployment even after good times finally return.

Hundreds of thousands of jobs have vanished forever in industries such as auto manufacturing and financial services. Millions of people who were fired or laid off will find it harder to get hired again and for years may have to accept lower earnings than they enjoyed before the slump.

So far, so good. Since unemployment is generally a lagging indicator, it seems likely that even after the economy stops contracting that the unemployment rate will continue to climb. Furthermore, sectors that were overbuilt during the bubble - autos, real estate, and finance - will lose jobs that will not come back. But what does this mean for full employment? Back to the article:

This restructuring -- in what former Federal Reserve Chairman Paul Volcker calls “the Great Recession” -- is causing some economists to reconsider what might be the “natural” rate of unemployment: a level that neither accelerates nor decelerates inflation. This state of equilibrium is often described as “full” employment.

Fallout from the recession implies a “markedly higher” natural rate of unemployment, says Edmund Phelps, a professor at Columbia University in New York and winner of the 2006 Nobel Prize in economics. “It was 5.5 percent; maybe it will be 6.5 percent, maybe 7 percent.”

This is certainly possible, but it seems like an optimistic reading of the situation. An unemployment rate that peaks somewhere around 11-12 percent and then recedes to 7 percent for the foreseeable future could also act as a powerful deflationary force on the economy. If banks begin to lend out some of the gargantuan excess reserves they hold, this could prop the economy out of deflation despite the relatively elevated unemployment level. In this context, the number of people working when the economy is at "full employment" could fall. But if the Fed tightens monetary policy, the inflationary impact of any credit expansion would dissipate, and the US economy could very well teeter along into deflation again.

Let us hope that we get high unemployment and inflation: the alternative is far worse.

Monday, May 4, 2009

Krugman: Absolute Wage Levels Matter Too

Economists usually talk about relative prices. If wages and prices all double in an economy, then an individual's consumption choices will not change. But this view of relative prices ignores the impact of fixed costs, particularly of debt. If wages and prices fall commensurate levels, the purchasing power of an individual should be unchanged - unless that individual wracked up excessive levels of debt when wages and prices were higher. In that case, the individual will need to devote a greater percentage of his income to servicing that debt than he did when his wages were higher. The collateral he used to secure the debt - say a house in the case of a mortgage - might be worth less than the value of the loan with general deflation across the economy, so he cannot sell what he owns to get out from under the debt. This is debt deflation.

Paul Krugman reminds us of the veritable economic horrors of debt deflation and the implicit importance of nominal wages in his latest column. From the New York Times:
And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.
Just a reminder that as bad as the 1970s were, if we face a choice between stagflation and a deflationary spiral, it's really no choice at all.

Condi Rice Schooled By A 4th Grader

First, college students were too tough for Condi Rice. Now, it's 4th graders who are too much of a challenge. After a speech at a Washington DC elementary school, the Washington Post reports a 4th grade student asked her "What did Rice think about the things President Obama's administration was saying about the methods the Bush administration had used to get information from detainees?" Again, she resorted to the Nixonian "it's-legal-if-the-president-says-it-is" defense.

Lucky for her, the student's question was toned down: he originally wanted to ask her, "If you would work for Obama's administration, would you push for torture?" Is the media paying attention? That's how you ask tough questions.

Sunday, May 3, 2009

"Contrarian" Naivete From TNR

Now that the "Wall-Street-controls-Washington" meme has gained traction, especially among the center-left, the oh-so-contrarian New Republic has taken to arguing that this isn't exactly true. After explaining several weeks ago that Simon Johnson's diagnosis of the United States as an emerging market crisis on steroids disquieted him, Noam Scheiber explains that the idea of Wall Street controlling the levers of power is problematic, since "Wall Street" is not a monolithic entity. To illustrate his case, Scheiber cites the recent controversy over mortgage cram-downs. When cram-down legislation, which would allow bankruptcy judges to renegotiate mortgages, came up in the Senate, lobbyists representing bankers and investors holding securitized mortgages united in opposition to the legislation. From Scheiber's piece:
When Obama unveiled his own housing plan in February, he asked Congress to revive the cram-down idea as part of a carrot-and-stick approach to helping borrowers. The carrot would be cash incentives--a series of $1,000 payments--for banks to perform modifications. Cram-down would serve as the stick.

Almost immediately, investors and banks joined forces to snap that stick like a twig. Investors hated the cram-down idea because they worried judges would force them to accept, say, lower interest payments for the sake of distressed borrowers. The big banks had similar worries for the mortgages they keep. Many also hold on to second liens (basically, second mortgages) after they sell off the first and worried judges would wipe those out entirely. And both groups generally feared the arbitrary ways judges might wield their power.

But then the script got flipped. The banks switched sides. Back to the article:

But a funny thing happened while the big banks and investors were uniting against the cram-down push: The banks cut their own deal. Top executives at four large banks--Citigroup, Bank of America, J.P. Morgan, and Wells Fargo--descended on Congress to proclaim they'd love nothing more than to modify mortgages, just like the president wants. It's just that, with all those greedy investors out there, you never know who's going to sue. The solution, they argued, was a "safe harbor" provision: Give us legal immunity, and we'll modify all the loans you send us.
Different classes of financiers going at each each other! See - Wall Street can't really control Washington if they're busy infighting. Scheiber explains that this conflict between banks and hedge funds is like the Iran -Iraq War: "Where there are no obvious good guys, the next best thing may be two powerful rivals beating each other to a pulp."

But why did the banks change their minds when it came to cramdowns? What were the fissures that led to the split up between banks and hedge funds over this issue? Scheiber explains that it was a matter of political savvy. From the article:

If the fight in Congress was essentially over who would eat hundreds of billions of dollars in housing market losses, the genius of the banks was to realize early on that, given the political environment, it wasn't going to be homeowners. That left them duking it out with investors, even if the latter weren't aware of it....

In the end, the problem for investors was largely sociological. Banking is a heavily regulated industry; in order to succeed, a bank's top executives must be as deft at navigating Washington as they are at lending money. But, with a few important exceptions, most hedge funds live by a meritocratic credo: You make money by having the more sophisticated computer model or arbitrage strategy. "Traditionally, investors aren't lobbyists, they don't have an eye toward Washington".

In short: banks are used to the ways of Washington and did a better job reading the political winds, so they abandoned their opposition to cramdowns. However, this ignores a key fact: the banks rely on the government for survival, both directly via capital infusions and indirectly in the form of FDIC-guaranteed debt. Is it inconceivable that the government, ahem, told the banks that it would be an awful shame if populist rage over cramdowns hamstrung Congress from going back for TARP II? After all, didn't something similar more or less seem to happen back in February when JP Morgan, BofA, and Citgroup agreed to a foreclosure moratorium? Not even considering this possibility smacks of remarkable credulity and naivete. If this is the case, then the degree to which the financial services industry owns our government is even more depressing. Even when the government has enough leverage over the banks to turn them against the hedge funds, the hedge funds still won. This hardly seems cause to break out the champagne.

Friday, May 1, 2009

Krauthammer: Torture Is Impermissible Except Always

This is really a masterpiece of partisan hackery from Charles Krauthammer. Weighing in on the torture debate (how sad is it that there is even a debate about whether the United States should torture) with his trademark sanctimonious liberal-who-has-been-mugged-by reality "toughness", Krauthammer informs us that "torture is an impermissible evil. Except under two circumstances." And what are these exceptions? According to Krauthammer, "the first is the ticking time bomb." Ah, the ticking time bomb. Never mind that this situation has never actually happened outside of 24. Indeed, consider all of the facts an interrogator would need to know to justify torture in this situation: he would need to know that an attack is imminent, he would need to know enough about the plot to capture the suspect without knowing where or when the attack was, and he would need to know that the suspect knew enough to stop the attack. This is the epistemiological aspect of the ticking time bomb scenario. It is extremely unlikely that such a situation would ever occur. Much more plausibly, an interrogator would justify chatter about impending attacks - there is always chatter - to go on a fishing expedition to see what a suspect knows. After all, there might be a ticking bomb! It is a very slippery slope from the ticking time bomb to allowing torture in any case.

What about Krauthammer's exception? Again, from Krauthammer's column:

The second exception to the no-torture rule is the extraction of information from a high-value enemy in possession of high-value information likely to save lives. This case lacks the black-and-white clarity of the ticking time bomb scenario. We know less about the length of the fuse or the nature of the next attack. But we do know the danger is great. (One of the "torture memos" noted that the CIA had warned that terrorist "chatter" had reached pre-9/11 levels.) We know we must act but have no idea where or how -- and we can't know that until we have information. Catch-22.

This is not an exception; this is a license to torture any suspect at any time. In fact, this is an exact description of the slippery slope entailed in allowing torture under the ticking time bomb scenario. So, per Krauthammer, torture is an "impermissible evil" except whenever we decide to do it. Sadly, this is about on par with the legal "reasoning" in the Bybee and Yoo torture memos. If this is the best defense torture apologists can marshal, they should move to countries that do not have extradition.


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