Simon Johnson: Economic Donkeys

This is a great follow up to my previous post. Simon Johnson and Peter Boone discuss the Wall Street-Washington connection, or as Tyler Cowen termed it, the politicization of the economy.

The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse.  In 1998, a much smaller Lehman Brothers was placed in financial peril by the aftermath of the Asian financial crisis and failure of Long Term Capital Management, a major hedge fund.  The Federal Reserve responded by lowering interest rates and other central banks followed suit.   This reduced the cost of obtaining funds, effectively bailing out Lehman and other institutions in trouble.

As markets have grown to recognize how quick the Federal Reserve is to bail out institutions (and executives) in trouble, they naturally respond.  In the 1990s, people talked about the “Greenspan Put” a term which derisively suggests that it is always safe to invest in risky assets, because the Federal Reserve is ready to bail out investors (a put is effectively a promise to buy an asset at a fixed price if you are unable to sell it to someone else at a higher price – this is a way to lock-in profits or limit losses on investments).  However, in months following the collapse of Lehman, we learned that the “Bernanke Put” is even more valuable since Chairman Bernanke, alongside the Bank of England, the European Central Bank, and central banks in much of the rest of the world, is prepared to take drastic measures to prevent asset prices from falling when there are risks of global collapse.

This policy of responding to the aftermath of bubbles, rather than addressing them before they get going, through tighter regulation, has become the mantra of most central banks.  It is usually combined with fiscal policy stimulus and other measures to support the economy.  Each time banks fail, by bailing the system out again, we teach our finance sector a lesson:  you can safely take too much risk because, when you lose, the taxpayer will pick up the bill.  We also send a simple message to creditors:  it is safe to lend to Goldman Sachs, or Barclays Bank, because taxpayers and our nations’ savers are standing by to cover your losses.  Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits.  Such a system is destined to fail, but the party can run for a long time.

A government implicit (now explicit) guarantee absolutely encourages excessive risk taking. FDIC and government implicit guarantees helped lead to the financial crisis by encouraging reckless risk taking, and then the government bailed out the companies. I’m not sure how much of a free market proponent Simon Johnson is, but for the record, what I just described is not how the free market operates. It’s also not capitalism, but once again, the mixed economy at work.

VF: Good Billions After Bad

Vanity Fair has a long article on TARP that I’m sure will be widely discussed. And for good reason. There are some truly startling revelations in the article. Here are a couple of the highlights:

But once the money left the building, the government lost all track of it. The Treasury Department knew where it had sent the money, but nothing about what was done with it. Did the money aid the recovery? Was it spent for the purposes Congress intended? Did it save banks from collapse? Paulson’s Treasury Department had no idea, and didn’t seem to care. It never required the banks to explain what they did with this unprecedented infusion of capital.

There were no internal controls to gauge success or failure. The goal was simply to dispense as much money as possible, as fast as possible. When Treasury began giving billions to the banks, the department had no policies in place to ensure that the banks were using the money in ways that met the purposes of the program, however defined. One main purpose, as noted, was to free up credit, but there was no incentive to lend and nothing to stop a bank from simply sitting on the money, bolstering its balance sheet and investing in Treasury bills. Indeed, Treasury’s plan was expressly not to ask the banks what they did with the money. As the Government Accountability Office later learned, “the standard agreement between Treasury and the participating institutions does not require that these institutions track or report how they plan to use, or do use, their capital investments.” When the G.A.O. asked Treasury if it intended to ask all tarp recipients to provide such an accounting, Treasury said it did not—and would not. “There’s not a bank in this country that would lend money under [these] terms,” Elizabeth Warren, the chair of a Congressional Oversight Panel that was eventually charged by Congress with overseeing tarp activities, would tell a Senate committee.

There wasn’t even anyone within the tarp office to keep track of the money as it was being disbursed. tarp gave that job—along with a $20 million fee—to a private contractor, Bank of New York Mellon, which also happened to be one of the Big 9. So here was a case of a beneficiary helping to oversee a process in which it was a direct participant. Most of the tarp contracts—for everything from legal services to accounting—were awarded under an expedited procedure that government watchdogs regard as “high-risk,” because it lacks a wide array of routine safeguards. In its first three months of operation, the Office of Financial Stability awarded 15 contracts worth tens of millions of dollars to law firms, fiscal agents, management consultants, and providers of various other services. There was enormous potential for conflicts of interest, and no procedure to deal with them. When the possibility of conflict of interest was raised, two of the contractors voiced vague promises to maintain an “open dialog” and “work in good faith” with Treasury, and left it at that.

The real issue is tarp itself, one of the most questionable ventures the U.S. government has ever pursued. Adopted as a plan to buy up toxic assets—one that was quickly deemed impractical even by those who first proposed it—it evolved into something more closely resembling an all-purpose slush fund flowing out to hundreds of institutions with their own interests and goals, and no incentive to deploy the money toward any clearly defined public purpose.

By and large, the cash that went to the Big 9 simply became part of their capital base, and most of the big banks declined to indicate where the money actually went. Because of the sheer size of these institutions, it’s simply impossible to trace. Bank of America no doubt used a portion of its $25 billion in tarp funds to help it absorb Merrill Lynch. Citigroup revealed in its first quarterly report after receiving $45 billion in tarp funds that it had used $36.5 billion to buy up mortgages and to make new loans, including home loans.

A.I.G., the largest single tarp beneficiary, wasn’t even a bank. The insurance company used its $70 billion in tarp funds to pay off a previous government infusion from the Federal Reserve. The original bailout money had flowed through A.I.G. to Wall Street firms and foreign banks that had incurred big losses on credit-default swaps and other exotic obligations. These were basically the casino-style wagers made by A.I.G. and the counterparties—wagers they lost. The government justified the help by saying it was necessary to prevent disruption to the economy that would be caused by a “disorderly wind-down” of A.I.G. The collapse of Lehman Brothers had occurred just days before the Fed took action, and the shock waves on Wall Street from yet another implosion might have been catastrophic. Bankruptcy court, where troubled corporations routinely wind down their disorderly affairs, would have been another option, though that prospect might not have quickly enough addressed the gathering sense of urgency and doom. We’ll never know. Certainly bankruptcy court would not have allowed A.I.G.’s clients to get full value for their bad investments.

If your blood is already boiling, then you may want to read no further. There are a lot more of “WTF were they thinking” moments in the article. You can read the full thing here.

Economist: Making Fiscal Policy Credible & Unnatural Selection

The Economist has two articles you should read in this week’s magazine. The first one is “Making Fiscal Policy Credible: Bind Games“. Below is an excerpt:

In America worries about the dollar’s international status and the appetite of Asian central banks for Treasury bonds may yet spur a consensus on the need for a binding fiscal framework. The rise in gold prices to above $1,000 an ounce this week reflects both fears for the dollar and concerns about the possible consequences for inflation of rising public debt.

What America needs is fiscal projections that say something about how and when deficits will be tamed, says Eric Leeper of Indiana University. That sort of detail would help taxpayers and bondholders to form views about future policy. As with monetary policy, fiscal policy works more effectively when people know what to expect, says Mr Leeper.

The other one is “The Financial Industry: Unnatural Selection“. Here’s an excerpt:

But the dramatic changes in the pecking order mask a lack of more profound change in the system of finance itself. Lehman aside, no big firms have been allowed to fail (as they would have done, unaided). Thanks to state aid, the law for big firms today is what Gordon Gekko, the red-blooded villain of the film “Wall Street”, dubbed “survival of the unfittest”.

Indeed, taken together, financial firms have not even really got smaller. Exclude “useful” loans to the real economy, and over the past year the remaining underlying risk-adjusted assets of the nine biggest investment banks worldwide have been broadly flat. Statistical measures of the maximum trading losses these firms could face on those positions suggest that, in aggregate, they are taking more risk. Their combined balance-sheet is 40% bigger today than in mid-2005. And all this has been amplified into public outrage by the foolish decision to pay out bumper bonuses again.

…No one should pretend that banking is an industry where pure natural selection takes place. But as guarantees, both explicit and implicit, are withdrawn, the hope is that self-discipline will be imposed on banks, not just swathes of new regulation. There are signs that riskier banks are already paying more to finance themselves. This differentiation must be promoted, so the weak and reckless are gradually forced to shrink and live within their means—and not off taxpayers’ largesse.

Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail

Bloomberg has a great (long) piece on missing the lessons of last year’s financial collapse. Below is an excerpt from the article:

Of all the quakes of 2008 — the fall of Bear Stearns Cos. in March, the takeover of mortgage buyers Fannie Mae and Freddie Mac and the salvaging of American International Group Inc. in September — the failure to account for the effects of Lehman’s demise was the most critical because its aftershocks came closest to wrecking the world economy.

“They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy, referring to government officials. “They were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’”

Paulson and Geithner, who succeeded him as Treasury secretary, both declined to comment.

Inviting ‘Catastrophe’

One year later, policymakers haven’t learned the lesson of the bankruptcy, said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch.

Rather than break up institutions such as Bank of America Corp. and Citigroup Inc., or limit their expansion, the U.S. has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger. To protect against a bank collapse touching off another freefall, President Barack Obama has proposed regulatory changes that rely on the wisdom of bankers and government overseers — the same people who created the conditions that led to Lehman’s bankruptcy and were unable to foresee its consequences.

“Designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe,” Bernstein said.

Rescue efforts exposed a financial system with so many moving parts that U.S. regulators and the world’s top bankers couldn’t keep track of them all. A reconstruction of the meetings at the New York Fed that preceded Lehman’s bankruptcy, drawn from more than a dozen interviews with participants, reveals a failure to understand the importance of commercial paper and how that market would be affected by the collapse of the New York investment bank.

Ice-Nine

It turned out to be a $3.6 trillion blind spot.

Like the fictitious substance ice-nine in Kurt Vonnegut Jr.’s 1963 novel “Cat’s Cradle,” a seed of which set off a chain reaction that transformed all the world’s water into ice, Lehman’s failure froze credit markets, said Simon H. Johnson, a former chief economist at the International Monetary Fund.

“Ice-nine was invented by a crackpot scientist, and it was unleashed by mistake,” said Johnson, now a professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management in Cambridge. “How did the financial system get so fragile that this could happen? What were the guys overseeing it doing?”

The bankers and regulators who met at the New York Fed unwittingly dropped the first seed.

Great stuff. You can read the whole article here.

Credit Rating Agencies Took “Bribes” for Higher Ratings

Alternative title: How the Fed Contributes to Crises

Hat tip to Washington’s Blog for bringing this story to my attention. Morningstar Advisor posted a great piece back in June when they held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Below are some highlights:

[Finance professor Ed] Kane: One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

[Prolific financial journalist, Brookings Institution scholar, and the author of more than 30 books on financial market issues Martin] Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

[Former Federal Reserve attorney and economist Walker] Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Read the whole Morningstar discussion after the jump…

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The Zombie Dance Party Rocks On

From the Institutional Risk Analyst. The results of their Q2 2009 stress test of the US banking industry are not pretty:

The second quarter FDIC data is online for consumer and professional users of The IRA Bank Monitor. The results of our Q2 2009 stress test of the US banking industry are pretty grim. Despite all of the talk and expenditure in Washington, the US banking industry is still sinking steadily and neither the Obama Administration nor the Federal Reserve seem to have any more bullets to fire at the deflation monster.  With the dollar seemingly set for a rebound and the equity and debt markets looking exhausted, one veteran manager told The IRA that the finish of 2009 seems more problematic than is usual and customary for the end of year.

Plain fact is that the Fed and Treasury spent all the available liquidity propping up Wall Street’s toxic asset waste pile and the banks that created it, so now Main Street employers and private investors, and the relatively smaller banks that support them both, must go begging for capital and liquidity in a market where government is the only player left. The notion that the Fed can even contemplate reversing the massive bailout for the OTC markets, this to restore normalcy to the monetary models that supposedly inform the central bank’s deliberations, is ridiculous in view of the capital shortfall in the banking sector and the private sector economy more generally.

As with Q1 2009, the Q2 preliminary Stress Index calculated by IRA jumped to over 6.7 or more than half an order of magnitude above the 1995 base year of 1, but then subsided down to “only” 3.11 vs. 2.8 in Q1 2009. As in the previous period, the preliminary score reflects the tough reality facing smaller community and regional banks, while the final score of 3.11 reflects the huge subsidies flowing through the top institutions. Whereas in past years the inclusion of the larger money center banks would skew the risk profile of the banking industry to a more risky posture, today, as zombie GSEs, the top banks make the industry look more conservative.

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Banks ‘Too Big to Fail’ Have Grown Even Bigger

This is a great article by David Cho of the Washington Post. As we Bailout more banks, we are creating more behemoths — reducing consumer choice, and feeding ever more Moral Hazard:

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

A year after the near-collapse of the financial system last September, the federal response has redefined how Americans get mortgages, student loans and other kinds of credit and has made a national spectacle of executive pay. But no consequence of the crisis alarms top regulators more than having banks that were already too big to fail grow even larger and more interconnected.

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