Month: September 2008
Every now and then I like to post about history:
Firms connected with the Nazi party outperformed unaffiliated firms
massively. Their share prices rose by 7.2% between January and March
1933 (43% annualised), compared to 0.2% (1.2% annualised) for
unaffiliated firms. The politically induced change was equivalent to
5.8% of total market capitalisation. This is a high number by
international standards. Johnson and Mitton (2003) estimate that
revaluation of political connections in Malaysia during the East Asian
crisis wiped 5.8% of share values. While comparable in magnitude, it
took 12 months for this change to occur.
Here is more, interesting throughout.
…the total liabilities of
Deutsche Bank (leverage ratio over 50!) amount to around 2,000 billion
euro, (more than Fannie Mai) or over 80 % of the GDP of Germany. This
is simply too much for the Bundesbank or even the German state to
contemplate, given that the German budget is bound by the rules of the
Stability pact and the German government cannot order (unlike the US
Treasury) its central bank to issue more currency. The total
liabilities of Barclays of around 1,300 billion pounds (leverage ratio
over 60!) surpasses Britain’s GDP. Fortis bank, which has been in the
news recently, has a leverage ratio of "only" 33, but its liabilities
are several times larger than the GDP of its home country (Belgium).
The Fed has possibly been bailing them out too (not necessarily by intention), as it is likely that some of these institutions had heavy exposure to the weaker U.S. institutions. Here is the link. Those failures should also put the U.S. regulatory failures in perspective. And what would happen if a big U.K. bank were on the verge of failing? Would the Fed have to step in there too? Contagion is contagion, as Aristotle once said…
Among the potential sources of tension is the Treasury’s ultimate
decision on whether it will buy troubled mortgage-backed securities
from non-American banks. European banks, like UBS, invested heavily in such securities.
Paribas has bought a mortgage-backed security, why can’t they present
it to Treasury?” Mr. Truman said. “If the government is going to do it
for the American banks, they should do it for everyone.”
could provoke a strongly negative reaction from lawmakers on Capitol
Hill, who already protested that other countries should chip in for the
$85 billion rescue of the insurance giant American International Group, because it has operations in those countries or has insured their banks.
the taxpayers in the United States going to bail out all the banks in
the world?” said Allan H. Meltzer, a historian of the Federal Reserve.
“I just don’t know how this works out.”
Here is the story.
Part of this new policing mentality is that publishers are becoming more
risk-averse – children’s book authors, for example, are being asked to sign
contracts agreeing to ‘appropriate conduct’ in their private lives.
Here is much more, mostly a discussion of how digitalization is changing the literary world.
“It’s important to pay taxes if you want to live a normal life,” said ‘Lisa’, a prostitute who spoke with the newspaper.
That’s from Sweden (no mention of patriotism), and apparently some social benefits are attracting more prostitutes to the taxed sector. The record of income creates or enhances rights to sick-leave pay, parental leave benefits, and a pension. Note that in Sweden it is illegal to buy sex but not to sell it.
Thanks to a loyal MR reader for the link.
Pundits continue to link the Enron debacle to a need for increased regulation,
especially of derivatives. What most of these people…don’t appreciate is that regulation and/or accounting rules are the
most fertile breeding ground for derivatives and synthetic or packaged
securities. Regulations and accounting rule-inspired transactions
describe the bulk of the well known derivative-related blow-ups of the
last two decades. Proscriptive regulation and the derivative trade have
a symbiotic relationship.
Investors and operating companies buy derivatives for two basic
purposes: speculation and risk transfer. A derivative, (a financial
contract based on the price of another commodity, security, contract or
index) either eliminates an exposure, creates an exposure, or
substitutes exposures. That last one, substituting exposures, is
important to heavily regulated investors.
For example, insurance companies were a goldmine for derivatives
salespeople in the last two decades, only slowing down in the late
1990s. The fundamental reason for this is not because insurance
executives were stupid, but because they manage their investments in a
thicket of proscriptive regulation. Insurance companies have to respond
to their national regulatory organization (the NAIC), their home state
insurance department and the insurance departments of states in which
they sell or write business. They file enormous statutory reports every
quarter using special regulatory pricing, and calculate complex
risk-based capital reports and "IRIS" ratios regularly.
Even though the insurance industry has been heavily regulated
throughout the entire post-war era, the incidents of fraud and
financial mismanagement have been numerous and spectacular. Remember Marty Frankel?
Mutual Benefit Life? For each of these cases that are in the news,
there are many smaller ones you don’t hear about. Some of that may be
the nature of the industry, but it doesn’t make a prima facie case for more regulation…
Insurance companies often need the yield of less creditworthy
obligations. So derivative salesmen see an opportunity to engineer
around the regulations. They package securities that substitute price
volatility for the proscribed credit risk. Then the investor can be
compensated for taking some additional risk, and the banker can be
compensated for creating the opportunity. A simple example of this is
the Collateralized Bond Obligation (CBO). A CBO is created by buying a
bunch of bonds, usually of lower credit quality, putting them in a
"special purpose vehicle" (SPV) and then issuing two or more debt
instruments from the SPV. The more senior instruments can obtain an
investment grade rating based on the "cushion" created by the junior
debt tranche. The junior bond absorbs, for example, the first 10% of
losses in the entire portfolio and only when losses exceed that amount
will the senior obligations be impaired. The junior instruments, known
as "Z-Tranches" become "toxic waste", suitable only for speculators and
trading desks with strange risks to lay off (or, in a famous 1995 case,
the Orange County California Treasurer).
A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing – they decrease frequency of loss but increase the severity.
So they blow up infrequently, but when they do it’s often a big mess.
Ratings-packaged instruments are less risky than the pool of securities
they represent but often riskier and less liquid than the investment
grade securities for which they are being substituted. As a result,
they pay a yield or return premium (even net of high investment banking
fees). That premium may or may not be enough to pay for their risk. But
they pass the all-important credit rating process and are therefore
sometimes the only choice for ratings-restricted portfolios reaching
…[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests
that regulation is often the derivative salesman’s best friend.
Complicated rules encourage complex transactions that seek to conceal
or re-shape their true nature. Regulated entities create demand for
complex derivatives that substitute proscribed risks for admitted
risks. If a new risk is identified and prohibited, the market starts
inventing instruments that get around it. There is no end to this
process. Regulators have always had this perversely symbiotic
relationship with Wall Street. And the same can be said for the
ridiculously complicated federal taxation rules and increasingly
byzantine Financial Accounting Standards, both of which have inspired
massive derivative activity as the engineers find their way around the
Dreck, in case you don’t know, used to blog with Megan McArdle over at Asymmetric Information. Here is what happens when you enter "Star Dreck" into YouTube.
He doesn’t like it. And he has another idea:
As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?
The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.
And now come the real zingers:
It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.
Addendum: Here is further comment.
Here is an excellent overview from Arnold Kling, read it. Soon I will myself cover derivatives in greater detail.
Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis. Let’s thank President Clinton (and Phil Gramm) for that wise bit of deregulation. The following potted history of the law, however, is all too typical:
Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks….The policy response was to erect a wall between investment banking and commercial banking.
Given a history like this people wonder how repealing the law could have been a good thing. But a significant academic literature has investigated these claims and rejected them. Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates. Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks. A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham. My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor). Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.
Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.
No. That is one common myth among the progressive left. Because it involves financial deregulation and the unpopular Phil Gramm, the Act is vilified and assumed to be part of a broader chain of evil events. Here are some of the articles which promulgate the myth that the Act caused or helped cause the housing bubble. One version of the claim originates with Robert Kuttner, but if you read his article (and the others) you’ll see there’s not much to the charge. Kuttner doesn’t do more than paint the Act as part of the general trend of allowing financial conflicts of interest.
Most of all, the Act enabled financial diversification and thus it paved the way for a number of mergers. Citigroup became what it is today, for instance, because of the Act. Add Shearson and Primerica to the list. So far in the crisis times the diversification has done considerably more good than harm. Most importantly, GLB made it possible for JP Morgan to buy Bear Stearns
and for Bank of America to buy Merrill Lynch. It’s why Wachovia can consider a bid for Morgan Stanley. Wince all you want, but the reality is that we all owe a big thanks to Phil Gramm and others for pushing this legislation. Brad DeLong recognizes this and hail to him. Megan McArdle also exonerates the repeal of Glass-Steagall.
Here is a good critique of GLB, on the grounds that it may extend "too big to fail" to too many institutions. That may yet happen but not so far.
The Act had other provisions concerning financial privacy.
Maybe you can blame some conflict of interest problems at Citigroup and Smith Barney on the Act. But again that’s not the mortgage crisis or the housing bubble and furthermore those problems have been minor in scale. Ex-worker has a very sensible comment. The most irresponsible financial firms were not, in general, owned by commercial banks. Here’s lots of informed detail on GLB and the bank failure process. Here is another good article on how GLB didn’t actually change Glass-Steagall that much.
Here’s a Paul Krugman post on GLB; he attacks Phil Gramm but he doesn’t explain the mechanism by which GLB did so much harm. The linked article has no punch on this score either, although you will learn that Barack Obama has scapegoated GLB, again without a good story much less a true story.
I may soon cover the Commodity Futures Modernization Act as well.
"Why does one person have the right to grant $85 billion in a bailout
without the scrutiny and transparency the American people deserve,"
asked House Speaker Nancy Pelosi (D., Calif) a reference to the loan
the Fed gave AIG with the Treasury’s blessing.
"No one in a democracy, unelected, should have $800 billion to spend as he sees fit," said Mr. [Barney] Frank.
He was referring to Bernanke’s balance sheet and not to Gerald Ford, in case you were not sure. Here is the link, courtesy of Arnold Kling, who responds: "I just get a chuckle hearing a Congressman complain about someone spending other people’s money." Here is Arnold on RTC-like plans.
Research by UCLA political scientists into the "facial competence" of candidates puts the Republican VP hopeful in the top 5%.Their paper (http://renos.bol.ucla.edu/AtkinsonEnosHill.pdf ) shows that facial competence explains a significant portion of the vote — about 4% of independent voters in a congressional election.Here’re some more details: http://renos.bol.ucla.edu/AtkinsonEnosHill.pdf
1. "Crows seem to be able to use causal reasoning to solve a problem, a feat previously undocumented in any other non-human animal, including chimps." Here is more.
2. "I, Crayon," so to speak, a video.
3. Should libertarians migrate to Canada?
4. Treadmill desks.
This was "unscripted", from Sarah Palin:
Disappointed that taxpayers are called upon to bailout another one. Certainly AIG though with the construction bonds that they’re holding and with the insurance that they are holding very, very impactful to Americans so you know the shot that has been called by the Feds it’s understandable but very, very disappointing that taxpayers are called upon for another one.
That’s via Andrew Sullivan. It’s the phrase "very, very impactful" I object to. The point about construction surety bonds is actually correct, as indeed AIG did issue them and it doesn’t seem that any regulation or state authority will make good those guarantees (readers, correct me if I am in error but I can find no record of such guarantees). That means a lot of people bought insurance against adverse construction events and will be left without that protection.
Of course this matters less at lower levels of construction.
The real lesson of this quotation is that the Republicans have no good language for discussing recent events. They’re not allowed to say anything that sounds like "showing sympathy for Wall Street," so they have to find someone else to show sympathy for but they can’t turn to traditional Democratic rhetoric about how an unregulated capitalist economy is failing us. Citing the construction bonds is like worrying that the financial crisis will postpone the retirement of many professors. Yes that is true but it’s odd (though not unprecedented) if that’s the first thing that comes to your mind or for that matter to your talking points.
Here is John McCain on the crisis, again unscripted, from The Today Show:
LAUER: So if we get to the point middle of the week as we heard in that report where AIG might have to file for bankruptcy, they’re on their own?
McCAIN: Well…quote, "on their own"…we have to – we cannot have the taxpayers bail out AIG or anybody else…this is something we’re gonna have to work through — there’s too much corruption, there’s too much access, we can fix it, I believe in America – we can have a 9/11 commission such as we had after 9/11, ’cause this is a huge crisis and we can come up with fixes and we can make sure that every American has a safer future and that is to make them know that their bank deposits are safe and insured.
Here is more of the session. He did worse than she did and that’s after decades on the national scene.