...Archive for April 2009

Meet Joe Peek

You just never know who you’ll run into here in blogland.

Joe Peek is a professor of finance at the University of Kentucky (where I am a very poor excuse for a graduate student). He has a guest post over at The Hearing.

Dr. Peek’s professional obsession is the Japanese banking system. He takes an unreconstructed view of the parallels between our response to the banking crisis and Japan’s, and is particularly unhappy with the recent softening of mark-to-market rules. Here’s a snippet:

Much like in Japan, U.S. policy makers have made efforts to avoid distinguishing among banks, for example, forcing all of the largest banks to accept billions of dollars of Troubled Assets Relief Program funds. The stress tests for the 19 largest banks provide policy makers with an opportunity for a “do over.” The results of the stress tests must be based on market values and whether the banks are truly economically viable. Government capital should not be injected into banks indiscriminately; only the strong should survive. We need disclosure, as well as closure, if a bank either is not viable or cannot raise sufficient private-sector capital to become viable.

The time has come for transparency to replace the “parency” of government support of non-viable firms, financial or non-financial. The “convoy system” did not work in Japan during their “Lost Decade,” and should not be expected to work here.

Do read the whole thing.

Value for value

Would it have been better if Timothy Geithner had had the power to guarantee all bank debt early on? As James Surowiecki reminds us, that was part of the Swedish solution. Justin Fox plausibly suggests that we might have avoided a lot of pain with a fast, full guarantee.

But that’s not the point. The question isn’t whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindight, would it have been a good idea?

How you answer that question depends upon how you view the crisis. Is it an aberration, a shock to a basically sound financial system, or is it a painful symptom of an even more dangerous condition? Under what circumstances would our political system be likely to impose reforms that would prevent large scale misallocations of capital and shifting of losses to taxpayers in the future?

If you think that our financial system just needs some tweaks, some consolidation of regulators’ organizational charts and sterner supervision, then you should prefer that we had just cut a check, passed Sarbanes/Oxley Book II, and moved on. But that is not what I, or most proponents of nationalization temporary receivership for insolvent banks, believe.

If you believe, as I do, that we need a root-and-branch reorganization of the financial system, which must necessarily involve the dismemberment and intrusive restraint of deeply entrenched institutions, does that mean pain is the only way forward, “the worse the better” in the old revolutionary cliché? It need not mean that. But it does mean that palliative measures, like giving the banks money, would have to be attached to curative measures, like enacting capital requirements and imposing regulatory burdens that would force financial behemoths to break themselves up or become boring narrow banks. For almost two years, policymakers at the Fed and the Treasury, including Secretary Geithner, have offered bail-out after bail-out and asked for nothing serious in return.

Do I regret that Henry Paulson was not empowered to issue a blanket guarantee of bank assets early on, as the Swedes did? No, I don’t regret that at all. Why not? Because I think that “Hank the Tank” was a crappy negotiator, not only for taxpayers in a fiscal sense, but also for the economy and the polity more deeply. He would have offered the financial system sugar without requiring it to make the medicine go down. He may believe, quite sincerely, that a cure would be worse than the disease. He may believe that, but he is wrong. If we “get past this crisis” by restarting a consumer-credit-based, indiscriminate-investor-financed, current-account-deficit-making, income-inequality-expanding economy, we will have increased, not diminished, the likelihood of a major collapse.

You may believe that we have learned our lesson, that if we can just get some stability and comfort for a while we are prepared to do what must be done. That’s a respectable position. But I don’t share it, and neither do the majority of Americans who are unwilling to allow their representatives to sign off on any more expensive aspirin. We want value for value, an ironclad commitment of root and branch reform in exchange for the unimaginable sums of money we are being asked to hand over.

Surowiecki has in the past suggested that those of us who favor nationalization would criticize any alternative simply because it is not precisely the policy we advocate. But it is not we who have refused to compromise. We’ve seen variations on the same basic proposal over and over again. Geithner’s PPIP really does resemble Paulson’s TARP, besides the part about actually asking taxpayers for the money. Each latest plan from our incestuous cadre of economic Mandarins demands only symbolic concessions from the dysfunctional organizations we are asked to support. The “moderate” political class goes on and on about how Geithner and Bernanke have to go all Enron, funding the banks via off-balance-sheet guarantees and special purpose vehicles, because “populist, childish” Congress won’t put up the money. Setting aside how audaciously corrosive that sentiment is to Constitutional democracy, it is simply wrong. Congress would, because the public would, support large, explicit transfers, if they were attached to reforms sufficiently radical to prevent a recurrence, and suitably punitive towards the people who managed the system that brought us here. Value for value.

I am a true believer in American-style capitalism. So I would like to see people who earned profits lending to banks in good times bear the high costs of failing to monitor the organizations they funded. Investor fear is what is supposed to prevent the indiscriminate misuse of capital. To the degree that creditors have leaned upon “implicit” government guarantees, I think it would both be just and set a useful precedent if they were reminded that investors have to take responsibility for where they place the precious capital they steward.

That said, like Paul Krugman, I would be willing to hold my nose and tolerate a Swedish-style guarantee of bank creditors. I’d acquiesce to that even without formal nationalization. Nationalization is no one’s idée fixée. It is a means to an end, and the desired end is a world in which too big to fail is too big to exist for any financial institution that originates or holds credit risk in any form. Secretary Geithner could send a bill to Congress today that would put all banks with a balance sheet of over $50B into run-off mode, while clearing away legal obstacles so that larger organizations could arrange their own breakups over time. I’d fax my Congressman and support a $2T on-budget buyout of bank creditors as part of that bill, as long as it had teeth. (“Teeth” would include making sure that off-balance-sheet and derivative exposures were included in the size cap, etc.)

It’s not that us pitchfork-totin’ populists are unwilling to pay the bill. It’s that we want to know that in exchange for writing a very, very large check, the people that we are paying will actually deliver the goods. Given the behavior of bankers before the crisis and of shifty policymakers during, we have every reason to watch warily and to insist upon every precaution while we hand over suitcase after suitcase of freshly printed Federal Reserve notes.

Update History:
  • 28-Apr-2009, 1:20 a.m. EDT: Thanks to the excellent Nemo of self-evident fame for pointing out that I’d forgotten the tricky distinction between “to” and “too”. Fixed, I hope. From now on, I’m jus’ gonna write “2B2F”.
  • 28-Apr-2009, 2:40 a.m. EDT: imply include

Control without accountability

I’ve been unimpressed with this oft-quoted bit from Phillip Swagel’s insider account of the Paulson Treasury.

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word “force” is used as a verb (“the policy should be to force banks to do X or Y”), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

Today’s news (Clusterstock + source docs, WSJ Deal Journal, McArdle, Naked Capitalism, Calculated Risk, Marketwatch), that Henry Paulson, um, forced Bank of America’s near suicidal merger with Merill Lynch kind of clinches the case. Pre-Merrill, BOA was viewed as relatively healthy among large banks. What’s the statute under which a Treasury secretary unilaterally fires and replaces the board of a healthy bank? The Paulson Treasury talked up legal constraints whenever they were faced with something Paulson didn’t want to do. When Paulson, or Bernanke, really did want to do something, they were very creative about bending the law to their will. The Fed’s “special purpose vehicles” are clearly not lending in the sense that the architects of the Federal Reserve Acts “unusual and exigent circumstances” clause foresaw. The FDIC has no statutory authority to issue ad hoc guarantees of bank debt, but flexibility was read into the laws.

With respect to the banks, the Paulson Treasury could have forced any big bank into a bail-out or receivership scenario just by looking at it funny, or by having the Fed take a conservative view of bank asset collateral values under the special liquidity programs. It’s worth noting that Treasury very ostentatiously forced banks to accept TARP capital, and Geithner’s Treasury was able to persuade holders of Citi preferred to convert to common equity.

It’s not exactly right to say that our don’t-ask-don’t-tell quasinationalization policy has given us “ownership but not control”. An assertive Treasury secretary has tremendous leverage over zombie bank managers. Instead, what we have is is control without accountability. An informal, unauditable, hydra-headed set of private managers and public officials controls how quasinationalized banks behave. Neither taxpayers nor shareholders have reason to believe that decisions are being taken in their interest. The informality and disunity of control impedes the kind of hands-on, detail-oriented supervision and risk management that ought to be the core preoccupation of bank managers. Exactly as opponents of nationalization feared, America’s large banks are poorly run behemoths that routinely make idiotic commercial decisions to satisfy tacit political mandates. No one really knows who is responsible for what.

Ironically, there might be less scope for political control if banks were in formal, least-cost-resolution receivership. A bank that has already failed cannot fail. If independent boards are appointed to oversee the receiverships, politicians might have very little leverage. Incumbent private managers face collapse, sacking, disgrace, and potential civil and criminal liability for improprieties that come to light during the post-mortem. New moderately paid, high reputation board members would bear no responsibility for what came before, and could very publicly resign in protest if pushed to act in a manner inconsistent with their charter. (Resignation in protest by long-affiliated board members of a zombie bank would have different reputational consequences, and it would be difficult to recruit high-reputation outsiders to serve on zombie bank boards.) Promoting insiders or recalling retired executives to run zombie firms leaves the leadership weak and compromised. A much higher caliber of outside talent could be recruited to oversee banks in receivership than would accept responsibility for banks that are insolvent but on government life support.

This is not to say that formal public control would be a panacea. The list of public and quasipublic organizations currently being gutted by politically motivated credit expansion includes Fannie Mae, Freddie Mac, FHA, FHLB, FDIC, and the Federal Reserve system. A bank in receivership managed by a weak board or not institutionally segregated from political bodies could easily join the list. But if received banks were put under strong boards, and given clear mandates to divide and sell their assets (maximizing taxpayer value subject to a scale constraint) while running off their lending books, there would be little hazard of politically directed credit or other shenanigans. That would imply that large insolvent banks would reduce their lending, contradicting the Administration’s endless exhortations that banks should lend, lend, lend. My view is that public encouragement of expanding indebtedness is very bad policy (read Finem Respice). But if you misguidedly believe that “credit is the lifeblood of a modern economy”, the thousands of well-run smaller banks in America are fully capable of taking advantage of today’s deeply subsidized lending spreads to serve creditworthy borrowers. Whether in private or in public hands, the big, broken banks are simply too compromised to lend.

Contracts are not bilateral

Commenting on Nassim Taleb’s provocative agenda for fixing the world, Felix Salmon notes that

Looking at the rest of the list, how on earth do you stop the financial sector from… creating complex products? Derivatives are, at heart, bilateral contracts: how can you ban two consenting adults from entering in to such a contract?

The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements. The state is not, and cannot be totally neutral in its role as contract enforcer: Communication between contracting parties is always imperfect; the universe presents an infinite array of unforseeable possibilities; even very clear contractual terms can be illegal, repugnant, or contrary to the public interest. The state makes affirmative decisions about how it will (or will not) enforce the terms of contracts. Libertarians may have perfect freedom to contract, if their agreements are self-enforcing or voluntarily adhered to. For the rest of us, every contract is a negotiation between three parties, the two who put a signature at the bottom the document, and the state which will be called upon to give force to the arrangement when disputes arise or someone fails to perform. I think of contract lawyers as two-bit psychics in fancy suits. Much of their job is to channel the voice of the incorporeal Leviathan, so that its quirks and predilections are taken into account whenever agreements are drafted.

This has something to do with derivatives, but even more to do with one of Taleb’s broader concerns: debt. At present, the state enforces debt contracts by permitting lenders to force nonperforming borrowers into bankruptcy. That is not a natural or obvious arrangement. Bankruptcy evolved as an improvement over automatic liquidations or men with big necks and brass knuckles. It serves to balance the contractual right of a lender to be timely paid with a broader interest in preserving the overall value of enterprises and preventing extremes of immiseration. To some degree, bankruptcy lets debtors to escape the terms of their own agreements and limits the right of contract (though bankruptcy is onerous enough that debtors don’t seek this sanctuary easily). The fact that creditors’ rights are limited is socially useful: it encourages lenders to discriminate between good borrowers and bad, reducing the frequency with which resources are lent foolishly and then destroyed.

One thing I think that we are learning from the present crisis is that the logic of bankruptcy hasn’t been taken far enough. Creditors’ rights are too strong. Creditors have insufficient incentive to discriminate, especially when lending to “critical” organizations, because the bankruptcy that would attend a failure to pay is too disruptive and destructive to be permitted by the state. We have seen tremendous resources lent to banks thoughtlessly, and then squandered or stolen rather than carefully invested. Similarly, those who entered into derivative contracts often ignored credit risk when a counterparty was seen as too dangerous to bankrupt. If it were possible for borrowers and counterparties to welsh on their agreements without provoking consequences as disruptive as bankruptcy, creditors would have more reason to be careful of whom they do business with, and potential deadbeats (like large financial firms) might not be able to take levered risks cheaply.

I think that, going forward, the state will have to limit the right of creditors to enforce claims via bankruptcy. Creditors and counterparties who go to the courts would run the risk of simply having their claims converted into something like cumulative (and maybe convertible) preferred equity. This would ensure that no dividends are paid to stockholders until the disgruntled creditors are made whole, but would not otherwise disrupt the operation of firms or affect other claimants. (Such conversions could be combined with tight compensation limits, to prevent shareholders and managers from taking payouts as wages and bonuses while failing to pay creditors forcibly converted to equity.) Judges would weigh the rights of creditors against the costs to other stakeholders in deciding between formal bankruptcy and ad hoc conversions, so that the risk to creditors would increase with the size and interconnectedness of borrowers.

It may be hopeless to try to control what kind of contracts private parties write amongst themselves. But we can control how contracts are enforced. There is nothing natural or neutral about how we currently enforce debt contracts. We made up some procedures that seemed to work reasonably well. The current crisis has exposed some shortcomings. Nothing prevents us from modifying how we enforce contracts in order to improve the incentives of parties to manage their own risk, and to prevent collateral damage when private contracts come undone.

Update History:

  • 22-Jun-2016, 2:40 p.m. PDT: “the state will have to limit the right of debtors creditors to enforce claims by via bankruptcy.”; “run the risk of simply having their claims converted”

PPIP gaming in a nutshell

Divide the world into the consolidated financial sector and taxpayers. Under PPIP, each dollar a “public-private investment fund” overbids provokes a net transfer to the consolidated financial sector from taxpayers. The size of transfer to the financial sector increases with the degree to which bids are overpriced, and is maximized if the true asset value is very small relative to the price actually bid. If an asset is worth $6 dollars, and financial sector actors purchase a contract for $7 while the Treasury invests alongside, the consolidated finacial sector gains a dollar. But if financial sector actors pay $70 for the same asset, the financial sector would receive a net transfer from taxpayers of up to $118. (For more detailed arithmetic, see below.) The more financial sector actors are willing to overbid, the greater the net transfer from taxpayers to the financial sector. In theory the scale of the transfers is limited only by the quantity of asset purchases the government is willing to guarantee.

There are problems with this story. In real life there is not a consolidated financial sector, but a lot of different players who are usually in the business of competing with one another. PPIP includes rules and tools by which the government could prevent the use of taxpayer money to fund overpriced bids, and ensure that the parties who take small losses are distinct from the parties who make large gains, eliminating incentives to overbid. An important question is whether the government genuinely wishes to prevent backdoor transfers to the financial sector, or views such transfers as a desirable means of helping core financial institutions. (See Joe Weisenthal and Noam Scheiber)

It is worth noting that overcoming coordination problems so that diverse parties can collaborate on profitable ventures is precisely what the financial sector is supposed to be good at doing. Ideally, we would like the profitable ventures to be welfare-improving projects in the real economy, but there is little question that financial sector actors will gladly apply the same skillset to extracting transfers and rents when the opportunity presents itself. Attempts to regulate away intentional overbidding by cooperating parties will have to outwit some very clever professional deal makers.

A few more caveats — financial sector actors do pay taxes, so they are not distinct from the taxpayers from whom transfers are made. Qualitatively, this overlap would’t change the story very much. (Quantitatively, it’s interesting, you’d have to think hard about the realizability of “deferred tax assets” from losses the financial sector would absorb without the transfers.) The numbers I’m using are for the PPIP whole loan program. The degree of nonrecourse leverage that will be provided by the Fed towards the securities purchase program is as far as I know unspecified.

Some links:

There are way too many good links on this issue, but rortybomb’s take is my all-time fave.

Restricting to the last 24 hours or so, see also Scurvon, Carney, Sachs, Nemo, Krugman, Free Exchange, Felix Salmon, Economics of Contempt, and Cowen. See also articles in the Financial Times (ht Conor Clarke, Calculated Risk) and the New York Post (ht Yves Smith). As far as I know, Karl Denninger is the first person to have pointed out the potential for gaming. My first take on this issue is here. Mish has a very similar take (here, here, and here). I’m sure I’ve left many great posts out of this linksplatter. My apologies to the unsung pundits.


Case 1: A private fund buys an asset for $7, but pays only $1, as the rest is borrowed from the bank via an FDIC guaranteed loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6. The private fund loses its dollar, but this becomes a gain to the selling bank, causing neither a loss or gain to the consolidated financial sector. However, the Treasury also loses a dollar, which becomes a gain to the selling bank, and amounts to a transfer of $1 from taxpayers to the consolidated financial sector.

Case 2: A private fund buys the same asset for $70, of which it pays $10 cash and borrows the rest on an FDIC guaranteed nonrecourse loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6, so each purchase amounts to a transfer of value to the bank of $64 dollars. When the value becomes known, the FDIC (indirectly) accepts the $6 asset in exchange for $60 of loan extinguishment, bearing $54 of the private investor’s $64 loss. The net effect of the private investment is a transfer of $54 from taxpayers to the consolidated financial sector. Taxpayers bear the full loss of $64 on the Treasury’s investment. So the total transfer fronm the public to the private sector is $118.