Friday, April 30, 2010

George: The Drama

Monday, April 19, 2010

Size Does Matter!

I love Paul Krugman. He outlines ideas and thoughts in easy-to-understand posts and op/eds and I've come to believe in the things he says easily and readily. He's nearly always right (as Brad DeLong says, "Rule #1 Paul Krugman is always right. Rule #2 - If you think Paul Krugman is wrong, see Rule #1). However, with all that said, I have a huge problem with his current tack on Financial Regulation and I definitely think he's wrong on his thinking about size.

Krugman believes that Too Big to Fail is not the most pressing regulatory issue, in the strictly asset-size sense. He thinks a cap on the absolute size of banks isn't necessary nor is it a key to successful Financial Regulation moving forward. In saying this, he's disagreeing with Paul Volcker and Simon Johnson, both incredibly intelligent economists in their own right. So I have a bit more comfort disagreeing with him because I believe size caps are a key to successful FinReg. In fact, size caps are just as important as limiting the predatory actions of the shadow banking sector, reducing opacity in financial products and so on.

The main reason Krugman isn't a big proponent of limiting banks' absolute size is because he doesn't view size as a major cause of the '08 crisis. He does admit that huge banks have stronger lobbying arms and are more dangerous in this way because they get to influence (or even write) legislation, but he also points out that the failure of hundreds of small banks can be just as damaging to the economy as the failure of a large bank.

Well, my response to that is, "What will happen if a bank that controls assets equal to 60% (or more) of GDP fails?"

After all, even if this hypothetical behemoth is the most regulated bank in history, subject to strict leverage limits, tougher legislation and daily government inspection, that doesn't guarantee it won't fail. We had strong legislation and regulations in place from the New Deal until 1980, and while the New Deal limited bank failures to just a handful between 1936 and the '80s it didn't eliminate them completely. There were still a handful. But FinReg also shouldn't completely eliminate bank failures anyway -- that wouldn't be a free or competitive market and it would create an implicit moral hazard in bankers as well.

So, does Krugman think the current legislation would achieve the complete elimination of bank failures and, does he think that's what we should be aiming for?  Or does he not think that a bank so big it's larger than our current GDP won't be a problem if (or when) it fails?

My guess is he doesn't believe any of those.  I think he's fallen into the trap of looking backwards at the '08 crisis and trying to fix the causes of that particular mess but only that particular mess (perfectly forgivable as he's been so close to the collapse; writing about it and talking about it since it happened). But what Krugman's failing to see is that proper legislation should not just be backward-looking, but forward-looking as well. As it currently stands congress has a chance to lay down rules and regulations 'post-crisis' that fix what caused this 'forseeable' panic. But they also have a chance to lay down rules and regulations that provide buffers for non-forseeable, future financial crises as well.

There are unknown unknowns out there (Taleb's Black Swans if you will) and there will always be unknown unknowns out there, so if we allow a bank to grow to such a size that the government can't perform an FDIC-style takeover because the bank is larger than the government itself (a la UBS in Switzerland), then we're just opening ourselves up to Black Swans.

I think someone needs remind Krugman of this.

Wall Street's Party

Well, you can scratch what I wrote in the last post. Turns out the Republicans are definitely going to carry Wall Street's water. I think what's most amazing to me about this is the type of mental (and moral) gymnastics Mitch McConnell, and his fellow 40 Senators, have to go through to actually pursue this strategy.

First of all they know America and Main Street are against the bailouts and angry at the banks. So the only way McConnell can defend Wall Street (and protect his hedge fund pals) is to paint FinReg as some sort of favor to the banks. In fact, he called it a 'permanent bailout' (and Matthew Yglesias notes that John Boehner joined the nonsense later as well).

Similarly, the banks are also going through some shameless moral gymnastics of their own. They know they're Public Enemy #1, but by enlisting McConnell's help it's obvious they don't care. They're happy to let McConnell disparage them to the taxpayers as long as they can keep fleecing the taxpayers.

I'm not sure if McConnell thinks the rest of the country is dumb enough to swallow this, but all-or-nothing strategies (see: Republicans, blockade of health care reform 2010) is the only way the GOP is playing these days. I guess we'll see how this strategy turns out for them in November.

Thursday, April 15, 2010

Adventures in Journamalism

Graydon Carter, editor of Vanity Fair and self-professed libertarian, opens the May issue of VF with an essay that's critical of President Obama. His essay is just wrong in so many ways.

VF is a fantastic magazine and I love most of the work they do, but Carter's opening  op/ed is terrible and misinformed.

He writes:
... the sense of disappointment among [Obama's] Democratic supporters is growing. Many feel that he took a wrong turn right from the beginning on the domestic front, i.e., that rather than work on the economy, jobs, and bringing the nation's rogue banking system to heel, Obama stuck his hand in the same woodchipper (universal health care) that Clinton did during his first term, and expected a different result. In trying to bring affordable health care to all Americans, Obama was going for the history books more than for the 24-hour news cycle. And there was something admirable in that. But here's the thing about America and universal health care: unlike in other Western democracies, not all of its citizens want it.
My guess is that the president is a slider-that is, someone who slides through life. When you're that good, that handsome, that educated, the world in your adulthood is your oyster ... My guess is that he's like a clever student who writes well and figures he can bull his way through an assignment for which he hasn't really done the dogged groundwork ... The administration overreached and underprepared. 
Now, granted, Carter obviously wrote this editorial before the historic health-reform bill passed, but that's not the major mistake in his editorial.

He's clearly asserting that Obama should have 'focused' on the economy, jobs and bringing the financial system to heel rather than dither about on health care reform.  My answer to Carter on the first two issues would be: Did you forget the $700 Billion stimulus package Obama passed three months into his term? WTF?

I'm not sure how Carter can overlook the stimulus, unless of course, he's doing it willfully. But if not, what did he think the stimulus program was for? Fixing health care?

Fiscal stimulus is a rare program and one that's heavy on spending is even more rare. But it passed and it has, so far, done what it can to turn around the economy. I daresay Obama, and his administration, were focused on little else but the economy and jobs during their first four months in office.

The fact that the stimulus wasn't big enough, that Obama's economists underestimated the depth and breadth of the recession or that Obama himself watered down the bill in a pointless attempt to get Republican votes (none voted for it anyway) are all legitimate gripes. But complaining that Obama focused too much on health care rather than the economy is hogwash. Absolute hogwash.

As for the second issue? Well, it's true that Obama may have put financial regulation on the back burner to focus on health care. It's also true that there was growing sentiment that a chance at 'real' reform was slipping away the further the economy moved from the financial crisis -- that banking regulations were losing 'centrality' in voter minds. But even that might not be the case anymore. Senate Republican leader Mitch McConnell took to the Senate floor this week and, in an unashamedly pro-banking move, proclaimed that any legislation directed at regulating the banks should be voted down. McConnell was lambasted by his hometown newspaper for his shameless antics, and couldn't rally his fellow GOPers to oppose FinReg.

So it seems, quite rightly, that the Republicans realize how suicidal it would be for them to carry Wall Street's water the way they normally do. Which means there's more than just hope for meaningful financial reform, there's actually a pretty good chance meaningful financial reform will pass.

So can we expect a mea culpa from Carter in the June issue of Vanity Fair?  Will he apologize and say, "During Obama's first year in office he managed to pass an economic recovery package that, although too small, still kept unemployment below 11- or 12%. He also pushed through a historic health care reform bill, and now stands on the verge of meaningful financial reform."?

I'm not holding my breath.

Saturday, April 10, 2010

Depression, Double-Dip Recession or Lost Decade?

Over at Naked Capitalism last week, there was a guest post by Gonzalo Lira, a Chilean novelist, comparing the "extend-and-pretend" situation we're currently facing with the big banks to the "extend-and-pretend" plan Paul Volcker instituted in 1982 during the Latin American debt crisis.


Lira makes the point that the banks' balance sheets are in horrible shape, which they are, but at the same time, I think he's overstating the size of the holes.  Lira's post is decidedly gloomy, and it doesn't seem to square with all the positive news coming out about the economy last week. So I decided to take a look at Lira's claims.


After my examination, I think I decided that his doomsday claims have some merit, but not overwhelmingly so.  However, I also think the recent spate of positive news should be tempered.


To begin with I looked at Lira's claim that the suspension of mark-to-market accounting standards has made the bank balance sheets completely fictional.  With the news about the repurchase agreements Lehman, BofA and, more likely than not, the rest of the bulge brackets were using, it's quite possible their financial reporting is completely fictional.


But I proceeded with my analysis as if there was some semblance of truth to them (and I figured WellsFargo was the best barometer for that, as they're less like the bulge brackets than the other major banks).  


How did I start?  Well I went back to the stress tests and Mike Konczal's post where he pointed out that the four biggest banks (Citi, JPMorgan, BofA and Wells Fargo) had a combined $477 billion in subordinated loans (2nd Liens) on their books. The government stress tests estimated losses on those loans to be in the 13-15% range, but Konczal pointed out that they were essentially worthless because they're nearly all underwater.  And recent revisions to the stress-test estimates are now raising those estimates significantly. 


For the sake of this argument, I assumed there was at least some salvage value in those loans -- and if home prices rise a little in the recovery, perhaps some can be salvaged.  So I went with Konczal's worst-case scenario that puts losses on those loans at 60%.  That means the big four have to write down $286 billion on those loans. 


Well, contrary to Lira's claim, the banks actually have started writing off and writing down those loans.  In fact between the stress tests and their 2009 10K filings (9 months), they wrote off a combined $43 billion (Citi, BofA and Wells Fargo all wrote off about $8 billion and JPMorgan wrote off $17 billion).  Again, this all assumes that those loans weren't simply shifted off balance sheet.  And, in fact, some of the expensing on the banks' income statements reflects provisions for bad mortgage debt, so it would appear they're trying.  


What's troubling, however, is that even if they're being completely truthful, at their current prorated pace of write-downs ($64 billion annually) it will still take them more than 3-years to shed it all (and that's if the losses on those 2nd Liens are, at max, only 60% and that they'll be able to maintain their current rates of profit-making).


Which brings me back Lira's post. He mentioned that extend-and-pretend will only last as long as the banks can earn profits in the environment that has been artificially created by the Fed (this environment was best documented by Tyler Cowen). It's a statement with which I agree, because I don't believe the "artificial" environment will last for another 3-years. So it looks like the banks are, and will be, back in trouble at some point in the future, but I'm not sure that validates the belief in another, imminent crash either.  


Lira predicts a coming Great Depression but I don't believe the situation is that dire.  Are we looking at a "double-dip" recession? Quite possibly. But it's also possible we're looking at a Japan-style "lost decade" where the banks need ten years or more to write-off the bad debt on their books (this coming on top of the 2000s which were already a lost decade shouldn't make anyone happy, however).  


There is stability in the overnight markets, the banks have avoided a crash, and they are (slowly) earning their way out of the hole. What it all means is that a crash likely won't happen again, but we'll probably see a lot of the same as what we saw through most of 2009 and the first quarter of 2010 -- businesses not being able to get credit, slow-to-meager GDP growth and high unemployment.


This is because the banks' most likely route to profitability -- which also seems to be their current core competency -- is through trading operations, not through long-term, small-business loans (when Yves Smith waded into the comments of Lira's post, she pointed this out by saying, "The equity markets are heavily manipulated right now -- I hear this from virtually every institutional investor I know, including ones at the top of large and respected firms.")


Well of course the equity markets are flooded with cash.  The debt markets are flooded as well.  The major banks don't appear to know any other way to earn short-term profits large enough to cover the holes in their balance sheets.  Which is why we're likely facing a lost decade.  The banks won't begin to properly loan to a credit-starved economy until they fix their own internal finances -- which could be at least three years away.

Friday, April 9, 2010

Cut the National Endowment for the Arts!

I don't surf into RedState.com that often, but it's a useful tool for checking out the pulse (if you can call it that) of the "intellectual" side of conservatism every once in a while.

Went there today and the first post on the page was a post about a Value-Added Tax. I won't get into the pros and cons of VATs since I haven't studied them enough to form a valid opinion... yet. But that's not the most illuminating part of the post.

Here's what is:




Bernanke argues that Americans need to choose between higher taxes or massive cuts in critical government programs. He mentioned Social Security, Medicare, Education and Defense as areas of government spending that would be targeted if we don’t raise taxes. This is a false choice. The federal government needs to reform entitlement programs, needs to root out waste fraud and abuse and should eliminate programs like the National Endowment for the Arts.
Brian Darling is basically reiterating exactly what Bernanke said... almost to the letter! He says that what needs to be cut is 'entitlement spending' which is exactly what Social Security, Medicare, Medicaid and the ACA (once it goes into effect) are.

These are popular programs. They're not likely to get cut anytime soon. In fact, it's unlikely they'll ever be cut. Which brings us to the crux of the Republican party's current problems with economics... they want to cut taxes but when they get into office they realize they can't cut government spending because nobody wants to cut the "entitlement" programs that make up the largest bulk of government spending.

However, not satisfied with completely disagreeing with Bernanke by totally agreeing with Bernanke, Darling then advocates cutting the National Endowment for the Arts, a program that receives nothing but scorn from the right. But our dear Darling fails to mention that the NEA's budget for 2010 is $161 million, while the Federal Budget is more than $3.6 trillion.

Let's put that into perspective: The NEA constitutes 0.00042% of the federal budget.

Let's further put that into perspective: Cutting the NEA would save the taxpayer approximately 74 cents in annual taxes.

But let's be completely fair to Darling, who no doubt sympathizes with the richest Americans -- those poor souls who are most frequently raped by the government. Let's be fair to him by hypothesizing that the NEA's entire annual budget is taken directly from the most blighted of US citizens -- those unfortunate enough to be cursed CURSED! with the burden of being wealthy in the United States.

If we imagine that every household in the country earning more than $100,000 per year (approximately 17-million households) bear the direct burden of funding the NEA every year, then we could save those poor, wealthy bastards nearly $9.42 per year by cutting it!

$9.42 is nearly two Venti Starbucks Lattes! Think of the children! Oh won't you please think of the children!

Alright, I'm rambling... but we really shouldn't overlook how neatly Darling summarizes the conservatives' stance on social issues, their economic ignorance and what has to be viewed as the complete intellectual collapse of the modern Republican party all in one paragraph.

To recap this amazing accomplishment:

Ben Bernanke said, "Americans need to choose between higher taxes or massive cuts in Social Security, Education, Medicare and Defense."

Darling replies, "No, Bernanke is wrong! Americans need to choose between higher taxes or massive cuts in Social Security and Medicare. Oh, and also... the NEA needs to go."








Monday, April 5, 2010

Greenspan vs. Burry

Michael Burry (of Big Short and Scion Capital fame) wrote an op/ed in the NY Times that was highly critical of Alan Greenspan. In it Burry wonders how, and why, Greenspan couldn't see the housing bubble coming -- which are fair questions. And it would be fine if Greenspan let it die there, since his reputation is already in tatters, but the former Fed Chairman digs himself in deeper (video below).
By claiming Burry's a statistical anomaly and saying Burry (and others) got lucky, Greenspan's defending himself like a six-year-old; a six-year-old who doesn't realize that the fact that he was wrong is not as important as recognizing his wrong-ness so it can be addressed -- something that ensures future mistakes don't happen again.
I think it might help if someone reminded Greenspan that Irving Fisher salvaged his reputation after he was colossally wrong about the 1929 crash. And in the process of recognizing and addressing his mistake he helped shape future policy.

Saturday, April 3, 2010

Treasury Profits

Felix Salmon is a financial / econoblogger over at Reuters and I must admit that I usually agree with most of what he writes. However, he's got an anti-nationalization position that he's still holding on to (and defending), even though evidence has moved against him.
He gave an interview to BNN recently and in it, he said the current profit of the Treasury's investment (bailout) in Citi is vindication of the anti-nationalization screed he wrote in October of last year. In his October post he said the government stress-tests proved the banks didn't need to be nationalized, which was a major weight-bearing leg of his anti-nationalization platform. However, that leg's been chopped off and can no longer be used to defend any anti-nationalization stance he takes (and I think he knows this, so why would he link back to that October post now?)
Let's see where else he went wrong... he also claimed (back in October) that the fallout from nationalizing the big banks would have hurt the Obama Administration's chances of passing Health Care Reform, but what support did the administration get from pro-banking Republicans after NOT nationalizing the big banks? And now that the administration has NOT nationalized the big banks, what further help can they expect from conservatives on FinReg and environmental legislation? None is a pretty good starting -- and ending -- point, if you ask me.
Again, this was another supporting leg of his anti-nationalization platform in October of last year but, like the stress-test leg, was chopped off, which means he shouldn't still be linking to that October post or pushing his anti-nationalization beliefs.
The other two legs of his platform rest on questionable views which deserve further scrutiny as well. The first is that it's okay for the FDIC to dismantle failing and insolvent small banks but it's not okay to do the same to failing and insolvent big banks. Nationalizing a big bank is not any different than how the FDIC breaks up small banks so how can he justify one but not the other? Sweep away that third leg if you want to, but for the sake of argument I'll be nice and leave it standing.
Which brings us to the fourth and final leg. He made the point that since the Treasury's stake in Citi had moved into the black by $7 Billion the Treasury should get out of the trade and get their money back. He felt that by leaving the money in any longer they were simply speculating and he was using the profits of the trade as a final justification for not nationalizing the big banks. This is a really important point because it gets at the real flaws in Salmon's thinking. He's viewing the Treasury as if it's a for-profit organization, but it is NOT a for-profit organization with a fiduciary duty to "maximize taxpayer wealth" in the same way a corporation has a fiduciary duty to maximize stakeholder wealth.
Instead the Treasury's duty is to protect taxpayers from economic collapses, bank runs and financial crises... in short their duty is to foster and create an environment that's conducive to "maximizing taxpayer wealth" through for-profit ventures. So Felix is wrong when he claims the Treasury should get its money out now that it's in the black. After all, they shouldn't be looking to maximize their returns, they should be looking to stabilizing the economy. And since Felix got his wishes and Obama and the Treasury went the anti-nationalization route, then he (like the Treasury) should stick to his guns and push for recapitalizing the Death Star as quickly as possible so that taxpayers can get back to enjoying a free, fair and productive economy. If he believes not-nationalize was the right way to go, he should also realize that the current profitable position the Treasury holds in Citi should be used as a capital buffer and loss reserve to write down the 2nd Liens chewing a hole in its balance sheet. If the Treasury does anything else (like take their profits now, for instance) all they'd be doing is forcing our largest bank to hold losses on its books, a la Japan during their lost decade. Believe me, I'm wholeheartedly for nationalization when a huge bank is on the brink of failure, but I also realize it isn't going to happen, so isn't it in the better interest of the taxpayers that Citi take the Treasury's money and use it productively? If the Fed wants to create a fair and equitable environment for helping taxpayers grow wealth then they also have to realize they're in a race against time because the gruesome way they're recapitalizing the the banks now is a scheme that isn't sustainable.

Thursday, April 1, 2010

What's the Yield Curve Signaling?

Paul Krugman recently put up a post arguing against inflationary fears by stating that, because we're up against the zero-bound on short-term rates, the yield curve is not currently pricing in inflationary expectations. Since long term rates can't be negative, the yield curve has to be upward-sloping. Jake, over at Econompic followed up Krugman's post by running a simulation which further highlighted that yield curve steepness is also a result of being up against the lower bound.
I agree wholeheartedly with them that inflation fears aren't currently priced into the yield curve, but both of them missed the chance to point out other reasons for a steepening yield curve.
First of all, they both assume rates reflect future expectations. And, of course, they do to some degree, but not in totality.
Institutional investors purchase treasuries with specific yields to match maturities on expected redemptions, payouts etc.
Liquidity Preference Theory also plays a big role in the yield curve and I imagine there's a wide swath of investors out there who want a more liquid, short-term investment rather than hold the long bond. Why? Well, with signs (generally) pointing to some sort of recovery, investors don't want to get locked into long-term, low-yield treasuries if they feel a better return in emerging markets (for instance) is just around the corner.
I must admit that Pure Expectations Theory is the most widely-held view of why the yield curve is shaped the way it is and why it's steep or flat. But, in reality, there has to be accounting for the other two theories as well... and all three can be used to combat the inflation hawks.