Saturday, September 19, 2009

Saturday Reading Pleasure

I’ve never been sure what to make of Geithner: For the most part, in my scathing critiques of Bernanke, Paulson and other government employees, I have assumed that Tim Geithner was part of the problem as opposed to the solution. I assumed that his position at the New York Fed and the fact that Citigroup asked him to be the CEO at one point meant that he had been captured and corrupted by the banks too. But, I was always unsure if he deserved to be included in the “controlled by Wall Street” crowd. The reason this is pertinent now is that Geithner has recently released some suggestions regarding reforming the financial system that on the surface look a bit anti- big bank and anti-Wall Street. From the Washington Post:

Geithner's principles make sense -- but perhaps too much sense. In summary, they are:

(1) Capital requirements should be set to protect the financial system as a whole.

(2) Capital requirements should go up, especially for systemically important financial institutions.

(3) Banks should be required to hold high-quality capital.

(4) Risk-based capital measures should accurately measure risks.

(5) Capital requirements should be countercyclical, not pro-cyclical.

(6) There should be a flat limit on leverage.

(7) Regulators should monitor bank liquidity, not just solvency.

(8) Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability.

I have to admit that it makes me uneasy to agree with Geithner but the severity of these proposals is a pleasant surprise. I am shocked that he would even hint that a flat limit on leverage should be implemented. The problem of course, is that the white paper in which the above recommendations emerged from does not include specific numbers. If the cap on leverage is too high or can be jumped over through the use of derivatives then it is likely not to do any good. Or if the definition of high quality capital includes formerly AAA subprime RMBS originated by Countrywide then the entire requirement would be a sham. This is America and everyone is assumed innocent until proven guilty. So I will give Geithner the benefit of the doubt until we see some concrete numbers. But, as the author of this piece points out, the devil will be in the details:

The problem is that without numbers, which are missing from the white paper, these are all platitudes, most of which would have been accepted (except No. 2) even before the financial crisis. There is little if any opposition from the banking lobby to proposals on this level. And if there is no opposition, that is a good indicator that regulatory reform is not going far enough. (Emphasis mine)

Leverage may be down, but asset concentration is up: Hat tip to The Pragmatic Capitalist for posting this link from Newsweek. The author points out how much leverage increased from 1990 to 2008, especially when you consider off balance sheet commitments and derivatives.

Between 1990 and 2008, according to Wall Street veteran Henry Kaufman, the share of financial assets held by the 10 largest U.S. financial institutions rose from 10 percent to 50 percent, even as the number of banks fell from more than 15,000 to about 8,000. By the end of 2007, 15 institutions with combined shareholder equity of $857 billion had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion—a total leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion. These firms had once been Wall Street's "bulge bracket," the companies that led underwriting syndicates. Now they did more than bulge. These institutions had become so big that the failure of just one of them would pose a systemic risk.

Last year's crisis made this problem worse in two ways. First, it wiped out three of the Big 15: goodbye Bear, Merrill, and Lehman. Second, because the failure of Lehman was so economically disastrous, it established what had previously only been suspected—that the survivors were TBTF, effectively guaranteed by the full faith and credit of the United States. Yes, folks, now it's official: heads, they win; tails, we the taxpayers lose. And in return, we get … a $30 charge if we inadvertently run up a $1 overdraft with our debit card. Meanwhile, JPMorgan and Goldman Sachs executives get million-dollar bonuses. What's not to dislike?

Yes, some Wall Street firms have since de-levered a bit and this is unambiguously a good thing. However, we have seen so much industry consolidation that the assets and liabilities are now concentrated in fewer hands. This of course leads to higher counterparty risk and could turn another liquidity squeeze into an all out collapse. I know the market is up and we have seen signs of improvement in the financial system. But, the risks that existed before the crisis and caused the meltdown seem almost as severe now as they did previously. We need some kind of reform and resolution authority for failed financial institutions quickly before there is another unexpected shock to the system. Even with the government propping up the markets I don’t want to find out if that support is sufficient to prevent a calamity.

Chinese rhetoric regarding US dollar policy is getting stronger: Hat tip to The King Report for posting the link to this article in the Telegraph. We hear the question all the time of what China will do with its huge reserves if it loses confidence in the dollar. So far it looks like they are buying assets in the earth; in other words, those that can’t be created by a printing press. China is clearly in a bind. If they trash the dollar the value of their holdings decline. But if they don’t speak up and the Fed creates massive inflation then the value of their holdings drops as well. What is obvious is that the Chinese have begun to try to diversify their portfolio of assets. If you listen to Eric King and the guests he has on each week, they believe this shift by China will be great for gold, silver and rare earth metals. As for me, I just worry that the argument that the US is deeply in bed with China so they have to keep buying our debt is far from convincing:

After years of selling cheap goods to debt-fuelled Western consumers, China now has $2 trillion dollars of foreign exchange reserves. That's 2,000 billion a reserve haul no less 25 times bigger than that of the UK. American leaders have relied on this Catch-22 for some time, guffawing that China is in so deep it has no choice but to carry on "sucking-up" US debt. But Beijing's Communist hierarchy is now so worried about America's wildly expansionary monetary policy that it is speaking out, despite the damage that does to the value of China's reserves.

Last weekend, Cheng Siwei, a leading Chinese policy maker, said that his country's leaders were "dismayed" by America's recourse to quantitative easing. "If they keep printing money to buy bonds, it will lead to inflation," he said. "So we'll diversify incremental reserves into euros, yen and other currencies". This is hugely significant. China is now more worried about America inflating away its debts than about those debts being exposed to currency risk. Economists at Western banks making money from QE still say deflation is more likely than inflation…they are talking self-serving tosh.

Long live transparency, whatever the cost may be: In this missive by Jonathan Weil of Bloomberg he argues that knowing the truth about bank solvency and the value of bank assets is worth the risk that more financial institutions fail. My own personal view is that we are fighting to protect our entire financial system and maybe even long term economic prosperity. If we decide to extent and pretend we risk sowing the seeds for another, even more calamitous cycle or having decades of stagnation like Japan. The clearest path toward avoiding those undesirable outcomes is through honest accounting and transparency, regardless of what entities go away in the cleansing process. Creative destruction is a very powerful process and is a cornerstone of a capitalist system. I have faith that from the ashes smarter and more flexible institutions will rise to power. But, if we don’t allow the sick and mismanaged companies to die, all we are doing is prolonging the acute pain and the return to legitimate (i.e. not Fed induced) wealth creation. Amen.

Rather than trying to convince the public that insolvent banks are healthy, through easy-to-pass “stress tests” and other gimmicks, he should direct their officers and directors to come clean about their numbers or else face prosecution. The risk, of course, is that if the bankers fess up, more banks may fail, bringing fear back to the markets.

That is a chance we must be willing to take. Until we start letting companies that deserve to fail actually fail, we will not have transparency and accountability in our markets. Instead, we’ll be setting ourselves up for exponentially larger meltdowns that in time may outstrip the government’s resources to deal with them.

Communiqués from G20s soirees are nothing but fancy posturing: In his blog this week Simon Johnson of the Baseline Scenario tries to set reasonable expectations for the upcoming G20 meeting. He argues that no country has the intestinal fortitude to take on the banking oligarchy, especially now that financial markets have reversed so dramatically. Unfortunately, this inertia will serve to either limit or eliminate the possibility of necessary financial reform. The consequence of all of this? Simply that we haven’t done anything to mitigate the risk of another financial collapse that will again leave the banks whole and the taxpayer with holes in his pockets.

What should we expect from the Pittsburgh summit on September 24-25? “Nothing much” seems the most likely outcome. The leadership of industrial countries does not want to take on the big banks, and the technocrats have contented themselves with very minor adjustments to key regulations (“dinky” is the term being used in some well-informed circles.) The G7/G8/G20 is back to being irrelevant or, worse, mere cheerleaders for the financial sector.

Overall, the global economy begins to recover, but the crisis created huge lasting costs for many poorer people in the US and around the world. Recovery without financial sector reform and reregulation sows the seeds for the next crisis. The precise timing of crises is always uncertain but the broad contours are clear – just like many emerging markets over past decades, the US, Europe, and the world economy look set to repeat the boom-bailout cycle. This will go on until at least until one or more major countries goes completely bankrupt, or until a real financial reform movement takes hold either among technocrats or more broadly politically – and the consensus then shifts back towards the kind of much tighter financial regulation that was established after the last major global fiasco in the 1930s.

Joe Nocera on the importance of executive compensation: In this piece, Nocera of the NY Times makes an interesting point. Prior to the current economic crisis, the idea that corporate executives were overcompensated applied (without specific categorization) to all industries. Previously, it was a problem within the entire system. But now we have seen that concerns should be more nuanced. If the execs at Circuit City were paid too well or incentivized to take unreasonable risks, the potential downside to taxpayers was nil because the company could file for Chapter 11 without impacting the broader economy. Yes, shareholders, bondholders, suppliers, and employees would be hurt. But, the failure of Circuit City would not affect the well being of millions of people. On the other hand, when financial company executive are overpaid and incentivized to take undue risks, the taxpayer and the financial system as a whole become the victims of the inevitable fallout after the firm goes bust. Accordingly, I would argue that it is significantly more important to get the compensation of these financial execs aligned with the interests of shareholder AND taxpayers than it is to do the same for non-Wall Street or banking firms.

Until the financial crisis, most people, myself included, did not make distinctions between different kinds of companies when it came to executive compensation. It was just one big problem, revolving primarily around the idea that there was something fundamentally wrong about executives taking home giant, multimillion dollar pay packages for mediocre performance or even outright failure — something, alas, that happens with annoying regularity in corporate America.

But if the near collapse of the financial system has taught us anything, it is that there should be a distinction. On the one hand, there are companies whose executives can make awful mistakes, even driving their corporations into bankruptcy, but whose actions have little or no effect on the rest of us. Most companies fall under this category.

And then there are those handful of companies — the too-big-to-fail banks and other large financial institutions that pose systemic risk — whose failure can wreak devastating havoc on the economy. For these latter companies, getting compensation right isn’t just a matter of fairness or improved corporate governance. It turns out to be critically important if we are to prevent a repeat of the calamity that has befallen us.

(Picture courtesy of