I have written extensively about how I believe the bank bailouts were the worst of all possible solutions – fixes that perpetuate too big to fail, moral hazard and crony capitalism.  That ship has sailed, but the questions still linger – in large part because the fix has not trickled down to common folk to better their lot.  Rising unemployment is but one demonstration of this.

Arnold Kling writes a post that goes beyond banking to AIG, mortgages and Fannie and Freddie. He offers real world solutions that don’t require creating special resolution authority, buying toxic assets or orchestrating bailouts.  While there would certainly be costs to these solutions as well, they would be far less than what we are paying now.

The interesting bit is he proposed them in the moment when the bailouts were ongoing. Don’t let anyone tell you that there weren’t other options available because there were in spades.

1. Existing Mortgages and home owners.

Actual policy: attempts to implement loan modification programs

My policy: pay the moving expenses of homeowners who default on their mortgages. But do not interfere with the foreclosure process.

2. Mortgage Markets

Actual policy: keep Freddie Mac and Fannie Mae going, and we now have 90 percent of mortgage loans made by federal agencies.

My policy: Limit Freddie Mac and Fannie Mae to their existing book of mortgage loans (I wrote this in September of 2008) and not allow them to purchase any new mortgages. Let banks take up the slack in mortgage lending.

3. AIG

Actual policy: creditors bailed out 100 percent.

My policy: Send in a "stern sheriff" to protect the liquid assets of AIG from creditors making "collateral calls." I was thinking of a government-suggested mediator, perhaps a former bankruptcy judge. If the parties did not like it, they could go to court. But my guess is that the parties would have preferred a mediated solution.

4. Big banks

Actual policy: bailouts of nearly all of them

My policy: Triage. Shut down the ones that have clearly failed, using FDIC procedures. Those that are clearly solvent should be allowed to proceed. Those that are neither clearly failed nor clearly solvent should be given forbearance, but with tight supervision to ensure that they do not use this forbearance to expand their risk-taking. Again, this was what I advocated in September of 2008.

Why proposals of this sort were not followed is the subject of much debate.

Source

Was TARP Necessary? – Arnold Kling

Related posts:

• Fannie, Freddie to get $15 Billion from U.S. government
• Federal takeover of GSEs now in the works
• A quick note on corporate bankruptcy and bailouts
• Treasury to Consider Further Measures to Halt Housing Slide
• Dean Baker: I saw this scenario in 2002

Video embedded below.

See also Democratic Rep. DeFazio Calls for Geithner and Summers to Be Fired – Yves Smith

Related posts:

• Geithner testifies before Congress on financial reform
• Weekend Video: A Conversation with Tim Geithner at CFR
• Geithner is open to suggestions
• Did Tim Geithner blow it?
• How did economists get it so wrong (parody version)?

Hat tip Rolfe Winkler.

Related posts:

• Steve Keen and the spectre of terminal debt
• Steve Keen: On the Edge with Max Keiser
• Bloomberg News is still after the Fed for more disclosure
• Dilbert on the asset-based economy
• What does Mises say about trying to stimulate the economy out of recession

After a huge fall off in credit consistent with the fall in nominal GDP, we are seeing credit stabilise at a lower level. Debt to GDP ratios may not be lower, but as GDP is lower, so too is credit in the system.  Yet there is a large difference between the haves and the have-nots, largely due to a difference in which banks received government largesse and which did not.

Bank analyst Don Coxe puts this in perspective for us:

A sustained U.S. economic recovery is unlikely until all banks, and not just the big institutions bailed out with government funds, start to recover from the effects of the financial crisis, according to longtime investment strategist Don Coxe.

Many banks that got funding from the government have seen their shares soar, while smaller, regional banks have not.

That’s a sign that investors believe the smaller banks are less well placed to participate in, and contribute to, the economic recovery, said the chairman of Coxe Advisors LLC in Chicago, who advises clients of the BMO Financial Group.

Think big banks – big business, small banks-smaller business.  In effect, the credit flow for large multinationals is now back to normal.  However, like consumers, small and medium-sized enterprises (SMEs) are finding a tougher reception. Revolving credit lines are being cut and loans are harder to come by (one reason Warren Buffett and Goldman Sachs are stepping into this space in this crucial holiday season).

This is a case of supply and demand constraints. One the one hand, credit supply is constrained because regional financials are loaded down with bad debts and have not received the same measure of bailout money that big banks have.  On the other hand, SMEs are having to downsize and are demanding less credit.

"The thousands of regional U.S. banks on which an economic recovery depends have not participated in the sudden explosion of trading profits" of the biggest five U.S. banks, he said.

The state aid granted to large banks during the financial crisis has convinced investors the government will step in again in future to save the behemoths if needed. That has helped pull share prices back up from the 12-year lows hit in March.

By contrast, as more commercial real estate loans turn bad in the still-feeble economy, regional and community banks are struggling.

A key gauge of the gulf between big banks and smaller lenders is the KBW Regional Bank Index exchange traded fund (KRE.P). The ETF’s recovery has lagged the rebound in shares of the biggest five U.S. banks, said Coxe.

"There will not be the kind of sustained U.S. economic recovery that will drive a sustained U.S. bull market until the shares of the Main Street (KRE) banks begin to outperform" both those of the biggest five banks and the S&P 500 index .SPX, he said.

Small bank index suggests recovery is elusive – Reuters

Related posts:

• More warnings on regional banks
• Regionals are exposed to credit crisis
• Michael Panzner: regional banks in trouble
• Relative value in financial services
• Fifth Third takes on assets of Freedom Bank

A friend sent me the following presentation earlier in the week when I was feeling a bit ill. So I neglected to post it.  But, I want to return to it because it is in keeping with my recovery/depression theme. These are the issues that were complicit in the latest financial crisis and almost none of them have disappeared.  They will most certainly rear their heads again precipitating or worsening the next downturn.

We’re talking about:

1. Duration mismatches (borrowing short and lending long)
2. Accounting (Mark-to-market, deferred tax assets and a lot more)
3. Conflicts of interest (no Chinese walls, ratings agencies)
4. Regulation (especially given poor risk controls)
5. Risk management (is Meriwether a leading indicator?)
6. Investment Banking vs. Utility Banking
7. Too big to fail (they must be downsized)
8. Heads I win, tails you lose (socialization of losses is crony capitalism)
9. Quantitative easing (QE has costs)
10. Hedges instead of capital

My baseline thinking at the moment is that we are seeing the beginnings of a cyclical recovery built on the back of asset relation more than anything else. The underpinnings of this uptrend are tenuous. So, when this latest burst of reflation hits the wall, all of the aforementioned issues will re-appear and policy makers will again do the who-could-have-known routine we saw in 2001 and again in 2008/ But the broader public is increasingly wise to this song and dance. Hat tip Scott.

Jim Chanos Presentation at Darden, 22 Oct 2009

Related posts:

• Chinese officials warn banks about reckless lending
• European banks: still undercapitalised
• The U.S. financial system is effectively insolvent
• Lessons from Japan’s Bank Crisis
• Bank of Canada blames Geithner for financial mess

In a recent post, “How is Citi going to deal with $38 billion in deferred tax assets?,” I pointed to a Reuters article which called into question Citigroup’s ability to earn enough money to prevent its having to take a charge for an incredibly large deferred tax asset. That post generated a response from a Citi representative who emphatically defended Citi’s capital position with a chart comparing Citigroup to other large global financial institutions.

Below is that chart:

As you can see from the chart, based on Citi’s reported public accounts, the company is well-capitalized. Moreover, even hedge fund operators like John Paulson who maid a mint on shorting financials in 2007 and 2008 now think Citi is in much better condition. Paulson was known to be buying shares in August.

You could agree or disagree with Paulson about whether Citigroup is a buy at its present share price. And you could argue that Citi should be taking the charge that Willens suggests. But the fact is, Citi has been recapitalized – at taxpayer expense. And that’s more the point here. 

Citigroup has received more money from the government ($45 billion) than any other bank in the U.S., none of which has been paid back. Moreover, the government was forced to not just forgo dividends on its preferreds but also convert these into common equity and provide debt guarantees for the company. Absent government money, Citigroup is the worst capitalized big bank. Absent government money, Citigroup would not exist.

Even still, Citigroup cannot be nearly as profitable as it once was because it has been forced to sell assets in order to achieve its ratios. Yet, it is an organization with almost $1.9 trillion in assets and is certainly still too big to fail.

I see Citigroup as emblematic of the problems we face in dealing with large systemically dangerous institutions. They insist that we return to some semblance of business as usual after they have received massive bailouts without any clear timeline when those monies will be repaid – if ever. Meanwhile, it is far from clear what these institutions would look like if the collateral they put up for loans received from the Federal Reserve and the rest of their assets were marked to market.

I, for one, think the big banks have made it. I said so as far back as April. I may not like the way they have been recapitalized, but I am in little doubt that they have been.

But Citigroup and Bank of America in particular have gotten there with great help from taxpayers. All of the too-big-to-fail financial behemoths exist because of government largesse. That high-level executives of these organizations show little contrition or remorse for having cost our economy tremendously is the saddest part of this crisis.

Disclosure: I have no financial positions in Citigroup or any other financial services company.

Related posts:

• My take on the latest Citigroup bailout
• The Citigroup Bailout: a blogosphere post-mortem
• Rubin resigns from Citigroup
• Credit Suisse cautious on Citigroup due to regulatory hurdles
• Citigroup and Redecard: shedding international assets

In the wake of a few significant elections in the American states of New York, New Jersey and Virginia, a lot of pundits are putting their spin on what these elections mean for Barack Obama and his political agenda. On the whole, I find most of the conclusions partisan leaps of faith.

So, I wanted to take this issue on and outline my thoughts on American politics and the feedback loop with the economy. I will then try to take on what the election last November and just this past week mean in regards to Obama’s political agenda and the missteps I believe he made early in his tenure as President.

Confabulation and the human need to explain

First, let me start off with a basic concept of behavioral psychology: confabulation.  Back in April, I quoted from an article in New Scientist about how people will develop false narratives to explain away decisions already made. This is called confabulation. The article says:

As anyone who has ever been in a verbal disagreement can attest, people tend to give elaborate justifications for their decisions, which we have every reason to believe are nothing more than rationalisations after the event. To prove such people wrong, though, or even provide enough evidence to change their mind, is an entirely different matter: who are you to say what my reasons are?

But with choice blindness we drive a large wedge between intentions and actions in the mind. As our participants give us verbal explanations about choices they never made, we can show them beyond doubt – and prove it – that what they say cannot be true. So our experiments offer a unique window into confabulation (the story-telling we do to justify things after the fact) that is otherwise very difficult to come by. We can compare everyday explanations with those under lab conditions, looking for such things as the amount of detail in descriptions, how coherent the narrative is, the emotional tone, or even the timing or flow of the speech. Then we can create a theoretical framework to analyse any kind of exchange.

What experimenters here have shown is that there is a real human need to explain. Things happen for a reason, don’t they?  Why did the stock market rally? Why did Harry do that? Why didn’t we do something to stop this? Why did I vote for that guy back then, when I now don’t like him as much?

To the degree there is an explanation void, it will be filled. The question is: filled with what?

Confirmation bias and the psychology of politics

In politics, how the void gets filled has much to do with philosophical/political predisposition and one’s world view.

Drew Westen, a professor of psychology at Emory University, published an interesting book a few years back called “The Political Brain.” Recently, Westen has had some important things to say about the psychology of the health care debate (see Washington Post article here). But, in the book, the most memorable political psychological experiment Westen described is very much related to confabulation. I quoted from Wikipedia’s synopsis of this experiment to explain confirmation bias in the econoblogosphere back in May:

In January 2006 a group of scientists led by Westen announced at the annual Society for Personality and Social Psychology conference in Palm Springs, California the results of a study in which functional magnetic resonance imaging (fMRI) showed that self-described Democrats and Republicans responded to negative remarks about their political candidate of choice in systematically biased ways.

Specifically, when Republican test subjects were shown self-contradictory quotes by George W. Bush and when Democratic test subjects were shown self-contradictory quotes by John Kerry, both groups tended to explain away the apparent contradictions in a manner biased to favor their candidate of choice. Similarly, areas of the brain responsible for reasoning(presumably the prefrontal cortex) did not respond during these conclusions while areas of the brain controlling emotions (presumably the amygdala and/or cingulate gyrus) showed increased activity as compared to the subject’s responses to politically neutral statements associated with politically neutral people (such as Tom Hanks).[2]

Subjects were then presented with information that exonerated their candidate of choice. When this occurred, areas of the brain involved in reward processing (presumably theorbitofrontal cortex and/or striatum / nucleus accumbens) showed increased activity.

Dr. Westen said,

None of the circuits involved in conscious reasoning were particularly engaged… Essentially, it appears as if partisans twirl the cognitive kaleidoscope until they get the conclusions they want… Everyone… may reason to emotionally biased judgments when they have a vested interest in how to interpret ‘the facts.’[3]

The study was published in the Journal of Cognitive Neuroscience 18:11, pp. 1947–58, a peer-reviewed scientific journal.[1]

Even before being peer-reviewed and published, Michael Shermer used the presentation by Dr. Westen as the basis for his July 2006 Skeptic column[4] in the magazine Scientific American.

In essence, political partisans with a well-developed political world view were confronted with data that did not fit their particular view.  This created cognitive dissonance and mental stress (remember, the brain areas for reason were not activated here, emotions were at play).  Their brains, rather than trying to resolve the conflict objectively, looked for ways to incorporate the new information into the previous pre-conceived view. When the subjects successfully accomplished this back flip, they were massively rewarded by the areas of the brain for pleasure.

In sum, our brains are NOT hard-wired for non-confirmatory evidence. We are not rewarded for seeking non-confirming data. Therefore, we generally seek confirmatory evidence after we have made any decision.

When you read the narratives of the recent election results, you should realize that confirmation bias is very much at play in tweaking the conclusion to fit a preconceived world view.  A perfect example is a recent piece by Charles Krauthamer in the Washington Post.

Speaking of a huge Democratic loss in Virginia, Krauthamer says:

In the aftermath of last year’s Obama sweep, we heard endlessly about its fundamental, revolutionary, transformational nature. How it was ushering in an FDR-like realignment for the 21st century in which new demographics — most prominently, rising minorities and the young — would bury the GOP far into the future. One book proclaimed "The Death of Conservatism," while the more modest merely predicted the terminal decline of the Republican Party into a regional party of the Deep South or a rump party of marginalized angry white men.

This was all ridiculous from the beginning. The ‘08 election was a historical anomaly. A uniquely charismatic candidate was running at a time of deep war weariness, with an intensely unpopular Republican president, against a politically incompetent opponent, amid the greatest financial collapse since the Great Depression. And still he won by only seven points.

Exactly a year later comes the empirical validation of that skepticism. Virginia — presumed harbinger of the new realignment, having gone Democratic in ‘08 for the first time in 44 years — went red again. With a vengeance. Barack Obama had carried it by six points. The Republican gubernatorial candidate won by 17 — a 23-point swing. New Jersey went from plus-15 Democratic in 2008 to minus-four in 2009. A 19-point swing.

Obama also benefitted in 2008 from unique circumstances with the recession and economic crisis favoring a change candidate. That uniqueness can be seen in the huge drop in young and black voters last week as well as the switch in independent voter allegiance from Democrat to Republican. I guarantee you we would have seen similar results in favor of George W. Bush had the recession of 2001 and 9/11 occurred one year earlier. None of these factors favored Democrats in 2009.

Krauthamer goes on to make some partisan claims about left-leaning agendas, hubris and taxation that I found unconvincing (Clive Cook also does this). I wished he had stopped here because he makes a valid point: the 2008 election was not some magical moment in American history in which we saw a sea change in political alignment at one moment in time. That’s confabulation, pure and simple.

What happened is Americans voted for those people who they felt would change course because they felt the country was headed in the wrong direction. That’s certainly what exit polling told us in November 2008.  Making up some other explanation is not necessary.

I know change when I see it and this is not it

So, what Charles Krauthamer and Clive Cook are doing along with Frank Rich and Paul Krugman is filling the explanation void. I agree with the analysis, but some of the conclusions are more dubious. I have done my share of filling that void (I see Frank Rich’s narrative as the one closest to mine).

But, for a moment, let’s leave the explanations aside. The great thing is humans are capable of complex decision-making and thought without having to explain those decisions. We know how to distinguish a frog from a prince and a pig from a princess – no explanation required.

And so it is here again. If you asked 1000 people in those exit polls from November 2008 – or even last week, “what would make you know America was headed in the right direction,” you probably would have gotten 700 different answers.

But, one thing is clear: Since January 20th, a lot of people are saying to themselves, “I know change when I see it and this is not it.” That’s what all polls are saying. So, whatever Obama and the Democratically-controlled Congress are doing, it’s not working.

Enter the Demagogue

That’s where demagoguery comes into play. Demagogues love an explanation vacuum.  Since time immemorial, where there has been public disenchantment with the status quo, there has always been some demagogue waiting in the wings with a ready-set explanation of what’s wrong and how they were going to fix it. These are people who are considered fringe elements in good times, but when economic hardship comes their ready-made explanations and confabulation become a toxic mix which propels them to prominence. (For the record, I am not connecting the gentlemen mentioned above with demagoguery. I am making a separate point here).

I would argue, that’s where we are right now. The global economy has just experienced an incredible shock. In the United States, more than one in six is unemployed or underemployed. Personal bankruptcies and foreclosures are still happening in record numbers. The economic situation is, in a word, grim.

Therefore, people are going to more open to a wider range of ideas and this is a prime opportunity for demagogues to advantage themselves and their allies. It also should make any incumbent politician very afraid of losing their job.

With this in mind, I look back to the early days of Barack Obama’s tenure and I can’t help but conclude that his economic strategy was too timid, too much aligned with the status quo. It’s not as if this should be a shocker; I pointed this out in January and again in February. His economic team erred in believing, as the Bush Administration had done, that the economic and financial situation was better than it was.  Remember, Obama’s stimulus plan was based on a forecast of 8.0% unemployment.

Future policy decisions

But that ship has sailed and here we are a year after Obama’s election in a technical but unsatisfactory statistical recovery. What should Obama do going forward?

Well, first of all, what he needs to do is give voters a sense that the recovery is for real. And that means unemployment, foreclosures, and stagnant personal income must be attacked. On some level, the health care debate is a net negative in that it consumes a lot of political capital without any obvious and immediate economic benefit. The bailouts and financial reform agenda also have been net negatives as well for similar reasons but also because they have not been seen as fundamental change and they further disenchantment.

Moreover, we know that the explanation vacuum is being filled by voices decrying big government and socialism. If you listen to people like Charles Krauthamer, you are likely to see Obama as a dangerous shift in America to the left. He makes a compelling argument which will sway those who are constitutionally predisposed to hating big government or deficit spending. So this means Obama is now constrained. In my view, fiscal stimulus is a political non-starter.

So, I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

If the economy turns up vigorously and permanently, we can put some of these thoughts to rest. You have to believe many fewer people would be yelling socialism or corporate communism if we were in a robust upturn. However, I don’t think that is a likely economic scenario. Even so, the unique circumstances of 2008 are unlikely to be repeated. That spells trouble for the Democrats in 2010 and 2012 unless they start doing something dramatically different.

Other sources

People Sometimes Seek The Truth, But Most Prefer Like-minded Views – Science Daily

Humans prefer cockiness to expertise – NewScientist (think demagogue here)

Related posts:

• Through a glass darkly: the economy and confirmation bias in the econoblogosphere
• Loss aversion and finding a bottom
• What motivates Hillary? Part 2
• Peer pressure and bubbles
• US Senate passes Economic Patriot Act 74-25

The Obama Administration is captured. To understand why it has acted as it has, one doesn’t have to take the view that its efforts to save the banking industry were a deliberate attempt to line bankers’ pockets by transferring money from taxpayers to the banking industry. One need merely read the last post I wrote on this topic.

In their wildly optimistic view, the banking industry is solvent and always has been. All that was needed to ‘solve’ than banking crisis was a lot of liquidity, government backstops and, most importantly, time. This blinkered view sees a looting of taxpayer money to bailout the banking industry as necessary to save banks whose credit is the ‘lifeblood of our economy.’

They are wrong. The banks did not need to bailed out. The banking industry industry needed to made solvent again. There is a big difference between those two sentences (banks versus banking industry and liquidity versus solvency) that goes to the core of the captured and politically damaging world view we have seen on display by the Obama Administration.

Change you can believe in

Think back some 18 months when Senator Obama was in a horse race with Hillary Clinton to see who would go up against John McCain in the Presidential election. If you asked any reasonable individual who had the least experience and the thinnest political resume of the three, he or she would have said Barack Obama. If Americans wanted someone long on inside-the-beltway experience, they would have chosen John McCain – or, at a minimum, Hillary Clinton, not Barack Obama.

So, Barack Obama did not best both Hillary Clinton and John McCain and get to the White House because Americans felt him more qualified for the job.  Rather, Americans believed the U.S. was on the wrong path and wanted a qualified person to lead the country who would also change course. They believed that person was Barack Obama.

And when it came to the economy, the presence of two men, Paul Volcker and Warren Buffett, born some 80 years ago, gave one the sense that, despite Barack Obama’s perceived relative youth or inexperience, he had the ablest of wise old men who would be his and our counsel in resolving this crisis.

Bailing out the banks

So when Barack Obama took office, it came as a rude awakening for many that he chose to bail out the too big to fail institutions with little or no strings attached, allowing them to later make record profits and pay record bonuses, while the economy was in a deep slump and ordinary Americans were being bankrupted and losing their jobs and homes at record rates. This was not change you can believe in.

What could or should the Obama Administration have done?

If you had listened to the chatter inside the beltway early this year, you would realize that Obama’s team believed it was not politically feasible to ‘nationalize’ Citigroup or Bank of America and force top executives to resign as was done at RBS, Bradford and Bingley or Northern Rock in the UK. This was a blinkered view which can only be described as captured (if not outright disingenuous).  We need look no further than Fannie Mae and Freddie Mac to see that nationalization was an option.

But this is not the kind of solution we needed.  What we needed was a solution by the Administration to take prompt corrective action in seizing bankrupt institutions, dismissing management, punishing any misdeeds and setting up a timetable to sell off the institution’s assets. That is change you can believe in.

I laid this out fairly comprehensively in February in my post “America needs a pre-privatization plan.” So I am not going to cover that ground here except to quote the key relevant passage in that post:

To my mind, there are three ways to deal with an insolvent financial institution:

• Bankruptcy. Allow the  institution to collapse (like Lehman Brothers)
• Nationalization. Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae)
• Bailout. Inject capital into the institution in order to allow it breathing room until it can meet capital adequacy levels.

As you can see, governments have tried all three solutions.  However, there are vast differences between the three.

The bailout solution is the most ‘anti-free market’ choice and seems to be the favored solution of governments everywhere.  It props up organizations, giving them an unfair advantage at the expense of other more prudent institutions.  It also acts as a subsidy, which favors domestic institutions over foreign rivals.  Bailouts increase moral hazard by rewarding risky and reckless lending practices.  And they are often the result of crony capitalism due to the power of the financial services lobby. There are many other problems with bailouts. All around, bailouts are a poor solution.

So what we have here is a case of crony capitalism and kleptocracy, plain and simple – whether by design or not is immaterial. And the American people are on to this. That is why people are resistant to other changes this Administration has put forth.

Don’t let the media’s spin fool you: Washington insiders are on to this too. Politicians in Congress realize that Obama’s bailouts have cost him political capital  and they are challenging his policy agenda as a result. This is why the health care bill, which Obama wanted passed before the summer recess, may not see the light of day before year’s end.

Are we home safe?

I would advise the Obama Administration not to run any victory laps about having slayed the beast. The lingering effects of crisis are still there. The Fed’s liquidity is still liquid. Impaired assets are still impaired. And zombie banks are still zombies. As I indicated in my depression piece:

In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized.

Since I covered this ground in that article, I will leave you to read my further thoughts there. What I want to turn to now is the ‘why.’

The Cheney-Rumsfeld replay

Now, I am not writing off Barack Obama’s presidency. I do worry he still could see a recessionary relapse which would cause him to seem more Herbert Hoover than Franklin Roosevelt.  But, despite his Nobel Prize, it is much to early to know what his legacy will be.

Nonetheless, I believe he has wasted a lot of political capital and this will make ushering through a meaningful legislative agenda very difficult.

Why did Obama throw it all away?

Here’s my answer: I call it the Cheney-Rumsfeld replay.

When historians look back at the Bush 42 presidency, it will be defined by 9/11 and the wars in Iraq and Afghanistan.  While George W. Bush was politically pre-disposed to the Neo-con world view, it was really advice from Dick Cheney and Don Rumsfeld which made Afghanistan and Iraq possible. George W. Bush was famously not well-versed in foreign affairs, having almost never travelled abroad.  He was completely dependent on Dick Cheney and Donald Rumsfeld to make foreign policy (although he could have listened more to Colin Powell, his actual Secretary of State; again it goes to predisposition).

So, I see George W. Bush’s presidency as having been defined by foreign policy and the War on Terror and, by extension, on Rumsfeld and Cheney.

Fast-forward to Barack Obama’s presidency and you have an almost identical situation, this time with the economy instead of foreign policy and Tim Geithner and Larry Summers instead of Donald Rumsfeld and Dick Cheney.

But, as with George W. Bush, it goes to pre-disposition. Paul Volcker was a critical member of the Obama 2008 campaign. He also was a key member of Obama’s economic policy team. But, he has been speaking a very discordant message that is not in sync with team Obama. So, as with Bush and his marginalization of Powell, one has to believe Barack Obama has chosen to side with Geithner and Summers over Volcker. Why anyone would do so given Volcker’s experience is beyond my comprehension.

The obvious conclusion, therefore, is that Barack Obama shares the blinkered and captured view of his policy makers and that this is why he has decided to go down this chosen path. And when it comes to Obama’s other ‘change’ decisions on the Guantanamo closure, torture, rendition, state secrets, and health care, the same logic also applies.

Is this change we can believe in? I will leave that for you to decide.

Related posts:

• The wildly optimistic view of Treasury’s handling of the crisis
• Bush Administration turns the TARP over to Obama
• The 3 a.m. moment – McCain blows it
• Greenspan: “If they’re too big to fail, they’re too big”
• Automakers likely to be bailed out

I was reading Kid Dynamite’s account of the recent Treasury – Finance Blogger meeting after having read a bunch of others (see them all in Abnormal Returns’ Nov 4th links). And I was struck by his characterization of the thinking at Treasury in regards to the financial crisis. I want to highlight two points and ask the question: didn’t the Treasury plan work as designed?

I will try not to editorialize and let you draw your own conclusions based on my (hopefully neutral) narrative of their goals.

Here is point #1 I want to highlight:

The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system.   The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently…

a number of STO’s present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital.  I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.

As I read it, Treasury wanted to show that it had a credible plan to identify any capital shortfalls amongst our biggest banks and to take corrective action.  Their belief is this would restore confidence.

Here is point #2 to highlight – why the need for secrecy:

I [Kid Dynamite] mentioned that the problem was that even if we had a "Counterparty Risk Czar" who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we’d see the same problems we saw when the government went to give out the TARP funds. The government didn’t want to "bail out" select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank – so they asked a large pool of financial institutions to take the money to hide the truly sick cows.

I read this to say that Treasury feared identifying ‘loser’ institutions would have a negative impact and cause bank runs (think Washington Mutual). therefore, they had to hide the ball, so to speak.  The same philosophy is behind the Fed’s refusal to release more information to Bloomberg on the Fed’s emergency lending counterparties.

The overall gist of the strategy was that Treasury wanted to identify the weak, give them time to grow stronger, and, in so doing, allow the panic phase to subside so that corrective action could be taken in a more normal economic environment.

Wasn’t the plan wildly successful? Blogger Accrued Interest thinks so.

Now, before you give a knee-jerk response, please read the following from a post I wrote in April called “Channeling my inner Larry Summers,” which was my attempt to read the intentions of Obama and his economic team (in the voice of Larry Summers). I think it dovetails nicely with what Kid Dynamite says were the actual goals of Treasury.

the question is how do we deal with this crisis.  The first priority must be  to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences.  The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending.  Is this re-flating the bubble?  No, because deflationary forces will continue to extract a price even with these measures in place.  The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.

But, spending alone won’t get it done.  Ultimately, we will need to increase credit availability.  Just because people are spending more, does not mean the economy will grow.  Growth depends critically on increasing credit in line with the growth of the economy.

I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing.  The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government.  What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.

Let me enumerate some mechanisms:

• First we should try bank re-capitalization.  Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that’s number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money.  What’s more is it limits government interference. Remember – most of these institutions are having temporary problems.  With enough capital, they can weather the storm.  There is no need for heavy-handed government interference.
• If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
• Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.

Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.

So have Geithner and his team not avoided the pitfalls and accomplished their goals?

Related posts:

• The less optimistic view of Treasury’s handling of the crisis
• Will banks exiting TARP take back their toxic waste now?
• Bank by bank breakdown of stress test results
• Ackman and Stigliz talk Stress Tests with Charlie Rose
• GMAC has been nationalized

And you thought the bailouts were over and market discipline might be restored.  Not a chance – the bailouts will continue, come hell or high water. The latest demonstration of this is GMAC, where the government will now be majority owner. GMAC has officially been nationalized. Now the government is running auto financing in addition to running the companies making the cars.

Below is a quote from the Financial Times. Notice the parts I have bolded.

GMAC, the car financing company, is set to receive up to $5.6bn in a new capital injection from the Treasury, filling a hole identified in the “stress tests” earlier this year and paving the way for the government to become the majority shareholder.

The company, formerly the financing arm of General Motors, was one of 19 institutions to submit to a capital adequacy programme led by the Federal Reserve and completed in May. That determined that GMAC had a shortfall, which will now be provided by the government in the form of preferred equity, according to two people familiar with the situation.

As widely expected, GMAC has been unable to raise the necessary capital in the market and the company – which will take on fresh lending responsibilities when it merges with Chrysler Financial – was seen as vital to the government-led restructuring of the US automotive industry and deserving of more funds from the $700bn troubled asset relief programme.

“When we laid out the stress tests, we expressly said that some additional Tarp capital may be needed given the severity of the downturn – this capital need is not new information,” said an administration official.

“But the transparency brought about by the stress tests allowed all other institutions to raise the capital required by the stress tests to ensure these firms could withstand a more severe economic scenario than anticipated,” the official said.

What you should be reading from this statement is the following:

• All the firms identified as lacking capital under the stress tests were given time to raise funds in the capital market to meet the shortfall.
• Some firms did meet the shortfall and they are now free to do as they please.
• Others have not and we the government are now going to take a more muscular approach in dealing with them.
• GMAC is the first public example of our flexing our muscles.
• But there surely are/will be other examples; some may already be happening in secret.

If the US government is going to throw its weight around to deal with financial firms short of capital, I would personally prefer they try a process which allows these firms to fail whereby equity and debt holders suffer consequences that are consistent with taking market risk.  Bailing out GMAC is a moral hazard plain and simple.

But, what’s done is done. The GMAC case does, however, give a lot more credence to my view that Citigroup’s actions are being dictated by government. As I indicated when the stress tests were done in April, firms were going to get some time to raise capital and if they didn’t, the government was going to move on to Plan B (debt-for-equity swaps, nationalization, and FDIC seizure). Expect to see more indications that other financial companies with capital shortfalls are falling under the government umbrella.

Related posts:

• Bank by bank breakdown of stress test results
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• GMAC: Loosening credit standards in the teeth of recession
• GMAC gets a helping hand
• GMAC chairman resigns effective immediately

Remember the iconic Depression-era movie “Mr. Smith Goes to Washington, in which Jimmy Stewart plays the wholesome young man in Washington out to do good? Well, Mr. Smith could just as easily have been your friendly banker at Washington Mutual. Unfortunately, Mr. Smith lost his way and turned predatory lender – and that’s the subject of the second part of a Seattle Times expose on the rise and fall of WaMu.

I posted yesterday on part one, which you should definitely read to get a sense of how WaMu culture changed. Now comes part two – also a must-read.

The lead-in says it all:

For decades, Washington Mutual lived up to its image as a staid, straight-laced Seattle institution. Its motto: "The Friend of the Family."

By the time WaMu made history last year as the nation’s biggest bank failure, it bore no resemblance to this homey image.

What few people knew was that bank executives crafted a radical new business strategy in 2003 that was intended to boost profits. The new WaMu used huge sales commissions and misleading marketing to hawk risky and overpriced loans to borrowers.

In short, WaMu became one of the nation’s biggest predatory lenders.

 

Here are a two quotes from the article:

• WaMu lured borrowers with a very low interest rate of about 1 percent. But this "teaser" rate was good only for one month. After that, the option ARM could have far higher interest rates than conventional 30-year fixed-rate loans. With each minimum payment, unpaid interest piled up. Once the debt grew too large, WaMu canceled the minimum-payment option. You could suddenly get a new bill for two or three times what you had been paying.
• "I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."
• The 1 percent interest rate Houk thought he was getting was only good for the first month. It had reset to 7.4 percent, nearly 3 percentage points above his previous WaMu loan. This was buried in the fine print in a sheaf of legal documents he had signed. "Who in their right mind would give up a 4.6 percent loan?" Houk said. "I felt totally duped."

The overall gist of the article (in conjunction with the previous one) is of a company whose CEO was obsessed with the share price as validation of success.  As a result, the company morphed from an institution worthy of Mr. Smith to just another profit-oriented bank. 

The key changes came in crisis after profits were devastated by the recession of 2001 and the jobless recovery afterwards. WaMu was forced into huge layoffs.

It is often said true character is shown in crisis and at WaMu it would be no different.  Instead of accepting a temporarily lower share price and reduced earnings from its bread and butter mortgage products, WaMu went all-in, wading into sub-prime and option-ARM products which were not its mainstay. That is when the predatory lending began, ultimately setting the firm up for failure.

More here.

WaMu: Hometown bank turned predatory – Seattle Times

Related posts:

• Anecdotes on reckless lending at WaMu from the Seattle Times
• WaMu on the brink of disaster: has agreement with regulators
• JP Morgan Chase buys WaMu out
• Is the new affordable FHFA loan program predatory lending?
• How refinancing helps the likes of Bank of America and Wells Fargo

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback.

Update: This phrase, "PDCF usage declined, reaching zero in mid-May 2009," suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: "The Federal Reserve’s Primary Dealer Credit Facility."

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• TALF: A bailout if one reads the fine print
• A few words from a reader on TALF mechanics
• Understand the Fed’s balance sheet
• Bloomberg News sues the Fed under Freedom of Information Act

The Seattle Times has a must-read piece on Washington Mutual today which reveals a lot of the fine detail on how the company was run and what led to its demise (hat tip calculated Risk).

As with many of the other busted financial giants like Northern Rock and Lehman Brothers, indications that something was amiss were apparent long before their ultimate demise.  However, in an environment of easy money and lax regulatory standards those signs were overlooked as share prices kept rising.

Here are a few of the verbatim quotes from the article which I found most telling.

• In its headlong pursuit of growth, WaMu systematically dismantled or weakened the internal controls meant to prevent the bank from taking on too much risk
• WaMu’s riskiest loans raked in money from high fees, but because the bank skimped on making sure borrowers could repay them, they eventually failed at disastrously high rates.
• WaMu’s subprime home loans failed at the highest rates in nation. Foreclosure rates for subprime loans made from 2005 to 2007 — the peak of the boom — were calamitous. In the 10 hardest-hit cities, more than a third of WaMu subprime loans went into foreclosure.
• By the summer of 2004, nearly 60 percent of the loans WaMu was making were the riskiest sort — option ARMs, subprime mortgages and home-equity loans.
• Talk to people who worked with Killinger, and the same phrases and adjectives keep coming up. Ambitious. Quick study. Smartest guy in the room. And always, always optimistic. "He’s a cockeyed optimist to the nth degree," one former associate said. "He always thought he could get out of whatever trouble he was in." But Killinger also is repeatedly described as avoiding confrontation and uninterested in the nuts-and-bolts details of WaMu’s business.
• And even more than most chief executives, insiders say, Killinger was focused on WaMu’s stock price as the company’s — and his — primary gauge of success. "Kerry’s view of himself was tied to a constant increase in the stock price," Chapman said. "He was fixated on it."

This article is the first of two parts. The link to the article is below. It is a good read and documents fairly extensively how all-encompassing the originate-to-sell model of securitization was at WaMu and how this relaxed internal controls and risk management, leading to its demise. What tipped me off to what was happening was the change in Washington Mutual’s lending profile as it rushed headlong into option ARMs. The whole episode is rather sad because WaMu was a great company with an amazing brand. And from most anecdotes I hear, Killinger was a brilliant man as well.

But, smarts are not enough when you are taking on too much risk, thinking you have somehow magically hedged yourself against those risks. No, you do not have to dance, if the music is playing. Given the bubbles now building again and the likelihood of a nasty end to this particular episode as well, this is something that bears remembering.

Source

Reckless strategies doomed WaMu – Seattle Times

See also “A Giant Downfall” from Portfolio.com last month. It documents WaMu’s last days and demonstrates that WaMu was the subject of a bank run – the major reason it was seized by regulators.

Related posts:

• WaMu: Mr. Smith goes to Washington and turns predatory
• WaMu on the brink of disaster: has agreement with regulators
• AIG down; Lehman and WaMu looking to be sold
• JP Morgan Chase buys WaMu out
• Consolidation through merger over bankruptcy

John Gapper had a good piece in the FT yesterday called “Goldman should be allowed to fail.” His conclusion is that Goldman is allowed to game the system. It is a broker-dealer masquerading as a bank. It takes on much more risk than a traditional bank. It engages in different activities. It compensates its staff differently as well. And it is too big to fail. Gapper says this cannot be tolerated.

So, if Goldman Sachs took on more risk when its equity was held by outsiders than with its partners’ own money, what can we expect now that the government implicitly accepts that it is “too big to fail”? Goldman has an even bigger incentive to risk other people’s money.

This is the problem I identified last week, with the most powerful broker-dealer on Wall Street having the same privileges as the most mundane commercial bank. Not only does the fact that it may pay $23bn in bonuses this year upset people, but also its incentives are skewed.

Solving this requires two things to be addressed. First, Goldman’s intention to operate as a institutional Wall Street firm – complete with its own hedge and private equity funds – while having government and Fed support. Second, its tradition of setting aside half its revenues each year for employees.

Gapper also points out about Goldman Sachs is that the firm is very different than the one that went public in 1999.  Back then sales and trading was only a third of revenue, however by 2006 and 2007, the fixed income and currency divisions were up to two-thirds of revenue. This year, in the first nine months, those units have contributed nearly 80 percent of the firm’s revenue.

In Goldman’s defense, Gapper admits that the firm is the most partner-like of all the big Wall Street firms.

Goldman probably has one of the most partner-like pay structures for its managing directors. About two-thirds of bonuses are in restricted stock that vests over four years and its most senior partners have to hold 75 or even 90 per cent of the stock until after they retire.

Gapper doesn’t believe that is enough and suggests returning to a  system in which 90% of Managing Directors’ money is tied up in the firm until retirement.

Now, to be sure, Goldman has a huge cushion of $170 billion in cash for events like the ones we witnessed last Fall. It is commonly considered the best run firm on Wall Street. But it is still a broker-dealer.

One thing Gapper fails to mention is how a large balance sheet necessarily translates into bigger bonuses. A lot of people have made the argument that big banks are so big because they benefit from economies of scale in activities like derivatives and they need to compete in cross-border activities. But, the dirty little secret in corporations is that the larger a company is, the more revenue and profit it makes and this justifies much higher compensation for senior staff.

Imagine for a second you have eight firms on one side with revenue of $1 billion and profit of $100 million each and one company on the other side that is just as big as the eight collectively with revenue of $8 billion and profit of $800 million.  Who do you think makes more money, the guy running one of the eight companies or the guy running the large one?

Size matters not just in economies of scale or competition but in paychecks as well.

In any event, Gapper believes that Goldman should not receive the benefits of the federal reserves discount window unless it is a true deposit-taking institution which carries out a central function that carries responsibilities.  The suggestion is that Goldman should be stripped of its bank holding company status unless it takes on these responsibilities. And if it gets into difficulty in the future using this same broker-dealer business model, Gapper says Goldman should be allowed to fail.

Goldman should be allowed to fail – John Gapper, Financial Times

See also Goldman Sachs Is Too Big to Tell It Straight: Jonathan Weil – Bloomberg

Related posts:

• Goldman crushes earnings estimates
• Goldman loses $2.1 in the third quarter
• Why is Goldman allowed to game the system?
• Goldman looking to buy a bank
• Goldman and Morgan Stanley are now banks

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

In case it’s not obvious:

• Charlie is a too big to fail bank.
• The matches are debt, the firecrackers are derivatives, the M-80s are asset-backed securities and the dynamite is OTC derivatives.
• You (Ms. Watkins) are Brooksley Born
• The headmaster is Alan Greenspan
• Little John is another smaller community bank
• The other children are banks and citizens of the broader economy
• The frog-glass incident was LTCM’s collapse
• The lit dynamite incident was Lehman Brothers

In the past, I have likened regulators to referees or playground monitors to illustrate why the concept that markets are self-regulating is absurd. In the last post, “Frontline – The Warning: Who Knew About the Looming Financial Crisis?” Alan Greenspan was at war with regulator Brooksley Born over this concept of self-regulation. Born believed that regulation was a necessity in any financial market. Greenspan believed that markets are inherently self-regulating. Even fraud was self-regulating through market discipline in his view. I believe he has now repudiated this. However, Born lost that battle with ugly consequences when the market she wanted regulated, OTC derivatives, blew up via AIG.

Self-regulation is to regulation as self-importance is to importance.

Note: Even though, I am pointing to Buiter’s piece here, I am not a believer in regulation-heavy in the least. Nevertheless, his ideas do merit consideration.

Related posts:

• Deregulation efforts from the late 1990s were blocked
• A conversation with Richard Posner on Charlie Rose
• Greenspan: financial crisis ‘will happen again’
• A conversation about AIG on Charlie Rose
• Forstmann on Charlie Rose: easy money caused crisis

Watch the hour-long retrospective which aired tonight on PBS’s Frontline.  It should be very enlightening in regards to the seeds of the bubble and meltdown.  It examines who the players in the 1990s and 2000s were, what their attitude to regulation was, and how lax regulation created a bubble and a bust.

Also see the following posts for more background:

• 1987
• Freshwater versus saltwater circa 1988
• 1995
• Deregulation efforts from the late 1990s were blocked
• FRONTLINE: Inside the Meltdown of Sept. 18, 2008

(video embedded below; runs just under one hour)

Related posts:

• FRONTLINE: Inside the Meltdown of Sept. 18, 2008
• Greenspan: financial crisis ‘will happen again’
• Ms. Watkins, why does Charlie have lit dynamite?
• Deregulation efforts from the late 1990s were blocked
• Ten lessons from financial crisis investors will soon forget

In one of my latest posts I said “greed is not good.” Quite frankly, I looked at this statement as self-evident in the wake of an economic catastrophe where greed was a defining element.  Yet, a remarkable number of people commented in defense of greed; they seem to believe greed is a good thing. So, I would like to clarify a few things about greed in the context of the recent financial crisis and prudent regulation of the financial industry.

Greed is not good

Greed is defined as:

• A selfish and excessive desire for more of something (as money) than is needed (Merriam Webster)
• An excessive desire to acquire or possess more than what one needs or deserves, especially with respect to material wealth (Free Online Dictionary)
• The selfish desire for or pursuit of money, wealth, food, or other possessions, especially when this denies the same goods to others. It is generally considered a vice, and is one of the seven deadly sins in Catholicism. (People who do not view unconstrained acquisitiveness as a vice will generally use a word other than greed, which has strong negative connotations.) (The Free Dictionary)
• The obsession with accumulating material goods (Access-Jesus)

Do you notice the commonalities in all these definitions? Excessive, selfish, more than what one needs or deserves, unconstrained, obsessive.  You can make the non-judgmental argument as I did that greed is neither good nor bad. But, in what twisted world view is any of this good?  Greed is not ambition or hunger or drive. Greed is by definition excessive and unconstrained, and, thus, leads to unstable and suboptimal outcomes. Greed is not good.

This version of the definition was quite telling:

Greed is something that can never be satisfied. Greed and slothfulness have similarities in definition. The greedy and slothful both crave material goods as well as they have no desire to work for or to exchange anything of value for the object of their desires. The slothful will not work even for basic necessities much less add value to the world around them. The greedy will use deception to acquire material goods. The greedy will lie and use false pretenses to acquired goods at the expense of others.

For more on this, see the Seven Deadly Sins.  And just to make it clear, greed is antithetical to the core beliefs of all major religions in the Indo-European world. Why Americans who are ostensibly religious think ‘excessive wealth accumulation’ is in keeping with the tenets of their faiths is beyond me.

Free market ideology is a religion

This is where the financial system comes into play. Back in 1987 when Oliver Stone made the movie “Wall Street,” he intended Gordon Gekko to be an anti-hero emblematic of a period of excess. Yet, for some reason Gekko has since become a hero worthy of emulation amongst Wall Street’s entrants. Why has this ‘greed is good’ anti-hero become the man to emulate?

Let’s go back to what Jared Diamond says about how kleptocracies maintain power:

“1. Disarm the populace, and arm the elite.”

“2. Make the masses happy by redistributing much of the tribute received, in popular ways.”

“3. Use the monopoly of force to promote happiness, by maintaining public order and curbing violence. This is potentially a big and underappreciated advantage of centralized societies over noncentralized ones.”

“4. The remaining way for kleptocrats to gain public support is to construct an ideology or religion justifying kleptocracy.”

Method number four, construct an ideology or religion justifying kleptocracy, should stand out for you. The religion, of course, is free market ideology. Now, I happen to believe quite fervently in the primacy of liberty and freedom over the the coercive power of the state. However, I see the free market as a means to an end not as an end unto itself.

In my post “Deregulation as crony capitalism” I said:

Obviously, if some always have more power and wealth than others, there is never a situation in which the economic playing field is level. Moreover, it is axiomatic that those with the means and access will always have greater influence over government than those without. So, in a very real sense, the socioeconomic elite of any advanced, stratified society will always  have disproportionate control of the economic and political system.

By that, I meant that a society with a perfectly free market is a fiction which is used to justify the theft from those with less access and power by those with more. It is an ideology which has never had any real world manifestation in any stratified society in history. To believe that markets are or should be completely free is to de facto believe that those with greater access and wealth should be free to use this access and wealth to bend the system in their favor.

Trust but verify

Regulators are there much as police officers, sports referees or teachers on schoolyard playgrounds are: to make sure people follow the rules or suffer the consequences. 

When I wrote the ‘Greed is not good’ post, one reader responded that regulation was unnecessary; market discipline is the only regulation we need.

Is market discipline alone going to prevent mortgage finance companies from engaging in predatory lending?  Is market discipline alone going to prevent mortgage originators from making bad loans, knowing they can offload the risk in the securitization market? Is market discipline alone going to prevent bank holding companies from retaining excessive leverage? No, it is not. The credible threat of the regulator is necessary.

“Speak softly and carry a big stick; you will go far."

So what about Lehman?

The Lehman decision was disastrous because it produced anarchy that resulted from the uncertainty of government action. I wrote a detailed post to this effect. When Lehman Brothers failed, I said the day after:

Yesterday was a volatile day in the global financial markets. With the Nikkei down 5% and European bourses down 2% in overnight trading, we should understand that more volatility awaits us in the coming days and weeks.

As I survey this situation in serene tranquility away from market turmoil, I realize that I am very troubled by how the Lehman Brothers bankruptcy was handled. In my estimation, it was like putting the cart before the horse – allowing a financial institution to fail before you have worked out a mechanism of how to deal with that failure.

This one action will expose the global financial system to enormous additional risk.

Hank Paulson at the U.S. Treasury and Ben Bernanke at the U.S. Federal Reserve wanted to avoid the moral hazard of supporting the acquisition of a failed institution with government funds as it had done when JP Morgan Chase bought Bear Stearns. Therefore, Paulson and Bernanke were both fairly adamant about not offering any backstops for a Lehman Brothers takeover.

This is the principal reason both Bank of America and Barclays decided not to pursue a takeover of the firm. And this is also the reason Lehman Brothers failed. Had the U.S. government offered guarantees on Lehman’s debt, Barclays or Bank of America would have bought Lehman Brothers. In fact, I reckon BofA would have preferred to buy Lehman Brothers over Merrill Lynch as the price tag was much lower.

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong.

They were wrong for three principal reasons:

1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.
2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.
3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.

Why we need a framework and process
It is clear from the difficulties facing AIG and Washington Mutual right now that further large failures are likely to occur.

In the case of AIG, we are presented with a potential derivatives nightmare as this $1 trillion firm has its tentacles in all manner of Credit Default Swaps, Collateralized Debt Obligations and insurance products generally. AIG represents a much more ominous case of potential systemic risk than either Bear Stearns or Lehman Brothers.

Washington Mutual is a large bank with $300 billion in assets. It is very leveraged to Alt-A and pay-option mortgages. Unlike subprime mortgages, which have seen the maximum number of interest rate resets, the majority of these products are resetting to higher interest rates now and in the future. This means a significant number of defaults in the sector will occur and that Washington Mutual will be stressed by these events. That may create liquidity or capital concerns which would force WaMu into insolvency. Were WaMu to be declared insolvent, the FDIC would need to be bailed out as it does not have adequate funds to deal with the likes of Washington Mutual.

These two institutions are suffering even more as a result of the uncertainty that allowing Lehman Brothers to fail has created. Due to investor and counterparty jitters, AIG and WaMu are now more likely to fail than had Lehman Brothers been rescued. This fact and the systemic risk that AIG represents and the threat to the FDIC’s adequacy that WaMu represents makes the need for a government bankruptcy framework and process more evident.

A too big to fail resolution process is needed

By and large this is exactly how things played out. AIG and WaMu both went bust and a Great Depression-like chain of events unfolded. Only due to herculean efforts and extreme government intervention was worse averted.

The problem with Lehman was not that Lehman was declared insolvent and put into bankruptcy, but rather that no adequate resolution process for the firm was in place to address this too-big-to-fail institution’s collapse without precipitating a market panic.

When a systemically important institution faces collapse there are three potential avenues a resolution can take:

1. Anarchy. Allow the company to fail spectacularly without any planning whatsoever so that the whole financial system faces financial Armageddon. The hope is that this solution does not produce despotism, war or famine. Let’s call this unpreparedness. This is what was originally tried with Lehman Brothers.
2. Crony Capitalism. Prop the institution up through bailouts, government backstops and guarantees, creating a moral hazard so that other banks know they too need to be too big to fail in order to avoid the consequences of market discipline. Let’s call this kleptocracy. This is what happened to AIG, Citigroup, and Bank of America after Lehman’s failure created panic.
3. Free market. Stop poor or potentially illegal lending and excess credit growth and risk through prudent regulation in order to prevent a spectacular bust and crisis. But, if presented with a bust, allow the institution to fail and potentially be liquidated in a controlled resolution process. This is what I am advocating. I see this as a more realistic free market solution.

What was needed when Lehman failed is also what is still needed today: a robust too big to fail resolution process. This should be priority one for regulatory reform in order to restore market discipline and reduce moral hazard. The heads of Standard Chartered, JPMorgan Chase and the FDIC understand this. Yet, there has been zero discussion of this issue in Congress.

What might this process look like?

1. Lay out specific rules regarding the provision of liquidity by the central bank at a penalty rate of interest or collateral to prevent bankruptcy if the true problem is liquidity and not solvency.
2. Set up a special court for adjudicating bankruptcies of large financial institutions quickly.
3. Mandate guidelines on haircuts equity and subordinated debtholders must take before any taxpayer money is used.
4. If liquidation is necessary, require a strict timetable for milestones in the process.
5. Set strict guidelines on what if any government guarantees a bankrupt or soon to be liquidated organization should receive and what the government should receive in return as compensation.

These are just a few ideas.  The point is that a robust TBTF resolution process can definitely be crafted if the effort is made. Future Lehmans can happen in the future without bringing the whole system down.

Lehman will happen again

Below is a 40-minute panel interview I did with Canadian TV station TVO and its program “The Agenda with Steve Paiken” just over two weeks ago. The questions: Saving Wall Street but forgetting Main Street? One year after the financial sector came close to collapse; could it happen again?

The answer is yes and yes.

Alan Greenspan was right when he reviewed lessons learned from Lehman’s collapse and said about the excesses leading up to the crisis:

It’s human nature, unless somebody can find a way to change human nature, we will have more crises and none of them will look like this because no two crises have anything in common, except human nature.

But let’s not absolve ourselves of the need to take action to prevent the negative fallout as Greenspan attempts to do. If we set the right course, we can also prevent a future economic crisis from being as severe as this one has been.

Related posts:

• Quote of the day: Gordon Gekko – greed is good
• Why Lehman failed
• The U.S. financial system is effectively insolvent
• Greed is not good
• Lehman missed out on $5 billion from Korea

In the 1987 movie classic Wall Street, the sinister protagonist Gordon Gekko played by Michael Douglas gives this famous quote:

In the last seven deals that I’ve been involved with, there were 2.5 million stockholders who have made a pretax profit of 12 billion dollars. Thank you. I am not a destroyer of companies. I am a liberator of them! The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.

Since that time, this quote has become famous as the “Greed is Good” philosophy of capitalism.  Gekko symbolizes an era in which it is believed that the free hand of market capitalism will steer the economy efficiently and effectively with little need for government intervention or regulatory oversight. Instead, so the theory goes, we are each allowed encouraged to pursue our manifest destiny of getting filthy rich. Screw everybody else.

Well, let me tell you something greed is not good.  Greed is corrosive and it is tearing at the very fabric of our democracy. A generation ago most people in America worked for a few institutions in their lifetimes.  Many had employer-paid healthcare and employer-financed defined benefit pension plans.

But, since the 1980s the moorings have come off and set us adrift in a world of economic insecurity.

• Job insecurity has increased dramatically, especially as reflected in part work statistics(see here and here). This has resulted in deteriorating health and declining work safety.
• The healthcare debate is front and center in the US today. Yet, incongruously, the focus has mainly been on how ‘socialist’ proposed remedies appear.
• And defined benefit has been almost completely replaced with 401(k) plans, leaving retirees to face potential economic hardship in old age.

This is “the Great Risk shift” in which corporations in pursuit of shareholder value (remember ‘greed is good’) have sloughed off as many economic risks onto ordinary Americans as they could reasonably get away with. This is crony capitalism, not free market capitalism. And a anesthetized American public has put up with this. I continue to ask myself why.

Maslow’s hierarchy of needs was very much on display earlier in the year as we entered the worst of this financial crisis. Everyone felt vulnerable. But now that recession is over, it does seem that America is returning to business as usual, both on Wall Street and on Main Street.

What I find most galling is that just one year ago Barack Obama was saying, “Elect me! Elect me! I am change you can believe in. But, no sooner does he enter office and he continues the massive bailout of the financial services industry that was begun by the predecessor administration. And today there are really no substantive regulatory changes on offer by this Administration. It was this same support for the financial elite at the expense of the middle class which has led to a widening gulf in income and wealth.

And by the way, if you haven’t noticed, real incomes are lower now than 36 years ago.  So, this is certainly not change I believe in…yet. And given many of the players today are the same as they were before the crisis, don’t expect any real change. Apparently the only thing that is going to induce change in Washington (or London) is a horrific depression.

So, what about greed then? Roger Bootle takes this on in his latest book, “The Trouble with Markets,” which I highlighted earlier in the week. Here is how the Telegraph quotes him:

The free-market vigilantes are already rushing to defend the unfettered market system. Their defence is based on one or other of three arguments. First, the market solution is to let failing financial firms fail. If the state intervenes to stop this, the blame for the resulting mess cannot be laid at the door of the market system. Second, banking has been a heavily regulated activity. The regulators have failed in their job. Third, the monetary policy authorities should have paid more attention to the growth of money and credit and the resulting inflation of the property market bubble.

In this way, they try to argue that what seems on the face of it to be a failure of markets is in fact a failure of government. So the solution, they say, is not less freedom for markets but more.

These people are dangerous. The idea of letting the financial system implode and then waiting for the market to bring spontaneous, healthy revival out of the wreckage might read well on the pages of a book, but in the real world it would bring human misery on a gigantic scale. In today’s society, people simply will not tolerate it. If that is what the market system is about then they will have none of it; and rightly so.

Have a go at the full article linked below. Bootle makes some very good points. I liked his last book, “Money for Nothing”. So I suspect his new book is a good read too.

Greed isn’t good– it’s dangerous – Telegraph

Related posts:

• Quote of the day: Gordon Gekko – greed is good
• More on greed, regulation, Lehman and the financial industry
• Bear Stearns: Last 72 hours chronicled in new book
• Guest Post: Did Gordon Gekko inspire Wall Street or the other way around?
• The Obama-Geithner Plan will fail

Marshall Auerback here.  I want to add a few thoughts on the situation in Latvia which Ed has highlighted on several occasions. His allusion to Argentina to describe the situation in the Baltics last July was on the money. I have a solution here out of the Argentine playbook.

In Latvia, the neo-liberal insanity continues.  The EU and IMF have told the government to borrow foreign currency to stabilize the exchange rate to help real estate debtors pay the foreign-currency mortgages taken out from Swedish and other banks to fuel its property bubble, raise taxes, and sharply cut back public spending on education, health care and other basic needs to “absorb” income. Higher taxes are to lower import demand and also domestic prices, as if this automatically will make output more competitive in export markets.

But Latvia doesn’t produce much to export. The Baltic States have not put in place much production capacity since gaining independence in 1991. Latvia, like other post-Soviet economies, has scant domestic output to export. Industry throughout the former Soviet Union was torn up and scrapped in the 1990s. (Welcome to victorious finance capitalism, Western-style.) What they had was real estate and public infrastructure free of debt – and hence, available to be pledged as collateral for loans to finance their imports. Ever since its independence from Russia in 1991, Latvia has paid for its imported consumer goods and other purchases by borrowing mortgage credit in foreign currency from Scandinavian and other banks. The effect has been one of the world’s biggest property bubbles – in an economy with no means of breaking even except by loading down its real estate with more and more debt. In practice the loans took the form of mortgage borrowing from foreign banks to finance a real estate bubble – and their import dependency on foreign suppliers.

So instead of helping it and other post-Soviet nations develop self-reliant economies, the West has viewed them as economic oysters to be broken up to indebt them in order to extract interest charges and capital gains, leaving them empty shells.

The sad part about this whole episode is that Latvia’s problems could be fixed over a weekend. Here’s what I would do:

1. Drop the peg to the euro, which functionally acts like an gold standard external constraint.
2. Don’t answer the phone when the foreign creditors call the government.
3. Have the banks declared insolvent, convert their external debt to equity, and then have them reopen that way on Monday with full deposit insurance guaranteed in the now free floating local currency.
4. Enact a 0% rate policy (use fiscal policy to regulate demand going forward).
5. Offer a local currency minimum wage job that includes healthcare to anyone willing and able to work as was done in Argentina after the Kirchner regime repudiated the IMF’s toxic package of debt repayment.

Full employment and economic prosperity would come in no time at all.

The last line is the key.  Improve employment and aggregate incomes and demand follows – as does creditWORTHINESS.  At the final stage, credit will follow.

Even a banker can figure that one out.

Related posts:

• China is set up for a big fall
• China issues bonds to “promote the RMB in neighbouring countries”
• Bloomberg talks Eastern Europe as Latvia downgraded
• Latvia as the new Argentina redux
• China can handle collapse of speculative inflows

Remember when Paul Krugman asked aloud “How Did Economists Get It So Wrong?” He had a very well-received answer.  But he left out something.

The elephant in the room was debt.  No one seems to have been noticing.

Below is a British video parody version asking economists and political leaders the same question (in a slightly more graphic version). Warning : this video is hilarious but graphic.  Don’t play it at work. I warn you.

Hat tip Yves Smith.

Related posts:

• Doubling down at AIG
• Tim Geithner defends himself before Congress
• Paul Tudor Jones: Trader – Flashback to 1987
• Bloomberg News vs. Fed: Judgment against Fed attached
• Wassup 2008

Hank Paulson and Ben Bernanke told us when the Troubled Asset Relief Program (TARP) was launched that they were not concerned about the health of our banking system.  In fact, this was not the case. They were concerned about specific institutions and the overall health of the system. The U.S. financial system was much weaker than we were led to believe as I indicated at the time.

Now the TARP Special Inspector Neil Barofsky is telling the American people what many of us knew all along. Listen to what he says in the video below with MSNBC’s Dylan Ratigan. His contention that these false premises undermined the credibility of TARP and subsequent government economic policy rings true. Even today, we don’t know what the banks are doing with their TARP funds.  If they are loaning it out, why is the unemployment rate 9.8%?

By the way, I love D-Rat. This is a guy who likes to talk – god bless him. Sometimes he goes on way too much, but I like his approach.

Related posts:

• US Bancorp CEO makes his case on TARP repayment
• Some banks not paying TARP dividends
• TARP dividends are killing bank profits
• Should foreign companies get TARP funds?
• Crony capitalism in U.S. banking bailout should end

The following is my translation of a much-discussed article that appeared in Swedish daily Svenska Dagbladet at the weekend.  This information was being withheld from the public and leaked at an inopportune moment.

Note that the Swedish government has secretly been preparing the banks for financial Armageddon, encouraging Swedbank into a rights issue which arguably was conducted under fraudulent pretenses – very reminiscent of Bank of America’s shareholder vote for the merger with Merrill Lynch.  In August, I asked “Why is Swedbank doing a second rights issue?.” Now we know.

This is the kind of thing that topples governments.

Secret meeting on the crisis in Latvian

Finance Minister Anders Borg has had secret talks with the major Swedish banks and warned of a near economic collapse in Latvia, Svenska Dagbladet has learned. A nightmare scenario for Swedbank and SEB.

Yesterday Anders Borg issued a stark warning to the Latvian Government that it must take its financial problems seriously.

The promised cuts must be implemented when the new Latvian budget is presented in late October, according to Finance Minister.

The international community’s patience is very limited, stressed Anders Borg at the summit of European finance ministers in Gothenburg where he hosts as the finance minister in Presidency.

His statement came after recent reports from Latvia on political divisions in the ongoing budget negotiations.

But for Swedish bank heads, Borg’s move came as no surprise. According to several independent sources, Anders Borg, over the last few weeks, has contacted the senior management of major banks and warned them of an acute political crisis in Latvia. This in turn can lead to both a devaluation and eventually a default. It is a kind of national bankruptcy, similar to what hit Iceland last fall.

In secret talks with Swedish banks, Anders Borg explained the growing pressure that exists within the International Monetary Fund (IMF) to force Latvia into a devaluation.

A collapse in Latvia would have serious implications for several major Swedish banks. With a devaluation the already high loan losses would explode overnight, especially because many Latvians have loans in euro, which would become significantly more expensive.

Swedbank has up to today lent 61 billion kroner to Latvian individuals and businesses. The figure for SEB is 40 billion, while Nordea has 30 billion in loans.

For Swedbank a possible devaluation would come at an especially poor time. The bank is currently in the middle of a second rights issue in which shareholders have been asked to put up 15 billion.

CEO Michael Wolf’s message to shareholders and customers has repeatedly been that the money would be used for offensive investments. To then have to deal with a severe national bankruptcy in one of its major markets and see new issue money disappear into a black hole would be a severe blow to the bank’s credibility.

That a serious crisis approaches in Latvia has already been flagged by Anders Borg in the budget he presented a few weeks ago. On page 99 he writes:

"Since it is difficult to safely assess Latvia’s ability to pay and with conditions for recovery, one cannot completely exclude the risk of a major default."

The background to the current situation is a crash in the Baltic economies. Latvia is just the worst hit. This year, the country’s GDP is to shrink by as much as 18 percent.

This led to a rescue package cobbled together at Christmas last year. The International Monetary Fund (IMF), the EU and the Nordic countries decided on payments totaling SEK 80 billion, of which Sweden accounts for 7 billion.

An essential condition for aid money, however, is that Latvia implement substantial cuts in order to get the economy in balance.

This means wage cuts for state employees in over 15 percent, including hospital closures and major tax increases.

In July of last year Latvia went to reduce their spending for next year’s budget by more than 7.5 billion crowns.  It opened the door to  a further one billion disbursements from the IMF and the EU.

But then, the domestic political situation deteriorated. The previous Latvian government fell in February and since then the country has been governed by a coalition of five parties. The Prime Minister is Valdis Dombrovskis.  Next year come elections again.

Two of the parties in this five-party coalition have now objected to the previously announced savings of 7.5 billion. Some want to go back on parts of the promise and believe that a reasonable savings is instead about 4 billion kroner.

The goal to save 500 million lats (7.5 billion kroner) is practically impossible to achieve without eliminating several parts of the economy, Vents Armands Krauklis from the influential Liberal Party, which sits in the government coalition, said the day before yesterday.

24 hours later came the response from the EU.

"Latvia does not have much room for maneuver; It must fulfill its letter-of intent," said Anders Borg yesterday in Gothenburg to the news agency Direkt.

Original Source

Hemligt möte om lettisk kris – Svenska Dagblaget

Also see my August post, “Zombie banks Scandinavian edition and the threat of too big to fail.” This problem looms even larger now.

Update 7 Oct 2009: minor translation corrections were made resulting from reader suggestion.

Related posts:

• Transferring Swedish bank risk onto Latvian taxpayers
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Estonia and Latvia: headed for the rails
• Earnings results at Swedish banks show large writedowns in Baltics
• Violence erupts in Latvia

In a 9-page Vanity Fair article “Wall Street’s Near-Death Experience,”giving us a sneak peek into the lives of bankers during the global meltdown last Autumn a hilarious quote of great significance was buried.

At issue was the near-death experience that Lehman’s demise caused for Morgan Stanley and Goldman Sachs. After receiving a mysterious call from JPMorgan Chase CEO Jamie Dimon, Colm Kelleher, Morgan Stanley’s CFO, is quoted as saying “Jamie is always hanging around the hoop”:

‘Listen, [JPMorgan Chase C.E.O.] Jamie [Dimon] just called me fishing around for something,” Colm Kelleher told John Mack midday Thursday as he marched into Mack’s office. “He said he was calling to see if he could be of help. It was strange.”

James Gorman, the firm’s co-president, had just reported receiving a similar call, Mack replied, and Geithner had phoned earlier to suggest that he talk to Dimon as a possible merger partner, too.

“It’s clear that, for him to be calling us, he wants to do a deal,” Kelleher said. “Jamie is always hanging around the hoop.… You know Jamie’s saying, ‘Let’s make friends with these guys before I eat them.’”

Mack was irritated by these suggestions; he didn’t particularly want to do a deal with Dimon, as he believed it would involve far too much overlap. But he decided to stop guessing what Dimon might be up to and ask him directly.

“Jamie, Geithner says I should call you,” Mack said abruptly when he reached Dimon on the phone a few minutes later. “Let’s get this out in the open: do you want to do a deal?”

“No, I don’t want to do a deal,” Dimon said flatly.

“Well, that’s interesting,” Mack retorted. “You’re calling my C.F.O. and you’re calling my president—why would you do that?”

“I was trying to be helpful,” Dimon repeated.

“If you want to be helpful, then talk to me. I don’t want you calling my guys,” Mack said, hanging up the phone.

I think this is a brilliant quote because it encapsulates the situation perfectly. (For readers who are not basketball fans, this was a sports reference to basketball players who stay close to their basket to score easy lay-up points). Dimon, a classic keep-your-powder-dry-when-everyone-else-is-losing-his-head conservative banker, is also an opportunist.  In a move straight out of Warren Buffett’s game plan, he was looking for some easy lay-ups when the chips were down and everyone was panicked. That’s how he got bear Stearns and it’s also how JPMorgan Chase got Washington Mutual.

Update: I just picked up Chris Whalen’s piece on BofA, where he contrasts Bank of America’s management with JPMorgan Chase’s.  He says:

As we have noted before and we’ll probably state again, the difference between BAC and Wells Fargo (NYSE:WFC), on the one hand, and JPM on the other, is that Jaime Dimon had the good sense to buy WaMu from the FDIC after it was restructured via the resolution process. All of the legacy liabilities of WaMu, including the legal liabilities from the massive securitizations sponsored by Washington Mutual Inc., were left in the DE bankruptcy court after the FDIC took control of the bank unit. That is why the cleansing process of bankruptcy is so important to the restoration of a healthy, growing economy.

Notice the focus on bankruptcy. WaMu was effectively nationalized and put through the bankruptcy process – a clear sign that it is completely disingenuous to claim that nationalization was not an option for other large financial companies. It was – but they were deemed to important to fail.

Related posts:

• Quote of the day: Wells and BofA are choking on acquisitions
• Jamie Dimon: “If You Are Not Fearful, You Are Crazy”
• Jamie Dimon on the economy
• Jamie Dimon: November was terrible, December is terrible
• Jamie Dimon: ‘we don’t need’ your money

Marshall Auerback sent me a link to a recent Simon Johnson missive about Goldman Sachs. I had already seen and liked this article, but his e-mail prompted me to write this post. My question is: Why is Goldman a bank holding company?

Goldman becomes a bank

The reason Goldman became a bank to begin with is because it was on the verge of collapse after the Lehman Brothers failure. Andrew Ross Sorkin has a good write up on this in Vanity Fair:

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

Just in case it’s not obvious, Goldman Sachs was a major beneficiary of the government’s bailout of the financial services industry, not only through the bailout of AIG but also through its ability to fall under the regulatory umbrella as a bank holding company* (technically Goldman became a financial holding company but the distinction is relatively minor. see definition here). – something which made it eligible for debt guarantees and other government backstops.

Late last year, every financial services company on earth wanted to become a bank and line up for the handouts coming from Washington – American Express (a credit card company), GE Capital (basically a hedge fund), GMAC (a car financing company), Genworth Financial (an insurance company), Aegon (a Dutch company), even Willem Buiter, a former central banker, wanted to become a bank.

This is why Goldman became a bank too. Now, Goldman was in a more precarious position than bank holding companies because of the vulnerabilities of being a broker-dealer. Nouriel Roubini warned repeatedly before Leman’s collapse that the large full services broker-dealer model was broken.  Here, just before Lehman failed, he talks about Goldman, Morgan Stanley and Merrill’s demise if Lehman collapses:

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

I happen to think Goldman is a well-run institution, but that is neither here nor there. They were vulnerable. 

And, apparently, policy makers heeded Roubini’s words as all the broker-dealers were immediately made into banks.  Government went so far as to try and merge Goldman with the bankrupt Wachovia (now a problem for Wells Fargo), but thought better of it because of the conflicts of interest for Hank Paulson and Robert Steel:

In an excerpt from his forthcoming book, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, Sorkin reports that the deal, which was nearly consummated, would have merged Goldman Sachs and Wachovia. Henry M. Paulson, the Treasury secretary and former C.E.O. of Goldman, was deeply involved in the process, contacting both Lloyd Blankfein, Goldman’s current C.E.O., and a Wachovia board member, and strongly urged both to consider it. Wachovia’s C.E.O., Robert Steel, was a former vice-chairman at Goldman Sachs and Paulson’s former number two at the Treasury Department.

Sorkin reports that Warren Buffett was also contacted about investing in the merged company, but told a banker at Goldman that it would never happen. “By tonight the government will realize they can’t provide capital to a deal that’s being done by the former firm of the Treasury secretary with the company of a former vice-chairman of Goldman Sachs and former deputy Treasury secretary,” Buffett said. “There is no way. They’ll all wake up and realize, even if it was the best deal in the world, they can’t do it.”

Goldman gets to game the system

These conflicts of interest has everyone up in arms about Goldman, dubbed “Government Sachs” by its haters (see here, here, and here). That is why the face-sucking squid polemic by Matt Taibbi was a zeitgeist piece. 

I think eyes should be focused firmly on the government’s responsibility and not Goldman when it comes to these issues. Which is why the issues that Simon Johnson raises are important. They go to the core of the regulation of banks.

Here are four questions we should be asking regulators:

1. Why is Goldman Sachs allowed to maintain leverage ratios significantly higher than the large legacy bank holding companies like Wells Fargo, Bank of America, JPMorgan and Citigroup?
2. Why is Goldman allowed to operate like a private equity company, holding large stakes of foreign non-financial corporations? (I should note that Financial Holding Companies do have ten years in which to sell their stakes)
3. Why is Goldman (and other large banks) allowed to operate like a hedge fund and take outsized risks with capital via large proprietary trading operations.  Most of Goldman’s profits are coming from this area. At least Deutsche Bank has offloaded these bets onto hedge funds in which it invests. Given the fact that the large too-bog-to-fail financial institutions have received a large backstop from the taxpayer, the fact that they are loading up in prop trading shows that regulation in the U.S.  is non-existent.
4. Why is Goldman allowed to have an interest in the failure of other financial firms? We now hear that Goldman has an interest in the failure of CIT, a major lender to small-and medium-sized businesses. These perverse incentives are everywhere in the derivatives world and were an enabler of the financial meltdown and the principal reason AIG was bailed out with taxpayer money.

Clearly, regulators are not serious about regulating or they would correct these problems.  MarketWatch reported on this as far back as July and nothing has happened.

When Goldman switched to a bank holding company, such big profit seemed unlikely as analysts worried the firm would face stricter regulatory oversight from the Federal Reserve, with limits on risk-taking and higher capital requirements. See story Wall Street changes.

But almost 10 months later, nothing much appears to have changed, some analysts said in the wake of the firm’s second-quarter results.

After two quarters as a bank holding company, Goldman is still "not reporting like a bank and not acting like one either," said David Hendler, Baylor Lancaster, Pri de Silva and Kristine Lanspa, analysts at CreditSights, an independent fixed-income research firm.

Given Goldman’s spectacular results so far this year, "the company has basically been given a green light to continue operating in a ‘business as usual’ fashion," they wrote in a note to investors after Goldman’s latest earnings report. "Bank regulators have their hands full with other deteriorating bank situations and, for the time being, seem content to let Goldman do what it’s always done."

Tier 1

Goldman still doesn’t report quarterly results like other large bank holding companies. For instance, the firm doesn’t disclose a full balance sheet in its earnings release or provide detailed information on revenue and valuation marks on exposures, the analysts noted…

"Our sense is that Goldman’s switch to bank holding company status was basically a security blanket in the worst of last fall’s troubles, and the company would be happier today if it could let it go," they added. "We also sense that Goldman Sachs many not yet have the same level of regulatory scrutiny that many banks routinely live with."

And CreditSights is right. Goldman have no intention of changing anything at all.

“Our model really never changed,” Goldman Sachs Chief Financial Officer David Viniar said yesterday in an interview. “We’ve said very consistently that our business model remained the same.”

Plus ça change.

The excerpt in this article from the RGE Monitor is copyrighted and re-published with the express permission of Roubini Global Economics LLC.

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Janet Tavakoli was a recent guest on “On the Edge with Max Keiser” and had some troubling things to say about the state of the present U.S. financial system. 

She believes the liquidity pumped into the system will not be sufficient to reflate the economy because of over-leveraged U.S. households. The real burden of debt is already increasing as nominal GDP contracts.  This means the system is now more fragile than ever.

Meanwhile, banks have been recapitalized in an effort to save the system when mechanisms to organize a bankruptcy resolution process for too big to fail institutions would be much less costly for the economy. This is a topic I covered in a recent post.

Steve Keen told Max that the only way out of this is a debt jubilee – a notion I believe is a political non-starter. So expect this end in a debt deflationary scenario as the Fed and other central banks are not yet getting any traction except in asset prices.

Below is the video of Max Keiser talking to Tavakoli by phone.  Tavakoli provides some enlightening words about fraud, derivatives, and broker-dealer bankruptcy. The video runs about 10 minutes.

Related posts:

• Janet Tavakoli: C-Span Q&A
• Steve Keen: On the Edge with Max Keiser
• Citi agrees to do cramdowns
• Forstmann on Charlie Rose: easy money caused crisis
• Chicago Tribune near bankruptcy