Friday, December 26, 2008

The Real Reasons Why Hank Paulson Screwed Up

For Hank Paulson's detractors (and there are many), the U.S. Treasury Secretary's main mistakes in dealing with the 2009 financial crisis often boil down to: 1. Letting Lehman Brothers go bankrupt. 2. Relying on an ad hoc approach: one day the $700 billion bailout is about buying bad assets, the next it's about recapitalizing struggling banks (remember the quote from a Washington lawmaker accusing him of flying a $700 billion plane by the seat of his pants).

But is this really where the former Goldman Sachs chairman blundered?

First, Lehman Brothers: Did its collapse really play such a large role in ushering in the nuclear winter in credit markets? It's not that hard to imagine that, absent a Lehman going belly up, a different bankruptcy or dire event would have brought us to the same juncture. Remember too that Lehman was revealed to be in worse shape than anyone imagined: its bonds wound up fetching a paltry nine cents on the dollar. Its implosion spooked markets partly because investors saw how much rot had spread through asset books of financial companies.

Of course a countervailing argument is that letting a Lehman perish isn't smart because of the outsized effect on money flows. Fear and caution become ascendant to an irrational degree; overnight lending rates between banks skyrocket as everyone wonders where the next Lehman Brothers may be hiding. The system is too fragile to allow such a big company to fail.

But imagine the Treasury made a mighty 11th hour effort; there was no bankruptcy; Lehman was saved. Then what would we have today? For one, an even more entrenched corporate bailout culture. Loans would flow a bit more smoothly for a while, while the underlying weaknesses remained the same. The financial system would still be highly susceptible to small shocks.

Now what about the second Paulson criticism: Does he deserve to be pilloried for being too quick to change direction? This seems misplaced. Steadfastness may be a virtue for a 50-year marriage; its value is much less clear for a complex, fast-changing crisis that has global ramifications. Should we favor hardheadedness and inflexibility over what may be a smarter, pragmatic approach that happens to look a bit messy?

So how did Paulson screw up? The best answer to that question comes from contrasting the American and British responses to the crisis. Paulson failed to:

1. Aggressively recapitalize and resolve uncertainty around struggling banks. The Treasury Secretary and Fed should be coordinating efforts to audit banks to determine who's really insolvent and who simply needs more capital to weather hard times. The insolvent companies need to be merged with healthier rivals or unwound. This would go a long way toward restoring confidence in the industry. This requires the political will to grab the bull by the horns; Bush's free-market ideologues have been reluctant to do so.

2. Strike hard bargains in return for bailout funds. Britain did this more effectively. The U.S. government should offer money on conditions close to what the private sector would demand: preferred stock, board seats, maybe a top-level reshuffle (throw out a president or two -- or three or four). When Barclays saw what the British government wanted in exchange for assistance, it promptly began looking elsewhere for capital. The benefits to knuckling down are many, including: 1. Lessening moral hazard risk. 2. Creating more opportunities for taxpayers to benefit from providing the rescue funds. 3. Necessitating fewer bailouts, meaning less government involvement and less money being paid out by an overburdened Treasury. 4. Encouraging private capital to move off the sidelines to recapitalize banks (private capital no longer has to compete with a government that offers sweetheart deals). That then helps establish a floor price for bank valuations -- and that, of course, is a necessary prelude to any long-term recovery.

Forget Lehman. Forget the ad hoc policy. These are the real failures Hank Paulson should answer for.

Monday, November 24, 2008

The View Through the Bushian Looking Glass

GM got a stern dressing down when it showed up in Washington with Detroit's other suffering automakers, hat in hand, seeking a bailout. Would you rescue an outfit with these characteristics:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (blue-collar employees got generous union contracts that provided unsustainable benefits). Its core business suffered from stunningly bad decisions (not developing enough good high-mileage or green vehicles, for example, leaving the company with unpopular products it has trouble selling).

The verdict: Let it perish! But what about the following supplicant:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (white-collar executives got outrageous bonuses and salaries that didn't reflect the long-term viability of the operations they oversaw). Its core business suffered from stunningly bad decisions (taking on too much leverage and acquiring risky, complex securities, leaving the company with unpopular products it has trouble selling).

The verdict: Save it at any cost!

Of course this second example is Citigroup. The financial giant not only received a bailout, but the terms were astonishingly generous. First Citigroup gets a $20 billion loan. Then the federal government agrees to backstop its losses on $306 billion of potentially crappy mortgage-backed securities. That's billion with a “b.” Worst-case scenario, taxpayers would be on the hook for roughly $250 billion on the backstop provision alone. That's more than ten times how much the embattled Big Three automakers sought to borrow, only to be rebuffed.

To be clear: GM shouldn't get a rescue package, not without a tough shakedown. But what about Citigroup? I know it's large. I know letting it fail would be akin to letting die the guy in the science-fiction film whose body is teeming with highly virulent viruses that, if he expires, will explode into the air and perhaps wipe out civilization.

But can’t the Bush team knuckle down and drive a hard bargain with at least one of these financial companies, especially since they’re bargaining from a position of weakness? It’s really baffling.

Saturday, November 15, 2008

Give Me a Lever Long Enough and I'll Buy the World

When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.

Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.

The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.

Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.

Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.

When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.

Thursday, November 6, 2008

Wall Street’s Deafening Silence

Throughout the long dark days of this financial crisis, one thing that has struck me is the silence of Wall Street’s public relations machines. I keep waiting for one bank, any bank, to give us their best-spin version of what went wrong, or why they aren’t as bad as all those others – or to say something. Surely they must see how vilified they have become. Shareholder activist Nell Minow even quipped that the Street is one bonus away from having the villagers descend with torches.

But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.

How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.

When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.

Thursday, October 30, 2008

Why Homeowner Mortgage Relief Ain't Going to be Easy

Like many others, I was rather shocked last month on hearing about the need for a $700 billion bailout of Wall Street. The early storyline was that financial firms were saddled with too many securities backed by distressed U.S. home mortgages and, in a climate of fear and panic, they couldn't sell them at fair value. So that meant the government would have to step forward and act as a buyer.

Setting aside the fact that this narrative was disingenuous at best, dishonest at worst (the assets are most likely cheap because -- surprise -- they're simply not worth that much), I found the approach bass ackwards. It seemed more efficient to work from the ground up. Namely, if the securities were hard to value because of uncertainty over the mortgages they held, why not provide a structure for homeowners and lenders to rework troubled mortgages? In this “trickle up” approach, the securities would gradually become more stable and thus easier to trade. It seemed like a pretty good idea.

I soon discovered a huge, gaping flaw: your 2005 mortgage probably isn't held by your friendly neighborhood bank. Rather, it was sold off by the mortgage originator (maybe your bank, maybe a mortgage company) and the payment stream was repackaged as part of a security. In fact, your mortgage payments may even have been sliced into pieces and spread across 10 or even 50 different securities.

Now here's where the headache begins. Once you begin modifying mortgages on a large scale, you create all sorts of havoc. An investor who bought a mortgage-backed security under one set of rules and understandings, now is operating under a different one. Some investors will win, others will lose -- and this being America, the losers will likely litigate. That's why the managers of the pools of loans, the so-called “master servicers,” probably won't renegotiate them. It's a real mess that can only be circumvented by some kind of federal law, and even then at a potentially dangerous precedent of rewriting contracts.

This New York Times op-ed piece captures the predicament about as well and lucidly as any I have read so far and proposes a solution. But don't be fooled: any solution is going to be very tricky to execute.

Sunday, October 26, 2008

The Danger of Clinging to Myths of Security

In my fairly voracious reading on the current financial mess, I've yet to see anyone tackle in thematic fashion the idea of “myths of security.” I think this is a highly relevant subject (a tad philosophical, but not too much heavy lifting I promise), as it helps explain why an asset bubble can become grossly inflated. Security is, after all, the comforting touchstone to reality we seek when we’re faced with counterintuitive evidence, such as home prices surging 20 percent a year.

So what myths of security allowed the housing market to soar so high? By myths of security, I refer to a false sense of safety or comfort. These myths create what might be called a “security premium” in prices of assets, such as homes. In other words, investors are willing to shell out more money for assets perceived as safe and reliable.

A quick detour: Why is this last sentence true in general? 1. The pool of investors, and thus the overall demand, grows larger for safe investments. Example: pension funds were enticed to buy mortgage-backed securities because of the glowing credit ratings on the products. 2. Investors want compensation to assume risk. If you offer to sell an IOU for $1,000, payable in one year, you may get $995 if you're a moral, upstanding citizen with a good job. But if you're Sam Shady, an out-of-work transient, that IOU may fetch only $800, $700 or even less.

(There is an interesting corollary of all this that I'll skip over here, but it goes like this: if you appear to wave a magic wand and create a secure investment with a return of say 8% when other similar-yielding investments are much riskier, you start to suck money away from those others. This can further pump a bubble. In fact, the myths of security play into a vicious feedback loop: money is diverted to investments that, at a given yield, are seen as “safer”; these assets then spiral higher, drawing in more money.)

Here are four chief “myths of security” in the housing and financial mess:

Housing prices never fall.
This myth was fairly widespread. I remember hearing it from a good friend in late 2005, while living in South Florida. At the time, home prices inexorably climbed every month; flippers and speculators were running rampant, snatching up unbuilt condos and queuing up overnight to be first in line for sales in new developments. The reasons for the myth are easy to understand: houses are real, tangible, critical assets. Everyone needs shelter. But even the most indispensable assets can become significantly overvalued.

The Federal Reserve under Greenspan would intervene to prop up falling prices of major assets, such as homes.
This myth is key because it was on Greenspan's watch that home prices had such a huge run-up. That rise in value benefited from a phenomenon known as “the Greenspan put.” “Put” in this context is a high-finance term. It refers to a product that protects an investor from losing money on an asset. Believers in the Greenspan put thought that, should home prices start to fall, the Fed chairman would step in and pump money into the markets to support prices.

Good ratings from respected agencies such as S&P and Moody's made mortgage-backed securities safe to buy.
The market for bonds backed by shaky U.S. home loans could never have grown so huge had they not received such high safety ratings from S&P and Moody's and Fitch. Now we find that the raters were mostly trying to win customers and boost revenue. They weren't that careful or rigorous in their evaluations. The cynic’s view is that their ratings became the best that money could buy, so to speak.

Even if you weren't confident of the ratings on mortgage-backed securities, you could buy insurance on the investments to hedge against a drop in value.
Insurance-like products called credit default swaps were supposed to provide this extra layer of protection. The trouble is, the credit default swap market became huge and is opaque and unregulated. It's not clear how many “insurers” actually have enough money to make good on future losses on mortgage-backed securities. Many of the insurers were hedge funds, an industry on the ropes amid the current market turmoil.

What happens when you inflate a bubble on four big “myths of security”? Once these myths are exposed, the bubble deflates quickly and violently, it would seem from what we are now seeing.

Thursday, October 23, 2008

Shakespeare and the Credit Rating Agencies

The current crisis in the financial markets is being portrayed as, above all, a failure of trust. Banks are seeking unreasonably high rates to lend to each other because they don't know who is hiding skeletons in the closet and may be teetering on the brink of insolvency. But if you really want to understand the concept of trust squandered, you would do well to look at the plight of the credit rating agencies.

These companies slapped attractive ratings on dubious mortgage-backed securities. Investors then snapped up the securities, reassured by the seals of approval bestowed by Moody's and S&P. Of course the ratings agencies had a conflict of interest so huge it was surprising that Washington regulators never had a Homer Simpson “d’oh” moment: Whichever bank created a security also paid for it to be rated. It's like a poor student who can buy good grades, except with more disastrous consequences, as we are now seeing.

How bad did it get? In an informal instant message exchange in April of last year, one S&P official expressed skepticism to another about a mortgage-backed security, saying the model being used for the rating “does not capture half the risk.” Then she made the snarky remark: “It could be structured by cows and we would rate it.”

Credit rating agencies are edging toward irrelevancy because they compromised their ideals and let their names be sullied in pursuit of short-term profits. Their very business model relies on their reputation and integrity of their work. When investors lose faith in their ability to evaluate products and entities, their role in the financial system becomes entirely superfluous.

They would be wise to remember Shakespeare who once wrote wisely, “He who steals my purse steals trash/but he that filches from me my good name robs me of that which not enriches him and makes me poor indeed.”

Tuesday, October 14, 2008

Hank Paulson: He Isn't One of Us

The John McCain line about Barack Obama could easily apply to the U.S. Treasury Secretary. Paulson, as you may recall, submitted an awful $700 billion bailout plan that was fortunately improved through the legislative process. But Paulson had to be dragged kicking and screaming into doing the right thing (agreeing to take ownership stakes in firms that take bailout money, so as not to leave taxpayers too much on the hook). He apparently preferred to just blow $700 billion on a mountain of bad assets and cross his fingers that they'll be worth something in five years.

Hank Paulson is now paid by the U.S. taxpayer, but he still hears most clearly the siren call of Wall Street, where he once headed Goldman Sachs and argued against regulations that could have helped avoid this current mess. Considering his conflicted heart, we would do well to monitor the Treasury closely during bank rescue operations. Paulson still wants to play Santa Claus; he has already said that the government will take only nonvoting preferred stock in banks it helps. That's like investing millions in a struggling company and then being told to keep your mouth shut about how they run things.

For the story, just read Felix Salmon’s astute and timely blog post here at

Monday, October 13, 2008

Fannie and Freddie: Not the Boogeymen

Check out this article from the Washington bureau of McClatchy Newspapers about why Fannie and Freddie shouldn't be the fall guys for the global financial crisis. The structure and logical flow are a bit choppy in places, but the central contention is dead on. It was good to see the authors argue the point forcefully, which newspaper reporters are often too timid or self-conscious to do. Anyway, the excerpt below shows how Fannie and Freddie were laggards in subprime lending, not leaders.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.

And Now a Word from our Sponsor

Now for some good news about the market for credit default swaps (those insurance-like products that guarantee the value of corporate bonds and mortgage-backed securities). These details are by way of a clearinghouse for trades that goes by the name Depository Trust and Clearing Corporation (DTCC).

* Pleasant surprise #1: DTCC, which claims to handle the "vast majority" of trades on credit default swaps, says it has registered $34.8 trillion of such contracts. That would make the credit default swap market about half of earlier estimates of $60 trillion, thus reducing its "neutron bomb" capacity for widespread destruction.

* Pleasant surprise #2: Less than 1% of its credit default swaps are for mortgage-backed securities. So, presumably, even if these securities (whose value rests on the fortunes of the cratering U.S. home market) take a tumble, that won't trigger huge CDS claims.

* Pleasant surprise #3: The net payout in the Lehman bankruptcy, from the sellers of credit default insurance to the buyers, will be about $6 billion, not $365 billion or some other ghastly-high figure. This is because, apparently, the players in this market are well hedged. In other words, if A owes B $30 billion, he's mostly covered because C owes him $29 billion.

The DTCC corrected all these misperceptions in an October 11 press release in which it decried "inaccurate speculation." What's going on here, I think, are several things. DTCC is trying to (1) quiet investor fears about swaps, (2) show that the products aren't part of some crazy Wild West marketplace being run off Uncle Jed's back porch, and (3) position itself for the coming onslaught of Washington regulation.

This disclosure is useful, though it helps underscore why there's so much concern about credit default swaps in the first place. The market has been operating in too many dark, unregulated corners. The fact that the net payout from the Lehman bankruptcy could have been misestimated by a factor of 60 shows how little is known about how these swaps work and who has how many of them.

Sunday, October 12, 2008

Halloween Costume Idea: Go as a Credit Default Swap

We are now entering a new roller coaster phase of the financial crisis. The G7 meeting this weekend produced little more than the illusion of a hint of group resolve. The communiqué that was issued contains fine-sounding principles but no plan of action. Markets will likely respond no more than if they had been slapped with a wet noodle.

The real news this week will be quietly going on behind the scenes: a scramble for cash to meet credit default swap obligations after the Lehman Brothers bankruptcy. That's a mouthful, and since I created this blog for curious people who aren't from the world of finance, I'll go slow here.

First, when you go bankrupt, your owners are wiped out. In Lehman's case, this means the stockholders. The bondholders, being creditors, are in a better position. They get to divvy what's left of the carcass, if you will. For every dollar they lent to Lehman, they may get 70 cents, 50 cents or even 10. Turns out, unfortunately, it's pretty close to 10 cents, as determined Friday.

So are the bondholders almost completely wiped out? Well, not so fast. If they owned credit default swaps, a sort of insurance on their bonds, they get to recover the remaining 90 percent. (Cue the rousing cheer sound effect.) So far, this sounds like a very savvy bit of Wall Street financial engineering, these credit default swaps, eh?

The problem, as with any insurance, is your insurer must have enough money to pay out the claim or the whole scheme falls apart. Large Wall Street banks and hedge funds have been happily writing credit default swaps and raking in the fat premiums for the last eight years. They don't have to show that they have sufficient funds to make good on the swaps because this market is COMPLETELY UNREGULATED. I could theoretically write one of these contracts from my bedroom, in my pajamas, with $26 in my savings account. And the CDS market has exploded in size to about $60 trillion. (That's the cost of about 100 Iraq wars).

Here's another wrinkle: you can buy these pseudo-insurance policies without even owning the underlying bond. In other words, it would be like taking out a fire insurance policy on Fred's house across town. You don't own the house, but you can collect when it burns down. That wrinkle matters hugely because it inflates the size of the CDS market. Lehman, I believe, had about $128 billion of bonds and an estimated $400 billion worth of credit default swap coverage on those bonds. This is where a CDS stops looking like insurance and more like a roulette wheel bet. Insurers write swaps for buyers who just want to take a flyer on whether or not Lehman will go belly up.

Now, to the heart of the matter: why this week could be especially turbulent in the markets. The insurers for the Lehman credit default swaps will have to start coughing up about $365 billion -- that's right, billion with a “b.” Now remember, the CDS market is totally unregulated, so no one is entirely clear who all these insurers are, or how much they’re on the hook for, or whether they'll be able to come up with the funds.

Two possible outcomes: 1. If some of the CDS insurers are cash-strapped hedge funds, they may have to sell off truckloads of stock to meet their obligations, driving down the Dow and S&P for yet another week. 2. If some of the CDS insurers are banks, the steep payouts could potentially bankrupt them. The second possibility is scarier, as it ushers in a death-spiral scenario: they go bankrupt, which triggers payouts on the credit default swaps on their own debt, which causes more bankruptcies, etc. etc.

This week and the next could be a major stress test for the credit default swap market. And then the whole thing starts anew with Washington Mutual's bankruptcy settlement at the end of this month. Better take some Dramamine.

Tuesday, October 7, 2008

Pin the Blame on the Donkey?

The search for a scapegoat in the U.S. financial crisis will reach new heights if markets around the world continue to gasp and flounder. Banks are still terrified to lend to each other. Who can you really trust in a high-stakes shell game where mounds of bad assets are hidden somewhere, but where exactly?

One narrative of the financial crisis would lay the blame at the feet of Fannie Mae and Freddie Mac. The two mortgage giants, conservatives contend with increasing vigor, were pushed hard by Congress (especially by Democrats) to lend more to low-income families who had poor credit. What brought this mess upon us, so goes this interpretation of events, were meddling politicians, not failures of regulation or the free market.

It’s a nice story, especially for those who tend to see bleeding-heart liberals behind every tree (or hugging every tree). But it’s like trying to put a size 6 foot inside a size 12 shoe – not a good fit. Sure, Fannie and Freddy screwed up. They did buy home loans made to risky borrowers. And their very structure seriously needs reform. Congress created a monster: private companies with public responsibilities. So they can take risk like a private firm, while knowing the government will be there to bail them out if they get in trouble. Uh oh.

Still, this crisis needed rocket fuel to take off. To be this severe, it needed something beyond a bunch of plain vanilla subprime loans going belly up. And that’s where Wall Street comes in. Firms on the Street dabbled in a lot of sophisticated financial engineering. They sliced and diced lousy mortgages like a financial Ron Popeil, creating a bewildering assortment of securities and derivatives. They pushed their levels of leverage from 12 to 1 to 30 to 1. In short, they made wild bets with massive amounts of borrowed money.

Wall Street embraced unheard-of levels of risk, and that’s the main story, though there were lesser culprits. It’s a complicated narrative that requires an understanding of an alphabet soup of products and entities: ABS, CLOs, CDOs, SIVs. Listeners also have to wrap their minds around the concept of credit default swaps to appreciate how the teetering tower got so tall. But I suspect in the weeks to come, Congressional hearings will give us all a crash course in the story of 21st century risk taking, Wall Street style – and how it brought us to this awful juncture.

Sunday, October 5, 2008

On the Lighter Side

From the “how NOT to do Wall Street PR” department
The photo above accompanied CNN’s Friday story about the House passing the financial rescue bill. I know the intent was to show Wall Street's jubilation. But what we got was this well-fed trader who appears to be laughing at, not with, the U.S. taxpayer (especially since the market took a dive Friday).

How to make your own financial crisis. Step one: get a snow blower. Step two: fill it with money. Step three: turn it on.

“I wouldn't have loaned me the money. And nobody I know would have loaned me the money.”
-- Clarence Nathan, as quoted in the New York Times. Nathan had no job and no assets, but received a $450,000 mortgage.

My favorite 15-word analysis of the Paulson plan, which Congress passed, to buy hundreds of billions of dollars of toxic financial assets:

Throw a trillion dollars down a rathole with no debate and no alternatives considered.
-- poster Jeffrey Knoll, in the comments section of Econbrowser.

Saturday, October 4, 2008

Gazing into the Crystal Ball

Congress, in an appalling failure of imagination, approved Treasury Secretary Paulson's wrongheaded plan to bail out financial firms that acquired too many risky assets. He got his $700 billion check (in installments) to start snapping up distressed bonds and other investments that have taken a tumble in the U.S. housing meltdown. Ironically, members of Congress who voted for the unpopular legislation will probably glumly console themselves that they made a tough but necessary stand. Come on. It requires little courage to play the role of the outraged lapdog. Not one of 535 legislators deemed it worthy to craft an alternative, despite all the better ideas put forth by economists on the right and left.

But what's past is past, so let's look forward. Here are my predictions for the post-bailout bill future.

1. This bill, despite all the hoopla, won't even be the big rescue effort. We’ll see a more aggressive, all-encompassing solution that will probably involve seizing banks. Once this moment arrives, look for a few commentaries on the themes of “Where the hell did that $700 billion go?” and “Why didn't we just do this in the first place?”

2. Now there will be a financial version of the Oklahoma land run, as companies from Singapore to Switzerland, carrying a Baskin-Robbins assortment of toxic financial waste created in America, race forward to dump it with the U.S. government. Look for brigades of lobbyists and politicians to step in and try to direct the spoils, since everyone knows that $700 billion won't be nearly enough to buy up all the crap out there.

3. Success has many fathers; failure is an orphan. When this rescue plan flops, look for at least one of its high-profile backers to disown it publicly (Paulson? Pelosi? Dodd?) This person will complain bitterly about not being told some vital bit of information, or about how the original good idea got perverted in the execution because of all those damned incompetent Washington bureaucrats/Democrats/Republicans.

4. There'll be a House cleaning when voters go to the polls in November.

Friday, October 3, 2008

The Bailout: The One Thing I Don’t Get

It’s early Friday morning. In hours, the House will vote on what would be a historic $700 billion bailout of Wall Street. The bill will likely pass, though it’s essentially the same as the version the House shot down on Monday. (The Senate sprinkled on some pork and tinkered with FDIC limits on deposit insurance.)

What’s puzzling is that, facing the financial crisis of a lifetime, Congress can’t manage to draft even one alternative to the lousy Hank Paulson plan at the heart of this legislation. They could’ve been working on something since Monday. They could’ve consulted the legion of economists who have burst forth brandishing better proposals. In fact, I have yet to read a worse idea than what the Treasury Secretary wants to do: Buy a slew of bad assets with taxpayer money while failing to directly recapitalize struggling banks. This seems exactly the prescription for a long, drawn-out endgame of this mess with the likelihood we’ll start chucking good money after bad.

There is a vibrant marketplace of ideas in a democracy; it is one of our greatest strengths. We have the right to debate and disagree: with each other, with our government. And during this crisis, the response in the financial blogosphere has been smart, electric, incisive. Many, many good ideas are circulating. But no one in Congress sees fit to offer even one rival bill to the deeply flawed Paulson plan.

I don’t get it.

Thursday, October 2, 2008

Your Bailout Bill, Presented by the Other White Meat

The Senate overwhelmingly passed a version of the bailout bill that, instead of taking the bull by the horns, seized the pig by the ears. Amid what may be the greatest financial crisis of their lifetimes, Senators rolled up their sleeves ... and began stuffing the legislation with pork. Most egregious example seen so far: a tax exemption for certain kinds of wooden arrows designed for children.

Now, if the House can browbeat a few members into switching their “nay” votes, the $700 billion rescue of Wall Street will be complete. That something needed to be done quickly was becoming frighteningly apparent. The New York Times did a nice job of laying out, in plain language, how the financial system could come undone.

It's a shame though that legislators crafted such a poor bill. They could've driven a hard bargain. They could've said to Wall Street firms, “Hey, we’ll buy your bad assets, even pump in capital, but we want to own a chunk of your company in return, no exceptions.” That would've scared away hundreds of opportunists from seeking bailout funds. Instead look for chaos as this plan unfolds and firms both domestic and foreign make a grab for that big, fat $700 billion mound of money.

Tuesday, September 30, 2008

Blow It All Up; Go Back to the Drawing Board

That would be my advice to Congress after the House repudiated the $700 billion bailout plan, 228-205. I've read enough online comments to realize that Wall Street is stunned, perplexed, and not a little bit irritated. But I think that reaction just underscores a growing gulf between the two streets, Wall and Main. Joe Sixpack hated this bill with a fury, and that's what Congress has been hearing.

Now I think legislators have two choices (short of nudging 12 members into changing their votes):

Incrementalism (if you like sports metaphors, call this “going short”): Scale back the size and scope of the rescue. One suggestion floating around would provide for $150 billion in low-cost loans to companies weighted down with too many bad assets backed by U.S. home mortgages.
Advantages: Easier to marshal political support on both sides of the aisle. Sidesteps knotty questions of what to pay for hard-to-value toxic financial waste. Minimizes government involvement.
Disadvantages: May be too little to restore confidence and fix ailing firms. Could leave the Treasury Department and Fed injecting funds into the U.S. financial system and stamping out fires for years to come as the economy muddles along.

The “Bear Hug” (or, “going long”): Have the government aggressively take ownership stakes in financial firms in return for buying bad assets and pumping in capital. Try to weed out weaker companies that are insolvent and so badly run they don't deserve to survive.
Advantages: If we can get our arms around the whole problem at once, that could reduce the chances of a drawn-out resolution where good money is thrown after bad. Protects taxpayers better from losses. Also, a government that drives hard bargains (as Sweden did with such a program) will motivate financial firms not to seek Treasury help and to find private funds on their own to recapitalize.
Disadvantages: Wall Street won't like this one, after the tantalizing mirage of being able to dump their toxic waste at above-market prices under the original Paulson plan. And politicians too may balk at the size of the effort and the ideological implications.

Time to get a dialogue going. Two places to start: what Chile and Sweden did during their financial crises, with good outcomes.

Monday, September 29, 2008

And Poof! There Goes $700 Billion

My working title for this blog entry was “Now Serving: a $700 Billion Entrée Garnished With Political Fig Leafs.” But that was a little too long.

The storyline of the Wall Street bailout: King Henry triumphed, while politicians harumphed and bloviated and found tiny fig leafs to cover their exposure before an irate electorate (voters go to the polls in a few weeks). Paulson essentially won what he wanted, as legislators skirmished in the margins of relevance. Some highlights of what we got:

1. The Democrats can crow that they clamped down on executive pay excesses for anyone receiving bailout funds. In truth, the provisions are pretty limited in scope and meek – and don’t always make sense. Example: the CEO of a company getting rescued gets to keep his existing golden parachute, but any new CEO hired won’t be entitled to one. Come again? So the CEO who presided over a financial firm that acquired a lethal amount of toxic waste gets off scot free, while a fresh leader who works to right the ship gets punished?

2. Not to be outdone, the Republicans inserted their own piece of idiocy. Seeking a free-market fix, they came up with an “insurance” idea. Financial firms could opt to keep their bad assets and guarantee their value by buying special insurance through the government. Sounds like someone was drinking the Wall Street Kool-Aid. The Street, if you recall, protested vigorously that their toxic waste has a “fair value” much higher than what they could get in today’s troubled markets. Taking out insurance only makes sense if you really, really believe that and think you won’t get a sweet price from the government. Move on, nothing to see here.

3. Anyone who gets more than $100 million of bailout funds MUST give the government preferred bonds or rights (known as warrants) to buy stock. That’s promising, as it allows the Treasury to claw back some profits. That will be especially critical if investments bought with the $700 billion turn out to be duds. The caveat: the language in this section is vague and if Paulson doesn’t support the concept (and I don’t think he does), he might not push too hard to get a good deal.

Sunday, September 28, 2008

Why a Reverse Auction Won’t Work

Exhausted Congressional leaders, after hours of testy negotiating, reached a deal on the great Wall Street bailout. The devil, of course, is in the details. But from what I gather, the central feature of the plan was preserved: the Treasury will buy up to $700 billion of bad assets backed by U.S. home mortgages.

The latest version of the plan also requires financial firms to give the Treasury warrants in return for getting rescued. A warrant allows you to buy shares in a company at a fixed price. So if, say, Invest-orama receives a bailout, and then its shares soar from $20 to $40, the government can profit. That’s something at least.

From where I sit though, the troubling problem remains how much to pay for this toxic waste (see my previous blog entry). Warrants don’t eliminate that issue; they just add a complicating dimension to it. A financial firm that might’ve sold a deteriorating bond at 55 cents on the dollar might revise the price upward to 60 cents to account for the warrants.

But how to arrive at that original price, whether it’s 55, 40 or 30 cents on the dollar? There’s a huge spread between what owners of these assets think their investments are worth and what a buyer in the current jittery markets will pay. Fed Chairman Ben Bernanke has floated the idea of a reverse auction. Whereas a normal auction has one seller and many buyers, a reverse auction has one buyer and many sellers.

Reverse auctions make sense for buyer-designed products (a buyer might issue, say, detailed specifications on a car door latch that it wants manufacturers to bid on the right to make) and commodities. If you want to buy 100 barrels of road salt, in a reverse auction there could be 18 sellers that submit continuous bids, each lower than the one before, until reaching the best price.

The problem is that Wall Street isn’t trying to unload barrels of road salt. On the contrary, the toxic financial products held by these firms are complex, hard to value, and often unique. Each mortgage-backed bond is yoked to a specific batch of U.S. homes, and each home in turn has its own history of timely or late payments, its own odds of foreclosure. So Bond A, offered at 40 cents on the dollar, may turn out to be a much riskier (and worse) deal than Bond B at 60 cents.

Also a reverse auction is too scattershot, spraying money through the system without regard to who receives it or how much they get. In a financial crisis, we need a more sophisticated and aggressive approach. Some companies will die; they deserve to. The government should review balance sheets, let insolvent firms perish and pump funds into those that can be rehabilitated (or need to be, for the stability of the system).

I would NOT vote for this bailout plan. A better idea waits in the wings. Check out what the economist Nouriel Roubini proposes; it’s a much smarter way to go and better protects taxpayer funds.

The financial system won’t suddenly implode on Monday without a bailout package. It’s under stress, but we still have some time. Why not do this right?

Saturday, September 27, 2008

Four Reasons to Punt on Paulson’s Bailout Plan

This weekend Congress will try to thrash out an agreement on a Wall Street bailout. Treasury Secretary Hank Paulson wants to spend $700 billion to buy distressed bonds and other assets that are backed by soured U.S. home mortgages. Okay, let’s pause and take a deep breath and look at four big reasons why NOT to.

1. There is no way to know the right price for this stuff, leaving it likely the government will overpay. The seller of a bad mortgage-backed bond may claim its “fair value” is 60 cents on the dollar. Right now, amid jitters over tightening credit and a still-deflating housing bubble, the best offer on the open market may be 20 cents. So do we trust government accountants – toiling under time pressure, analyzing thousands of different (and complex) securities, probably using vague guidelines – to arrive at the proper price?

2. The U.S. taxpayers will pick up the lousiest of the lousy, probably at the worst prices too. There’s estimated to be more than $2 trillion worth of bad mortgage-related assets out there. So, shocking as it may seem, a $700 billion check doesn’t come close to doing the trick. Financial firms will surely cherry pick the wormiest fruit to offload while pretending it’s better than it is. Their knowing more about the individual investments boosts the chances of the government getting hoodwinked on some of these deals.

3. This is a horribly inefficient use of resources in a free market system. The bailout program could become a full employment act for the investment banking industry. For starters, the government would need consultants and specially trained employees to help it process the deluge of applications from financial firms seeking to shed their toxic waste. Then the decisions: what to buy, how much to pay (the research on that alone should keep a platoon of analysts busy around the clock). Then someone has to manage the assets, decide when to sell them, execute the sales.

4. Letting financial firms off the hook sends the wrong signal and sows the seeds for the next crisis. The message: Go ahead and take huge risks, make bad bets, overextend your capital – the taxpayers will be waiting in the wings to pick up the pieces. It encourages the bad actors to keep behaving the same risk-crazy way they have been, and the good ones to follow suit in order not to fall behind.

Thursday, September 25, 2008

The Sly Sage of Omaha

Sometimes, to know what a man really thinks, you need to watch his feet, not his lips. Words are the units of an often-cheap currency that’s easily manipulated and debased. And so when Warren Buffett, finance’s plain-spoken wise man, voices support of a $700 billion plan to bail out Wall Street, one might reasonably glance down to see what his feet are doing. After all, Mr. Buffett’s company Berkshire Hathaway is pretty well cashed up right now, having patiently waited on the sidelines recently while more reckless rivals dabbled in risky ventures.

Buffett’s latest bit of deft footwork: buying a $5 billion stake in Goldman Sachs. While calling any investment bank “blue chip” during this period of financial turbulence is a bit of a stretch, Goldman merits the stamp of quality if anyone does. Goldman is highly profitable, employs many of Wall Street’s smartest bankers, and – perhaps not coincidentally – was rare among peers for foreseeing troubles developing in bonds backed by U.S. home mortgages. So Buffett walks away with ownership in a well-run, top-tier (arguably the top-tier) investment bank on Wall Street. All for $5 billion. Sweet.

If you think, however, he supports such a smart deal for the U.S. taxpayer, you’d be dead wrong. Treasury Secretary Paulson’s plan seeks a towering pile of money to buy Wall Street investments that have gone sour largely because of the U.S. housing crisis. Even after getting a discount, the government would probably pay well above market value. If the investments turn out to be worth only $600 billion, $500 billion, or even $50, tough luck. For all his troubles, the U.S. taxpayer will own nothing of anything. Not even a third-rate boutique investment house or a paperweight bull.

Buffett has a lot of money under his thumb but little apparent appetite for acquiring, even at a deep discount, any of the risky mortgage-backed investments being offered to the American taxpayer. The same appears true of another high-profile cheerleader of Paulson’s plan. Bill Gross, a Master of the Bond Universe and the chief investment officer of Pimco, argues for the bailout on the pages of the Washington Post, even guesstimating how much the government could profit. So why isn’t he eyeballing any of this toxic waste for his portfolio? (Note: Gross is, however, eyeballing a well-paid role in managing the $700 billion pool of bad assets, should Paulson succeed in buying them.)

So as we seek advice from high-finance sages while trying to resolve the financial crisis, the advice bears repeating: Watch their feet. Not their lips.

Wednesday, September 24, 2008

Hands off the Ferrari

One of my favorite Hank Paulson quotes, as he tries to drum up support for a $700 billion rescue of Wall Street, was this one. (U.S. taxpayers are preparing to buy a bunch of bad mortgage-backed bonds to clean up the balance sheets of financial firms.) Paulson was responding to a proposal by those grumpy Democrats to cap executive pay packages at companies that receive bailout money.

“If we design it so it's punitive and so institutions aren't going to participate, this won't work the way we need it to work."

Restrict CEO compensation? L’audace! Haven't the red-faced chieftains of Wall Street been humiliated enough just by virtue of having to step forward and ask for help? In all seriousness, the Democrats' pay slap-down isn't one of the better ideas to attach to this bill. Either firms will find loopholes to ladle out compensation in new, innovative ways or they’ll face a talent drain. Reforming executive pay excesses on Wall Street should be hived off from the urgent matter at hand, fixing a financial crisis.

What's galling though is how Paulson’s quote shows him to be out of touch with reality. In truth, financial firms of all stripes are queuing eagerly to get a chunk of this $700 billion. Will a few gracefully demur, saying “no thanks, we’ll keep our toxic waste ” if they find out that aid comes at the cost of no longer being able to so richly compensate their top executives? Maybe. But somehow I doubt it.

Tuesday, September 23, 2008

The Big Lie Behind the Great Wall Street Bailout

At the heart of Treasury Secretary Hank Paulson's bailout plan is a Big Lie. The $700 billion plan is predicated on this Big Lie, concocted by financial firms holding a bunch of stinky investments. In brief, Wall Street claims they can't sell the investments (securities backed by deteriorating U.S. mortgages) because of the current upheaval in credit markets and nervousness about the U.S. housing market.

That's a lie. The truth is, the firms can’t sell the securities for nearly as much as they would like. So in other words, let's say they think they're holding investments worth 60 cents on the dollar, when a buyer right now might give them only 20 cents. Their argument: once the fear and panic abates in the financial markets, they'll be able to recoup the "fair value,” or the 60 cents on the dollar. But they need money now. So they're looking for a chump with deep pockets.

Enter the U.S. taxpayer, stage right. Paulson's plan would have the government snapping up armloads of lousy investments in order to bail out Wall Street. If you wonder, how do we figure out how much to pay, go to the head of the class. That’s the $700 billion question. Paulson's line is essentially, “Trust me, I'll take care of it.” In private, he has essentially conceded that the government will pay too much for what are bad assets. (See this excellent blog entry by naked capitalism for the inside scoop.)

With Lehman Brothers recently going bankrupt and mammoth insurer AIG getting $85 billion of cash, the U.S. government is rightly resolved to do something about the financial crisis, and sooner rather than later. That's commendable. But the Big Lie makes this Paulson plan rotten at its core, especially considering the irresponsible behavior of Wall Street's financial firms over the last few years.

When your drunken uncle Hal staggers in from a two-week bender, should you write him a blank check to cover his expenses, buy him a jug of moonshine, and send him back out the door?