Are We Finally Ready to Do Something Meaningful About Shadow Banking?

I've been heartened by a growing number of news stories that pose the question: "What to do about shadow banking?". Here's the latest, from the New York Times, to pop up on my screen (though this piece isn't very substantive).

Barry Ritholtz shows us with this graphic from the Wall Street Journal that shadow banking never went away after the big financial crisis; the Fed and Treasury just stepped in to pick up the slack.

Finally: Be very, very wary of people peddling solutions that make the world's central banks the shadow bankers of last resort.

Why You Should Be Very Depressed About Climate Change

This is a bit off topic, but for years I've been following the climate change debate. Today I came across this terrific list of "myths vs. what the science says". There are 173, total.

So that's 173 myths that nothing's really wrong, debunked.

Still, part of me wanted to cry at the earnest thoroughness of the debunkers. They even break down their answers into basic/intermediate/advanced, to suit everyone from pea-brained U.S. Senators (doesn't Jim Inhofe actually, physically look like a dinosaur?) to climate scientists who can handle advanced formulas and charts.

But it's all just spitting into the wind.

Even if the science were agreed upon by 100 percent of the population -- yes, climate change is coming if we don't restrain levels of carbon dioxide -- does anyone really think anything would change in any significant way?

One problem is, we all live on one planet, share the same air, but are governed by hundreds of different political systems. And we can't compel global cooperation. So there's a huge incentive for any one country to cheat while others cleave to aggressive carbon-dioxide lowering rules -- and that's if we ever got close to agreeing on anything substantial globally, which we won't.

Another problem is, in the U.S. (the worst of the carbon-spewers per capita), we don't do pain. We don't want our lifestyle threatened. Just look at the federal gas tax. It's been frozen at 18.4 cents per gallon for almost two decades. If you double, triple, quadruple (or more) that tax, that will change driving habits and fill up some of those one-person cars you see everywhere zooming down the freeways.

There are lots of great reasons to do this -- reduce pollution, encourage energy independence, generate revenue for a cash-strapped budget, fight global warming. Conservative economists like Greg Mankiw have gotten behind this proposal. But the average American hates the idea, so don't hold your breath.

One last problem (though there are many; this is the short list): To combat global warming, we would be asked to make real, immediate sacrifices for a hypothetical, distant problem. That just won't happen.

So what now?

If we wait too long, and the effects of global warming are as serious as we've been told, we'll just find a way to cope. If half of New York City winds up under water, we'll just adjust. Highways on stilts. Floating homes. Water taxis.

On global warming, I'm sorry: I just don't think there's anything to be optimistic about.

Must Read: A Smart Takedown of Economist's Cheerleading on Financial Innovation

Recently the Economist had a terrible report on the benefits of financial innovation. I read only part of it, but the jejune, spirited prose suggested an earnest college student who has discovered all he thinks he needs to know about the free market and economics via a couple of high-level courses.

I was pleased afterwards to read this smart, extremely thorough takedown by frequent guest poster at Naked Capitalism, Satyajit Das. It's a great piece (though has Das's singular failing -- he can't write a shopping list in less than 500 words ;)). Everyone should read Das on financial "innovation" to learn how the Economist comes up woefully, naively short in its analysis.

A few highlights I plucked out are below.

First, Das has a terrific section on risk transference (my bold):

Securitisation for the last 15-20 years entailed shifting assets from banks to structure[s] which reduced the amount of capital required, arbitraging regulatory capital requirements.

If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation.

The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing.

Das also includes quotes from Fabrice Tourre of Goldman Sachs, whose candid e-mails captured the arrogance and reckless complexity of the industry:

“More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

“Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!"

Finally, Das concludes with this withering paragraph:

Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool – the “search engine” – with could have been used by The Economist to check and research such facts.

Is Australia About to Slay the Ratings Monster?

Uh oh. Looks like Standard & Poor's may be on the verge of getting its comeuppance for all those hallucinatory, fee-inspired AAA ratings, in of all places, Australia. A 10-week court case has just concluded.

So what happened? The AAA rated investments weren't really all that bad, were they?

The twelve [NSW] councils bought a bunch of “Rembrandt” toxic structured-finance products in 2007. They tanked 90 per cent in six months and now the councils are suing investment bank ABN Amro for making the Rembrandts, Local Government Financial Services (LGFS) for selling them and S&P for appending their once-hallowed AAA credit rating.

Okay, okay. Let's be philosophical. Things tank sometimes. That's life in Market Land. At least this was the kind of well-established, safe product upon which S&P has historically bestowed a AAA rating right?

Looking at the closing submissions which have now been filed with the Federal Court, the councils contend that S&P failed to exercise reasonable care and had “no reasonable grounds” for its AAA rating on the Rembrandts.

The councils argue that this is supported by the limited historical data relied upon to rate the product. This was a new product, a “CPDO”, even more risky than a CDO and based on an index of derivatives which had only been going for a couple of years.

Have no fear, legal team! In court, S&P undoubtedly showed itself to be tough and independent when modeling these particular investments. Yes?

They also say S&P made a “critical error” when it relied on the advice of investment bank ABN Amro regarding the Rembrandt's historical volatility.

Fine. One mistake. But that was surely just one input into S&P's otherwise complex model, so we can overlook this lapse in judgment?

“The evidence at trial established that S&P did not conduct any modelling for the Rembrandt 2006-3 Notes, or discuss the results of such modelling at any ratings committee."

Yipes! Looking grim. But at least things can't get any worse, huh?

“Further, the Rembrandt 2006-3 Notes were assigned AAA ratings “because S&P did not want to reveal to investors the error they had made in assigning a AAA rating to the Rembrandt-2”.

Oops. Can you say "slam dunk," Timmy?

One Prediction, and One Quiet Cheer

First, the quiet cheer: regulators seem to be moving on shadow banking. For one, the SEC is talking about a floating net asset value for mutual funds and thicker capital buffers, which has predictably set off a howl of protest from the industry.

And Reuters wrote:

Watchdogs to Drag Shadow Banks Into the Light

Then, the prediction:

There will be something in the fine print of the as-yet undetailed giant mortgage settlement that will elicit a chorus of "we let the banks off the hook for that -- what the hell?"

NYT's DealBook Gets It All Wrong on CLOs

This was a painful piece to read at the New York Times DealBook: "A Debt Market's Slow Recovery Is Burdened by New Regulation."

Steven Davidoff whips out his violin, tucks it under his chin, and plays a mournful lament for the market for collateralized loan obligations, which is under threat by none other than the act that the bankers have all flicked out their switchblades for: Dodd-Frank. Specifically, Dodd-Frank meanies want CLO originators to retain 5 percent of their funds, to prevent them from stuffing the investments with, er, crap.

The Times should have top-notch journalists who know more about CLOs and junk debt than Davidoff appears to here. Because, honestly, in this piece I can't tell sometimes if he is playing the fiddle or he is being played by someone else like a fiddle.

Here are five problems I have:

1. "CLOs are largely made up of loans that are at much lower risk of default than the risky high-yield, or "junk," bonds that also finance private equity buyouts."

He's trying to make these loans seem safer. But let's take the buyout for the old TXU, which as Davidoff notes, was made possible by leveraged loans and bonds. Right now TXU (renamed Energy Future Holdings) is rated CCC, deep into junk territory, only four levels from D (which, for non-credit junkies, means "D" for default).

If Energy Future goes belly up, the loans and bonds should both default. The loans will probably enjoy a better recovery rate, because they're higher on the capital structure and secured, but they will default. I'm not sure where Davidoff gets this idea that the default risk is "much lower" for leveraged loans than bonds. When a company is rated Total Junk, the default risk will be high for both.

2. "CLOs had a default rate of less than 1 percent even as the loans underlying them had a default rate of about 6.5 percent."

So? Davidoff seems to imply that CLO structurers have somehow transmogrified straw into gold by using this numerical comparison. Look! The default rate is much lower! But it's disingenuous and incomplete.

The CLO is the loans, in aggregate. Structuring doesn't magically conjure up a new income stream out of thin air. Those 6.5 percent of loans that defaulted -- they defaulted whether they're in the CLO, out of the CLO, or wrapped in something called a super duper wonderbar GCLO (giant CLO).

In fact, thought experiment: let's say you create that GCLO that almost never defaults, even when a mess of underlying loans do. Let's say the default rate is 6.5 percent for the loans, 0.8 percent for the CLO, and 0.001 percent for the GCO.

But let's say when the GCLO defaults, because it's so huge, there's a good chance the entire financial system will implode. So if I tell you that 6.5 percent of the loans have defaulted, but the GCLO has never defaulted, is that a good thing (by Davidoff's logic, it would seem to be)?

Or is it bad that when that GCLO explodes it's probably taking down the financial system, so you'd be better off having the loans outside of that only ostensibly super-safe structure -- out where they'll do less harm? (Note: if you've been thinking a lot about the financial crisis, you'll realize this is not an accidental sort of thought experiment.)

(3) "So new CLOs are crucial to support the corporate loan market. Without them, banks will be hampered from originating credit since they will be unable to sell these loans off their balance sheet."

Well, for decades preceding the invention of the CLO, the financial system seemed to bumble along just fine. In fact, banks were regarded as being safer because they kept loans on their balance sheet, because that meant they were more circumspect about what lending they did. Here, Davidoff is mourning an end to the easy money that securitization threw open the spigots to. But he doesn't really seem to reflect on whether being awash in easy money was a bad or a good thing.

(4) "Most managers do not actually originate the loans underlying these financial instruments [CLOs]. Instead, the manager buys these loans from originating banks."

So he claims that leads to a "secondary-market check" that "may be lacking with other structured products."

Davidoff says this to argue that CLOs are unlike the mortgage-backed securities that crashed and burned, and thus deserve to be exempt from a rule about securitization originators retaining 5 percent of the deal. But wait a minute -- check out this post about "Why Structured Finance?" -- because the securitization model for mortgages doesn't require that a structurer originate the debt either.

In fact, before the crisis there were plenty of Wall Street banks bundling mortgages that they never originated. So Davidoff's "secondary-market check" looks like a rather weak safeguard.

(5) "And of course, private equity would also be hurt if the CLO market dried up."

Ah, private equity. You know, Mike at Rortybomb just showed us that much private equity activity occurs because of our screwball tax code -- not because it makes sense, business-wise, and James Surowiecki at the New Yorker had a good bash on the subject too, revealing that these raw-meat capitalists actually get a lot of hidden supports that make them look more like welfare queens.

Davidoff never pauses to consider that it might be a good thing if private equity buccaneering was curtailed.

Of course Davidoff misses the really big story about the CLO market: mathematically, these things just don't make much sense. With all the fees that they suck out, they should collapse under their own weight.

Before the financial crisis, they were priced close to real AAA, as investors were fooled by the complexity into thinking they really were AAA safe. Today, investors aren't that dumb: they're onto the game and demanding higher, non-AAA yields for debt that's graded AAA.

But why would investors play along with such shenanigans? Check out:

The Ratings Charade Continues: A CLO Investigation (Part I)
The Ratings Charade Continues: A CLO Investigation (Part II)

Is Being an Ideologue a Contributor to Stupidity?

A gratuitously provocative question?

Maybe not.

Consider the following equation:

TA * TR = TB.

Let's say TB represents some "financial obligation" among a group of people. Further, let's say that at some point in time, the group has a TB of 40. And then, almost 30 years later, TB equals 55.

Now, if you don't know the values of TA and TR, what would be logical to conclude about how they must have changed over that period?

This one is so simple, it couldn't stump an eighth grader who wastes most of math class staring out the window. For TB to increase on the right side of the equation, one of the two variables on the left side of the equation must have increased -- or perhaps both did, in some combination.

But what if you're an ideologue? And what if your ideology leads you to think a "TB" of 40 for this particular group is already high? And what's more, you vehemently insist that TR should be as low as possible, and that a lot of economic problems result from a high TR?

So what happens when you see:

TA * TR = 40

Jump to:

TA * TR = 55

It's clear to you what the problem is. TR! Because TR is always the problem! You don't spend a lot of time mulling over what may be going on here. You fixate on TR, because that's what you always fixate on.

In which case, your name might be Ari Fleischer.

Because this equation is really: "Taxable Amount (taxable income of the top 10% of the population) times the Tax Rate (tax rate of the top 10% of the population) = Tax Burden (the percentage of overall federal taxes paid by the top 10% of the population)".

Fleischer, President Bush's former press secretary, recently tweeted that the "Tax Burden" of the richest 10 percent soared from 40 percent in 1979 to 55 percent in 2007. The implication: the TR (Tax Rate) on this group is already high enough, and this group is carrying more than its fair share of the TB (Tax Burden).

But ideology -- his visceral dislike of taxation, and the welfare state, and wealth redistribution -- has made him too dumb to see how a simple equation works.

Because consider this thought experiment: if in 20 years, the income of the top 10 percent explodes and the other 90 percent of the population become their slaves and earn no income (and meanwhile the Tax Rate doesn't change at all), the top 10 percent will pay 100 percent of taxes (up from 55 percent). But what does that show? That they're being taxed too much?

Of course not. It shows that we've regressed to something akin to a feudal society.

There are two variables on the left side of this equation, TA * TR = TB. If you're an ideologue you tend to miss stuff like that. (See Mark Thoma proving here that, yes, the answer to the mystery of what happened with the Tax Burden does lie with "TA," as the richest scored the biggest income gains over the last three decades.)

But ideologues don't do nuance well. They also abhor cognitive dissonance.

This is why I think Peter Wallison has become a sort of trivial hand puppet for the right, a useless one-note screech owl in his vehemence that it was Fannie and Freddie that caused the financial crisis (and he apportions no blame at all to Wall Street's securitization machine). He can't see beyond his ideological blinders.

P.S. For those of you thinking that Fleischer's "tax burden" is a percent, not a straight-up number like 40, yes, I've simplified. But the argument isn't impaired by this simplification. The ratio just introduces a second layer of complexity. If you understand math, you know what I mean. If you don't, I can write it all out ...