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Zimbabwe 2.0

Funny or sad?

Why I don't like the Consumer Financial Protection Agency

The financial reform bill may or may not include a Consumer Financial Protection Agency. I hope it does not. This is because the fundamental role of finance is to make loans that get paid back, and anything that dulls or distracts from this task of credit analysis is contrary to the fundamental role of finance and should be banned.

From the New Yorker:

What’s less explicable, and more troubling, is the way all the players in this deal in effect outsourced the responsibility for their own due diligence to others. On the macro level, of course, the investors accepted as a matter of course the idea that you could package together lots of mediocre securities—as you can see from the flipbook that was put together for the deal (pp. 55-56), the actual securities in the deal were generally only BBB-rated—and create a security that was virtually guaranteed not to default. While widely shared, this was an assumption that made absolutely no sense in the case of subprime C.D.O.s. Then, instead of looking at the fundamentals of the securities themselves, they simply assumed that they could rely on the credit ratings the ratings agencies bestowed, even though those agencies’ conflicts of interest were well-known. And they also implicitly assumed that they didn’t have to scrutinize the actual securities because ACA Capital—the asset manager—had done that for them.

Read more: http://www.newyorker.com/online/blogs/jamessurowiecki/2010/04/wall-street.html#ixzz0laSxMdjH

The CFPA is to the household sector what the Ratings Agencies are to the corporate sector--elements that undermine a bank's duty and responsibility to conduct credit analysis.

Why Goldman is Innocent

ACA met, face-to-face, with Paulson. Which means ACA had the opportunity to talk to Paulson about the CDO. This makes it about ACA incompetence, and not Goldman fraud.

Cognitive Capture

I very much liked this Michael Lewis quote in an interview with Christopher Lydon:

Lewis: “The people who were responsible for orchestrating the crisis, because they’re on top and they’re in the middle of it, they’re the only ones who are sort of fluent in the language of it. I mean, who’s to question Tim Geithner, the secretary of the treasury, about this or that, because he’s the only with the information . . . even though he is clearly culpable in what happened.”

Lydon: “Not to mention Larry Summers and Bob Rubin and all the other architects of the deregulation. They’re still calling the shots in a new administration after a change of party management. It’s unreal.”

Lewis: “It is unreal, because basically all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure. And I don’t know if that’s going to work.

I think that's pretty accurate, and it is echoed in the "scandal" around Goldman's double dealing wrt to Magnetar.

I think the general reaction to the SEC charge against Goldman Sachs is "at last". I'm not sure how many people understand the fraud, or its importance, but just as they caught Al Capone on tax charges, I'm sure they just want GS caught on something.

To me, the bigger issue is how far the financial industry has drifted from its primary purpose: to make loans that get paid back. The pay practices at banks, where you get paid when the money goes out, not when it comes back in; securitization in general; CDS and various other "hedging" strategies; third party ratings agencies; all of them are contrary to focusing on credit risk which is the entire reason we have a banking system in the first place.

Instead of tinkering with this system around the edges, we should take a "spike on the steering wheel" approach and have a banking system that makes loans, keeps them on its books until it matures, and lives or dies by the quality of its credit assessments.

It's a boy

8 lbs 11 oz

Greece goes hyperbolic

Greek debt is "trading" at about a 450 bps spread, although "trading" is a charitable term considering there are few bids in the market. I think that some commentators do not believe in the US stock market recovery as there has been no structural reform whatsoever, and they would like to believe that the US economy cannot "move forward" until it has been fundamentally fixed. This is not true.

I do think that the fundamental issues in the Eurozone, of governance and operations, truly must be solved to avoid a sovereign debt default, and a second credit crises as more bank capital gets written down. Greece, fundamentally, needs a fiscal fill-up, and I do not believe that the Eurozone has any mechanism to allow this. Gold bugs -- here might be your Mellonist moment!

What happened in Japan?

Japan had their credit crises 25 years ago, and has been mired in a slump ever since. The best source I've found to detailing that history is Richard Koo, but he's not great. Here's a nice article with some of this views:

'With quantitative easing under the circumstances we have now, you can double and triple the liquidity in the system but there will be no takers,’ Koo says. ‘But there’ll be no harm done, and if certain parts of the political spectrum are happy as a result, then, you know, why not?’

In fact, QE never works.

For years Koo, now chief economist at the Nomura Research Institute, has been talking about the lessons to be learned from Japan’s ‘lost decade’—the years of recession that followed the bursting of the nation’s economic bubble of the late 1980s. In his book, The Holy Grail of Macroeconomics he argues that when an economy is pole-axed by crashing asset prices, companies no longer want to borrow money to invest because of the need to repair their weakened balance-sheets. If there are no borrowers in the market, monetary policy becomes ineffective—you can supply as much money as you want at close to zero-interest rates, but there won’t be any takers. Essentially, this suggests that there are two kinds of recession: a regular business-cycle recession, which can be tackled using monetary policy, and what Koo calls a balance-sheet recession, a far deeper kind of post-bubble recession like the Great Depression, that requires the use of fiscal policy.

Koo's position is that monetary policy works in asset crashes, but not in credit (balance sheet) crashes. He does not question whether monetary policy never works, and that asset crashes are simply not that damaging and easily fixed through automatic fiscal stabilizers.

‘As I indicated in my book, it’s one of those recessions that happens once every God knows how many decades, where monetary policy is largely dead in the water,’ he says. ‘I mean there are no borrowers. And if the money multiplier is zero negative, what can monetary policy do? Those people in the financial sector in Japan are fully aware of this difficulty. But politicians, academics and media who are never faced with the real situation only remember what they are taught in universities, where neoclassical economics always assumes there are plenty of borrowers. They tend to bash the Bank of Japan for not doing more.

There is no money multiplier. Ever. Balance sheet recessions merely reveal what is always the case.

But when it comes to the issue of Japan’s national debt, Koo flatly rejects the notion that it presents any kind of financing problem.

‘At the moment, with long bond yields at 1.36 percent on the 10-year JGB, all these arguments that Japan has a financing problem are absolute nonsense. If the long bond yield is 14 percent like it was in 1997 then I know that this country has a horrendous financing problem. But at 1.3 or 1.4 percent, the market is saying “Please go on, we need the JGB.” A country with the lowest government bond yield having financing problems? I mean these people [who say that] really have nothing better to do.’

Japan will never have any issue servicing yen denominated debt, as it does not borrow. It has a fiat currency just like the US.

As for the notion that Japan has already used fiscal policy with little effect other than to run up the huge national debt in the first place, Koo makes the point in his book that the use of fiscal policy during a balance sheet recession is absolutely vital for propping up an economy. It’s the only effective way of boosting the money supply, since any extra liquidity pumped into the financial sector will have no takers.

It might not look as if fiscal policy helped Japan much after the bursting of its economic bubble, but the alternative would have been catastrophic, Koo says. He calculates that 1.5 quadrillion yen was wiped off Japanese assets in the wake of the bubble—that’s 3 times the size of the nation’s economy. Without fiscal stimulus, Japan’s GDP should have shrunk to between a half and a third of its size, he claims. But in fact, GDP did not fall below its bubble peak, something he describes in the book as ‘nothing less than a miracle.’

This is the key point. Did fiscal policy fail in Japan, or did it do its job, but it was simply too small? If the alternative was a dust bowl style recession, the fiscal policy was, perhaps, a modest success (although I'm sure it could have been implemented in a better way).

The question is, today, why does Japan bother to tax at all?

An alternative healthcare reform

Obama's healthcare plan requires individuals to buy insurance, requires insurance companies to accept all customers, and subsidizes those who cannot afford to buy insurance themselves. Public funding and private provisioning can be a good idea, but the flaws with Obamacare have been well documented elsewhere.

I am not interested in libertarian healthcare approaches that leave people to die, nor am I interest in nationalized services either.

The most interested alternative came from Warren Mosler -- here it is in a nutshell:

1. Every year, everyone gets $5000 from the Fed.
2. The first $1000 is to be used on preventative care. It's use it or lose it money.
3. The next $4000 can be used on healthcare or not. If you don't use it all up, you keep the balance.
4. If you use it all up, and need more healthcare, medicare kicks in.

The question most interesting to me is: what will this do to prices (both generally, and in healthcare). Generally, printing money they way this plan does creates an inflationary bias. But, if healthcare is riddled with all the inefficiency from private insurance claimed by the left, and inefficiency in delivery claimed by the right, then this should get market forces acting to reduce costs and improve service as consumers exercise their choices and produce Good Deflation. Very interesting.

Student loans

The public purpose of banking is to provide credit analysis -- namely, to separate good loans (loans that will be paid back) from bad loans (loans that will not be paid back). Therefore, having private banks issue loans that the Government banks makes no sense. Having the Government make student loans directly is a good move in that sense, although there are other parts of the program that are problematic.

Social Security will never go bankrupt

The NYTimes leads:

The bursting of the real estate bubble and the ensuing recession have hurt jobs, home prices and now Social Security.

This year, the system will pay out more in benefits than it receives in payroll taxes, an important threshold it was not expected to cross until at least 2016, according to the Congressional Budget Office.

There is nothing important about this threshold. Alan Greenspan, whose star has sunk quite a bit since his days as the Maestro, continues:

“When the level of the trust fund gets to zero, you have to cut benefits,” Alan Greenspan, architect of the plan to rescue the Social Security program the last time it got into trouble, in the early 1980s, said on Wednesday.

That episode was more dire because the fund could have fallen to zero in a matter of months. But partly because of steps taken in those years, and partly because of many years of robust economic growth, the latest projections show the program will not exhaust its funds until about 2037.

This is not correct. When the level of the fund falls to zero, the Treasury, who cuts social security checks, and continue to write checks and the checks will not bounce.

The Government prints money whenever it spends, and is thus never operationally constrained in its spending. Spending too much will, of course, cause inflation, but whether the system pays out more than it takes in, or whether it accumulates a "trust fund" (which is a meaningless concept) or exhausts this "trust fund" has no bearing on anything.

Two Chartalist perspectives of Health Care

The first from David Kelly via Mosler:

The most obvious quantifiable impact of the bill is an increase in taxes for upper income Americans, particularly on investment income. Starting in 2013, the Medicare tax rate on households with income over $250,000 will be increased from 1.45% to 2.35%. In addition, a new 3.8% Medicare tax will be introduced for the same group on investment income....
...it's not like we haven't been here before. On average over the past 40 years the maximum federal tax on capital gains was 24.7% and the maximum tax rate on dividends was 44.6%.

For the Medical Care Industry, this bill will expand demand without much effort to reign in costs. A combination of federal subsidies and mandates will increase the pool of insured, and while there many constraints preventing insurance companies from limiting coverage there are few which limit how much they can charge for it.

However, whatever else is said about this bill there is nothing in it to suggest a reduction in either the quantity or prices of health care services consumed.

* - There is no meaningful malpractice reform.

* - There is no reduction in drug patent lives.

* - There is no compulsion to force insurance companies to compete across state lines.

* - There is no effort to limit health care procedures in the last year of life.

* - There are no meaningful incentives to force the insured to take better care of their own health.

Despite dire predictions, it's not clear that health care reform will really slow economic growth that much. Most of the tax provisions don't kick in until 2013 and the mandates on businesses and individuals don't kick in in a big way until 2016. Between now and then, the economy is quite capable of staging a full cyclical recovery. It may be that businesses will, in the end, be forced to pay more for the health care of their workers – however, overall, American business is quite capable of limiting wage increases to add to benefit costs.

And from Wray:

he most significant outcome of this legislation is the windfall gain for insurance companies—who will be able to tap the wages of the huge pool of nearly 50 million Americans who currently do not purchase health insurance. Since many of these are too poor to afford the premiums, the government will kick in hundreds of billions of dollars to line the pockets of health insurers...You might wonder how Democrats can call this a deficit reduction deal? Elementary, dear Watson. They will slash Medicare spending

I don't believe Medicare spending will be cut, and taxes don't increase much under the bill until about 2013-4, IIRC. I'm not as sanguine as Kelly about the economy though, as private sector debt remains too high, and the EU presents significant downside risks to equity. Net net though, I think this Bill is good for the insurance industry primarily, and OK for the healthcare industry. It is a strange creature, requiring households to pay private companies and give them Government money to do so, but then healthcare is a strange industry.

Eric Buell

For those of you into motorcycles, here's a series of great interviews with Erik Buell, who used to make the only bikes on the planet worth thinking about.

What's a repo?

Marketplace has a nice video on how Repo 105. Unfortunately, they completely miss the role repos play in the banking system. It actually took me a while to figure this out and I understand the banking system very well, so this may be confusing other people as well.

All banks with reserve accounts at the Fed have reserve requirements. These reserve accounts are primarily used for payment settlement, but are also used in a convoluted way to set the Federal Funds Rate. At the close of business, some banks find themselves short their reserve requirements, and other banks find themselves long their reserve requirements, and so those that are short borrow from those that are long via repos. This overnight, interbank lending market uses repos as the vehicle for its overnight interbank loans.

Note that the repo market is not some shady thing, it is how the Fed has decided to enable payment settlement and set the FFR. If all banks closed long reserves, the Fed would intervene in the market until some were short, and force those banks to repo with other banks.

This mechanism means that quality of collateral and counterparty risk enter into a market for payment settlements and the FFR, which is a terrible design. Instead, the Fed's discount window should be the mechanism for payment settlements, and it could set the FFR to zero and be done with it.

James Hamilton is sympathetic to why the Fed should have regulatory authority, despite it's failure to do so.

Insofar as the Fed is expected to fulfill its function as a lender of last resort through the discount window, surely it needs detailed knowledge of the borrower's financial situation. And actionable information on the financial system's health and stability is just as surely essential for knowing when and how fast to change interest rates.

If you understand how the banking system works, however, you would have the Fed lend uncollateralized (thus solving the issue of liquidity risk) and rely on the FDIC to assess capitalization, and hence, solvency. The Fed should not be judging solvency because it is the ultimate liquidity provider to the payment settlement system.

Repo 105 part deux

Looks like I'm not on the only one struck by how the Lehman Examiner's report elides how the bank was insolvent. And I'm not talking about coming in under regulated capital ratios, I'm talking about a (massively) negative equity number.

Two unanswered questions stand out. The first is that even with the extensive Jenner & Block report, we still do not have even a rough sense of how big the shortfall in Lehman’s equity was at the time of its collapse. We know it was hiding $50 billion of liabilities at the end of its fiscal second quarter through its Repo 105 program, but that only tells us the size of one of the cover-up mechanisms. The Lehman report indicates that William Dudley at the New York Fed thought Lehman might require a $60 billion bailout entity, with Lehman providing $5 billion of equity, which says the authorities pegged the unreported shortfall at $55 billion.

The focus of the report was on how Lehman was shut out of the overnight interbank lending market, and did not go to the discount window. It never explicitly states that the reason it was shut out of the repo market was because it had negative equity, and there was real counter party risk to extending what (by design) should be a riskless loan.

Repo 105

I scanned a the opening few chapters on Lehman's Repo 105 and I must say, the report, while excellent in its detail, seems to be to conservative on the state of Lehman just prior to its demise. For example:

Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion.8 But the assets were predominantly long?term, while the liabilities were largely short?term.9 Lehman funded itself through the short?term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.10 Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate.

This sets up the problem as one of liquidity, where Lehman's main problem was that other banks lost confidence in it. Certainly, this is the view of Geithner and the Obama administration. But Lehman made a huge number of loans that would not get paid back, loans they kept on their books. I don't know what the capital requirements are for whatever status of bank Lehman Bros was, but Lehman was booking income losses of $3B a quarter, and if it was honest about writing down its CRE and RE assets, it would probably blow through its remaining $22B in capital. So you have an entity with negative equity -- is its main problem that counter-parties will not lend to it?

Lehman did not turn to the Fed discount window, probably because it did not have collateral at the time, and maybe because they wanted to avoid the shame that comes with that. This to me illustrates how poorly the discount window, and interbank loan market, is designed.

A Waste of a Good Crises

Like the Bourbons, the Main Strem Media -- and many bloggers -- both remember nothing and forget nothing. The New Yorker's John Cassidy demonstrates this in his haigography on Obama's Geithner:

And yet—whisper it softly—there is good news about the financial system and the roundly loathed bank bailout, the seven-hundred-billion-dollar relief package that Congress approved in October, 2008. During the past ten months, U.S. banks have raised more than a hundred and forty billion dollars from investors and increased the reserves they hold to cover unforeseen losses. While many small banks are still in peril, their larger brethren, such as Bank of America, Wells Fargo, and Goldman Sachs, are more strongly capitalized than many of their international competitors, and they have repaid virtually all the money they received from taxpayers.

Huh? Anything given billions of dollars will be billions of dollars richer, but that does not count as "success" or "health". A healthy financial system is one that does not pay itself billions while destroying trillions, a healthy financial system is one which pays itself millions while creating billions. And "success" is achieving such a system. In every way, the financial system of 2010 is worse than the one we had in 2007. It has more moral hazard, more concentration, more political entanglements, more unwritten gaurantees, and even more incentive to loot than before. While Cassidy stands in awe of the geniuses at Goldman Sachs, I will humbly submit that I could make that much money too if the Treasury gave me billions and then promised to underwrite any losses I might incur. So could my cat.

If you want to look at what's put a floor under employment, look at a Government sector that now hires about 25%-30% of all workers, plus a slew of automatic stabalizers, and a fiat (non-gold standard) currency, none of which existed in the 1930s. You will note that Obama's Geithner had nothing to do with any of these. Just as the failure of the financial system seems to be an orphan ("economists are still trying to understand what caused the financial meltdown") the "recovery" has a proud father ("Shhh. The Geithner plan is working").

Simon Johnson points out some of the fallacies in this line of thinking quite well.

Other parts of the econ-blog sphere though grow tired of the wreck that is the financial system and now want to make the money they missed by not buying into the S&P last march. Or, depending on their political leanings, they come up with corkers like this:

...we cannot fix the financial sector without addressing the problems and contradictions [of inequality] which we depend upon financiers to paper over. This never was just a financial crisis. It was, and is, an economic and political crisis, and we are only a very short way down the path towards resolving it.

SRW's a nice guy, but we do not need to build a New Jerusalem before we can focus the financial system on its public purpose: making loans that get paid back. It's a shame to see Steve degrade from a smart thinker about finance to just another cog in the all-consuming kto, kogo industry.

More options if you understand the monetary system

Rolfe Winkler lays out a good, if often unspoken, reason for why the Obama has supported his predatory financial system instead of fixed it.

Throughout there was much indignation as to why such sensible reforms haven’t been enacted. Wall Street’s lobby machine got most of the blame, the rest went to “the people” for their perceived lack of outrage. But of course people are mad, and though the lobby machine is strong, it’s not the real obstacle to reform.

We are.

We don’t really want it. More to the point, people care more about their jobs than they do about reform.

What the reforms in paragraph 4 all have in common is that they reduce the availability of debt finance. That’s smart because our chief economic problem is that we’ve too much of the stuff.

But said another way, the reforms reduce credit. Like a lot. And that means deep and prolonged recession. Crucially, it means higher unemployment.

The private sector is over levered, and the solution to this is for the Government to pay in additional equity by running higher deficits. If it tries to limit paying in this equity you'll get what we have -- high unemployment and an overleveraged financial system.

SRW once said that the financial system had a MAD strategy, and this is part of that I'm sure. But the Government has the ability to disarm the financial system by levering up, so it can be levered down.

Love this interview

I love this Harry Markopolos interview.

It's like a car crash, only worse

A small plane took off in dense fog, crashed into a day care, and took down the power in my neighborhood today. Everyone in the plane died. Thankfully the day care was empty. The lights are back on now.

This post, and the resulting discussion, is a similarly horrible crash, and although no one has died, the lights are still firmly off. Don't waste your time with this, rubbernecking is wrong.