Via Yves Smith, John Hempton analyzes the quarterly results of Bank of America (so-so) and Fannie Mae (terrible). The underlying issue is that bank quarter-to-quarter results are largely driven by the amount of provisions they take against future loan losses. You can think of this as a very rough approximation to marking-to-market — instead of waiting for the loans to default, you estimate how many loans will default in the future (that estimate should change as the economic situation changes) and put that amount of money into reserves. Then when the defaults actually happen, you take the money out of reserves.

Hempton argues that Bank of America and Fannie Mae are estimating extremely different future loan losses, and those differences cannot be attributed to differences in their current performance (the rate at which loans are defaulting now). If I wanted to be provocative I would only show you this quote:

“If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.” [emphasis in original]

(“Totally cactus” — I like that.)

But to be fair, Hempton actually thinks that Bank of America is being only slightly optimistic and Fannie is being extremely pessimistic. Here’s his interpretation:

“[R]egulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

“It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. [Hempton is saying that if they took any more provisions they would be unprofitable.] Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible. …

“[A]lmost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

“Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.”

By James Kwak

One of the Free Exchange bloggers (some people know who is who by name, but I don’t — if anyone wants to enlighten me, I’m listening) admits choosing his bank because it was big, and staying there because it is big. He also links to James Surowiecki, who asks in the “notes” to his latest column,

“[W]hy, given the broader backlash against the big banks and the less-than-inspiring performance they’ve turned in over the last couple of years, are people still sticking with them? What makes this even more curious is that the big banks, which have historically offered their customers worse deals than smaller banks, have not changed their ways: they pay less for deposits, charge more for loans, make billions from overdraft fees, and have jacked up credit-card rates.”

When it comes to retail customers (you and me), Surowiecki highlights switching costs (add your own example) and brand (“It’s nearly impossible for consumers to evaluate how healthy a bank is. So, at a time when banks are failing with some regularity, the size and ubiquity of these big banks is reassuring.”). Free Exchange thinks the issue is the implicit government guarantee:

“[I] bigness is associated with security, then real bank competition means convincing customers, along with everyone else, that the government has a plan to unwind its implicit guarantee for banks and that ultimately the country’s largest banks will be as subject to failure as everyone else. If that can’t be achieved—if real market pressures aren’t ever going to apply—then it may be time to start thinking of large banks as natural monopolies, to be treated like regulated utilities.”

I’m a little skeptical of the brand/security argument, since most people don’t have more than $250,000 (the FDIC insurance limit) in their bank accounts. But maybe people don’t really trust the FDIC, or don’t realize how seamless the process is for them, and they would rather trust the Citibank logo.

The switching costs certainly are high, and I can provide some anecdotal details. I’m in the process of switching out of Bank of America. Moving all my bill payments and direct debits from B of A to another bank was pretty easy, although in some cases I had to call someone to get the right form. Moving my safe deposit box was a pain that cost several hours of time. Moving my direct deposits was pretty easy, although again it required paper forms. The trick was the ATM fees, but I found a checking account (PeoplesBank in Holyoke, Massachusetts, with branches in the Springfield-Holyoke-Northampton area) that refunds other banks’ ATM fees. (In the interest of fairness, I should also put in a plug for my other local bank, Greenfield Savings, which pays 0.75% on checking accounts.)

It can be done. But a bigger question would be, why? I feel like I need to as a matter of principle, given my well-known positions on this issue. But I don’t expect the average person who is frustrated by big, unfriendly, bailed-out banks — even the average reader of this blog — to invest the few or several hours it takes to switch. Most people probably don’t have enough money in their deposit accounts for the higher rates you can get at local banks to matter. When it comes to most political issues, I think most people feel individually helpless; when it comes to Too Big To Fail, which, let’s face it, is a pretty technocratic issue, I suspect we feel even more helpless.

Update: One reader wrote in to say that Florence Savings Bank (also in Western Massachusetts) also refunds depositors’ ATM fees incurred at other banks.

By James Kwak

Last week, Charles Calomiris wrote an op-ed in the Wall Street Journal arguing that big banks are better for various reasons. Simon wrote last week saying that Calomiris underestimated the political dimension, and that his proposed solution — a cross-border resolution mechanism for large institutions — is the policy equivalent of assuming a can opener.

I wanted to look at Calomiris’s specific claims. I think I’ve already dealt with the myth that banks “need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.” Calomiris also argues that there are economies of scope (it’s better to be big because you can play in multiple businesses). Here’s his evidence:

“True, some empirical studies in the field of finance have failed to find big gains from mergers. But those studies measured gains to banks only, and measured only the performance improvements of recently consolidated institutions against other institutions, many of which had improved their performance due to previous consolidation.

“Yet even unconsolidated banks have improved their performance under the pressure of increased competition following the removal of branching restrictions, which permitted the consolidation wave in banking. And when an entire industry is involved in a protracted consolidation wave, the best indicator of the gains from consolidation is the performance of the industry as a whole. One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.”

Note that Calomiris concedes that you can’t find benefits from mergers by looking at merged banks directly; this is why he falls back on an industry average.

First of all, there must be a joke to be made here about correlation and causality. Wait, here it is.

Second, 1991-97 was only the beginning of the merger wave; The Riegle-Neal Interstate Banking Act wasn’t passed until 1994. Let’s assume that mergers after 1995 wouldn’t show up in the 1991-97 data. That includes Nations-Boatmen’s, Nations-Barnett, Nations-Bank  of America, B of A-FleetBoston, Chemical-Chase, Bank One-First Chicago, J.P. Morgan-Chase, Wells-First Interstate, Wells-Norwest, and Wachovia-First Union.

Third, I was interested by that statistic, because 0.4% annual productivity growth from 1991 to 1997 seems like nothing to write home about – labor productivity growth (the figure you usually read about) over that period was about 1.7% per year for the economy as a whole. So I tracked down the source: Kevin J. Stiroh, “How did bank holding companies prosper in the 1990s?,” Journal of Banking & Finance, Volume 24, Issue 11, November 2000, Pages 1703-1745. (I’m not sure if anyone can download the paper or I could only do it because I’m on the Yale VPN.)

I found out that Stiroh is measuring total factor productivity, not labor productivity, so 0.4% is better than average for the non-manufacturing sector. (The economy average was 0.3%, but the manufacturing sector was 1.9%, so by implication the non-manufacturing sector was less than 0.3%.) So far, so good.

But what does Stiroh say about this productivity growth? His main explanation for the productivity growth is not consolidation, but information technology: “The finding of steady productivity growth, in particular, is important since it is consistent with the idea that the massive investment in new technology is working to improve the performance of the banking industry.” This is not proven in this paper, but Stiroh went on to write a bunch of other papers on the link between information technology and productivity. For example, this paper (on the entire economy, not just banking) concludes:

“IT-producing and IT-using industries account for virtually all of the productivity revival that is attributable to the direct contributions from specific industries, while industries that are relatively isolated from the IT revolution essentially made no contribution to the U.S. productivity revival. Thus, the U.S. productivity revival seems to be fundamentally linked to IT.”

That second paper also finds (Table 2) that productivity acceleration — the difference between productivity growth in the 1995-99 period relative to the 1987-95 period — was lower in finance, insurance, and real estate than in the economy as a whole, including the services sector. I don’t know exactly what this means, but at first glance it doesn’t look good for banking consolidation.

Going back to the first paper (the one Calomiris cites), what does Stiroh say about bank size? “Despite the strong overall performance, roughly 10% of costs were due to inefficiency and 30-40% of potential profits were missed. Moreover, efficiency does not significantly increase with bank size as one might expect if economies of scale are an important determinant of success. Rather, there are efficient and profitable BHCs in every size class and increased size does not guarantee success.” Figures 6 and 7 show that there is no difference in cost efficiency across size classes and that the largest banks actually seem to have lower profit efficiency.

However, Stiroh also says that continuing consolidation seems to offer the possibility of reducing these inefficiencies, so on balance I would say he is slightly positive about size. Stiroh also has a paper on banks in Switzerland which I didn’t read, but whose abstract says:

“We find evidence of economies of scale for small and mid-size banks, but little evidence that significant scale economies remain for the very largest banks. Finally, evidence on scope economies is weak for the largest banks that are involved in a wide variety of activities. These results suggest few obvious benefits from the trend toward larger universal banks.”

I wish I had more time to read more of these papers. It seems to me that Stiroh has done a lot of serious empirical research on banking productivity and finds the evidence mixed — consolidation should be good, but it doesn’t really show up in the data. I haven’t read much of his work (or talked to him) and I certainly don’t want to imply that he is against big banks. I just think that citing a study he did of the 1991-97 period to back up a claim that banking mergers are good is a bit of a stretch.

By James Kwak

Overheard on the streets of New Haven, just ten minutes ago:

Two young women, almost certainly Yale undergraduates, are walking down York Street, discussing their efforts to get jobs as bankers.

Student #1: “Why does everyone want to go into banking?” [Note: When an Ivy League undergrad says "banking," he or she invariably means "investment banking," meaning underwriting or trading.]

Student #2: “We should advertise – ‘Being a lawyer is so much better than banking.’”

Student #1 (after a pause): “Seriously, everyone wants to go into banking.”

End scene.

Also further proof that no one does campus recruiting better than a Wall Street investment bank. Or do undergrads these days want to work in investment banking after the financial crisis? At least, after the last twelve months, no one can claim that he didn’t know what kind of business he was getting into.

Update: I edited out a crack I made that, on reflection, was gratuitous. I’ll let the rest speak for itself.

By James Kwak

Gillian Tett has the latest perspective on a curious deal that Barclays did earlier this week (hat tip Brad DeLong). The deal goes something like this. Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Or does it have the same true economic exposure? If things go badly, yes, since Protium will default on the loan. If things go well, however, Protium’s investors get all the upside since they get the residual cash flows after the loan is paid off. So Barclays is left with all the downside and none of the upside. In return for giving away the upside, they should have gotten a good interest rate on the loan. The interest rate is LIBOR + 275 bp, and I have no way of calculating if that’s a good rate or not. But even assuming it is a good interest rate, this is what Nassim Taleb calls a nickels strategy – picking up nickels (the nice interest rate) in front of a steamroller (the risk of the assets falling in value).

Finally, we have the other kind of arbitrage. Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want. Given the size of Barclays, the shareholders won’t notice $40 million here or there, especially if it looks like it’s coming from someone else. Everyone wins.

By James Kwak

Probably most of you have already read David Cho’s Washington Post article on how the Big Four banks (a) have gotten bigger through the crisis, (b) have increased market share (“now issue one of every two mortgages and about two of every three credit cards”), (c) are using their market clout to increase fees (while small banks are lowering fees), and (d) enjoy lower funding costs because of the nearly-explicit government guarantee.

I just want to comment on this statement by Tim Geithner: “The dominant public policy imperative motivating reform is to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy.” (Emphasis added.)

Um, no.

There were all those nuts saying that Treasury should have taken over the banks. This would have allowed the imposition of haircuts on creditors and limited moral hazard. There was also the less controversial option of making real, lasting constraints on banking practices a condition of the bailouts; the conditions that were imposed were peripheral and timed to evaporate when the TARP money was paid back. As a result, now Geithner has to bargain with Congress and an increasingly confident industry to get his regulatory reform.

It’s also important to differentiate between September 16-October 14, when you could give the government the benefit of the doubt because of the intense panic and uncertainty caused by the collapse of Lehman, and November-February (when the follow-on bailouts of Citigroup and Bank of America took place), when the government was able to choose among a range of options.

Saving the economy was a good thing. Doing it a particular way was a choice.

That said, I’m glad that Geithner says that undoing this situation is “the dominant public policy imperative motivating reform.”

By James Kwak

Felix Salmon has a good example of why disclosure (the preferred consumer-protection regime of free-market conservatives and bankers) doesn’t work, courtesy of Ryan Chittum. The topic is no-interest balance transfers offered by credit card companies.

As Salmon points out, most people probably realize what the game is. That is, most people know that banks aren’t in the business of lending money for free; they know that the bank is betting that it can raise the interest rate before they pay off the balance. It’s possible that you will end up getting a free loan: “If you’re smart and disciplined and lucky, you might be able to game the system and pay no interest at all on that balance. Bank of America, for its part, does its very best to make you think that you’ll be able to do just that, essentially getting one over on The Man.” But the bank knows it has the numbers on its side; and most consumers know it too, because they know that’s the only reason the bank would make the offer.

And people take the bait anyway, because they think they’re the exception. “Most people, when they sign up for one of these offers, think that they’ll successfully game the system. But of course most of them are wrong.”

The people who think that disclosure solves everything, like Peter Wallison, are remembering only half of what they learned in first-year micro. In order to get utility-maximizing outcomes, you need perfect information and rational decision-making. Disclosure gives you information about the product you are buying, but it doesn’t make you a rational actor – especially not when you have to make predictions about your own future behavior. Remember, not only are we a species in which 90% of people think they are above-average drivers, but 85% of people in hospitals who just caused auto accidents think they are above-average drivers. (Sorry, I can’t remember where I heard that – it was recently, probably on an NPR show.) (Update: engineer27 found the story – it’s from the Planet Money team.)

I suspect that the real divide in the battle over the Consumer Financial Protection Agency is between outcomes and principles. CFPA supporters believe that policies should attempt to achieve the best possible outcomes for the largest number of people; if the number of people harmed by a product exceeds the number helped, then it should be banned, or at least made harder to buy. CFPA opponents believe that policies should faithfully reflect certain principles; in this case, people should be free to make their own financial choices, even if in aggregate most people will make bad choices, and they should bear the consequences of those choices.

This is a fairly common way that policy debates break down these days. Sex education and contraception are the best example, but there’s a similar fault line when it comes to guns, drugs, and crime, among other things. It’s also an indication that the debate can never be resolved by any amount of empirical data.

By James Kwak

This morning, Simon asked why community banks seem to be opposing the Consumer Financial Protection Agency. Felix Salmon agrees that community banks should be in favor of the CFPA, for three reasons: (1) the CFPA should increase the cost of complexity, not the “boring banking” that community banks are typically thought to do; (2) the CFPA should level the playing field with predatory lenders, saving community banks from the choice of losing market share or becoming predatory lenders themselves; and (3) the CFPA should shift competition from finding hidden ways to gouge customers to traditional underwriting, which should be a community bank strength. He later adds (4) the big banks’ big advantage is in deceiving customers, which the CFPA should be able to rein in.

Salmon thinks there are still two reasons why community banks may be afraid of the CFPA:

I think it’s a combination of fear of the unknown, on the one hand, and fear of the big banks, on the other. Since every regulator to date has been successfully captured by Wall Street, it’s reasonable to assume that the CFPA might end up being captured by Wall Street too. In which case the burdens of the CFPA might end up being borne disproportionately by smaller community banks.

The commenters on Simon’s post made some similar points, beginning with Bond Girl – “I know several executives at small banks that were flipping subprime mortgages and the like” – and Russ – “it’s not irrational for the smaller banks to fear that in practice regulation would be gamed to further empower the big banks while falling on the backs of the smaller.”

I think it breaks down this way. To the extent that community banks were ripping off customers with mortgages they had no chance of repaying (if Richard Posner or Peter Wallison is reading this, replace everything from “ripping” to “repaying” with “helpfully giving customers the option of rationally speculating on housing prices”), then that is something that should stop, and the CFPA should be aimed against them. Put another way, if that is the case, then community banks should be ignored on this issue just like Angelo Mozilo should be ignored.

That said, I think there are probably many community banks that do fit the “boring banking” stereotype. When I bought my family’s house, I got a mortgage from Greenfield Savings Bank, based in Greenfield, Massachusetts, which, I believe, did not even reserve the right to resell my mortgage. Looking at their current rate sheet, I see that they offer 15-, 20-, and 30-year fixed-rate mortgages; a 5/1 adjustable-rate mortgage; and 30- and 40-year fixed-rate mortgages for first-time homebuyers. And that’s it.

The first question to ask about these banks is: if size is so important in banking (I’m thinking of all those people who say that breaking up mega-banks would hurt consumers or, worse, the entire country), then why does Greenfield Savings even exist? Community banks must have some source of competitive advantage over Bank of America and Citigroup. There are two obvious possibilities. One is that customers prefer dealing with local banks, and based on my personal experiences, the level of customer service is far superior than what you get with a megabank. The other is that community banks, as Salmon said, are better at underwriting, because they actually know the characteristics of the neighborhoods they are underwriting in and, possibly, the borrowers they are underwriting. The reason I went with Greenfield Savings was that they offered me a lower rate than any national bank, and presumably they were able to do this because they knew something about the local market that the national banks didn’t.

Now, both of these are advantages that should be protected by the CFPA. That is, if your goal is to provide better customer service, you are probably not in the business of screwing your customers. And if your competitive advantage is in underwriting, then you have no need to confuse customers with unnecessarily complex products. You should be happy that Elizabeth Warren is keeping predatory lenders out of your backyard, because even if you refuse to match their mortgages, they are driving up housing prices and making it harder for you to find qualified borrowers.

(On the other hand, if you decide that your strategy is to originate toxic mortgages and flip them to investment banks, then you have no competitive advantage left and no business to go back to when demand for your mortgages craters, and no one will bail you out because you are too small.)

So we are left with Russ’s problem: small banks believe that once the CFPA is created, it will be captured by big banks, who will use it to screw them – not an irrational fear, given the way regulation is often used as a stick with which one set of corporate interests beats on another. But the simple answer there is that Tim Geithner and Michael Barr (and Barney Frank) need to design the CFPA in such a way as to minimize this possibility. Maybe they could have rules requiring the CFPA to allocate auditing resoruces in some proportion to firms’ size. Maybe they could slap special anti-lobbying provisions on the CFPA (high salaries but no ability to work for a company you regulated for a long time) to reduce the risk of capture. Maybe they could put in a tax-and-transfer mechanism to ease the compliance costs for small banks. Maybe something else.

The bottom line is, either community banks are just as guilty as the unregulated mortgage brokers and the investment banks that funded them, in which case Geithner et al. need to make the case that Congress should not listen to them; or community banks are part of the solution, in which case Geithner et al. need to make the case to them that they should support the CFPA. I obviously support what Geithner is trying to achieve with the CFPA. But it’s time to close the deal.

By James Kwak

I had a post criticizing John Carney on the topic of bankslaughter. However, I must say I agree with him when it comes to Goldman Sachs. Even more surprising, I largely agree with the Wall Street Journal editorial that Carney links to.

Here’s what the Journal has to say:

We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

. . . Banks that want to be successful will also want to be more like Goldman Sachs, creating an incentive for both larger size and more risk-taking on the taxpayer’s dime.

One policy response to the incentives created by last fall’s bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up.

Did I read that right? The WSJ proposing a new tax?

And here’s Carney’s conclusion:

What’s worse, letting CIT fail might not help this situation at all. Rather than clearing the way for market discipline to reassert itself, CIT’s failure might only reify the policy of Too Big To Fail.

Financial firms that are deemed too small to be rescued will find credit hard to come by and expensive, which will incent them to grow or sell themselves to a systemically important firm. In short, we’re increasing the concentration of financial power and hence systemic risk in the largest Wall Street firms that led us into this mess.

To use traditional labels for a moment, the right-wing criticism is that the implicit government guarantees created by Too Big to Fail distort the market. The left-wing criticism is that bailing out large banks enriches capitalists at the expense of ordinary people, and the benefits don’t trickle down into the economy at large (see the number of foreclosures, for example).

The Obama Administration’s defense is that only by enriching those banks can we keep the economy from sinking further and hurting everybody. It’s not an implausible position to defend, but it can’t be fun, especially for people who always thought they were progressives.

By James Kwak

Mike from Rortybomb has an interview with Perry Mehrling on the shadow banking system. I was going to try to put this in some context, but Mark Thoma (who played an important role in this saga) beat me to it.

Merhling’s takeaway point is that there needs to be a “credit insurer of last resort,” who will insure any asset against a fall in value – for a sufficiently high premium. This would make it possible for financial institutions to unload the risk of their asset portfolios in a crisis, if they are willing to pay enough to do so. The only institution that would have the credibility to play this role in a real crisis would be the federal government; as we saw, AIG – the world’s largest insurance company, remember – was not up to the task. Still, though, I’m not sure this would do the trick. If I’m a large bank with a balance sheet full of toxic assets, and I don’t want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout. The credit insurer of last resort would need to be coupled with a commitment not to provide an alternative form of government support, or we would end up where we are today.

By James Kwak

It’s getting somewhat lonelier being a large financial institution skeptic, although there still a lot of us left. I would say that among the skeptics, the general view is that we may have seen an end to bank panics for this cycle – I’m not sure anyone is saying there will definitely be another crisis in the near future – but we may not have, and we may come to regret not taking stronger measures now. (How’s that for prognostication?)

Lucian Bebchuk, in Project Syndicate (a well-intentioned collaboration that manages to sound ominous and conspiratorial), makes the argument in clear terms. First, the recent stress tests only projected losses through 2010, ignoring the large number of loans and mortgage- and asset-backed securities that mature in later years. More fundamentally, though: “Rather than estimate the economic value of banks’ assets – what the assets would fetch in a well-functioning market – and the extent to which they exceed liabilities, the stress tests merely sought to verify that the banks’ accounting losses over the next two years will not exhaust their capital as recorded in their books.” Put another way, the focus has been on the accounting value of assets, not their economic value; so for a given asset, as long as it doesn’t have to be written down before the end of 2010, there is no problem.

Bebchuk also points out that the ability of banks to raise equity capital should not be taken as an “all clear” sign. As he and others have previously argued, equity in large banks by its very nature represents a leveraged bet whose downside risk is limited by the implicit government guarantee. That is, as a shareholder, if the economy does OK and bank assets appreciate in value, you get all of the upside (leveraged by the bank’s liabilities); if the economy does terribly and bank assets fall in value, your losses are not only limited to the amount of your investment, they are further limited by the implicit guarantee that the government will not wipe you out. That guarantee is weaker than the implicit guarantee on bank liabilities, but it is still there; given the way the government has treated Citigroup, Bank of America, and GMAC, betting on the “no more Lehmans” policy seems like a sensible bet.

Most attention is now focused on the battle over financial regulation (if it isn’t on health care and energy), which is appropriate. But it may be premature to declare victory over the financial crisis.

By James Kwak

The banking industry is exceeding all expectations.  The biggest players are raking in profits and planning much higher compensation so far this year, on the back of increased market share (wouldn’t you like two of your major competitors to go out of business?).  And banks in general are managing to project widely a completely negative attitude towards all attempts to protect consumers.

This is a dangerous combination for the industry, yet it is not being handled well.  Just look at the current strategy of the American Bankers’ Association.

Edward L. Yingling is justifiably proud of his organization’s postion as one of the country’s most powerful lobbies. 

His testimony to Congress on the potential new Consumer Financial Protection Agency plainly shows where his group stands.  The most revealing quote, highlighted in the ABA’s own press release, reads:

“It is now widely understood that the current economic situation originated primarily in the largely unregulated non-bank sector,” he said. “Banks watched as mortgage brokers and others made loans to consumers that a good banker just would not make and they now face the prospect of another burdensome layer of regulation aimed primarily at their less-regulated or unregulated competitors. It is simply unfair to inflict another burden on these banks that had nothing to do with the problems that were created.”

The premise here is false.  If major banks had really not been involved in the mortgage fiasco, we would not have had to roughly double our national debt-to-GDP in order to save the US and world economy.

Within the banking community, and presumably within the ABA’s membership, there is serious tension.  The small banks feel – overall with some justification – that the essence of the recent problem was not about them.  But they can’t bring themselves to suggest publicly that the economic and political power of the largest banks should be curtailed.

Small banks have always had clout in the American political system, particularly when they work through the Senate.  But we have not always had our current kind of crisis.  The executives of these banks lived comfortably in the 1950s and 1960s; their kind of banking was boring, stable, and nicely remunerated.

It is the changing nature and power of the largest financial institutions – banks of various kinds – that has damaged our system since the 1980s; the rise in financial services compensation is part symptom and part pathogen.  Big banks present the major risk going forward – to both the economy in general and to smaller banks in particular.

Most banks are “small enough to fail” (seven closed yesterday).  It is absolutely not in their interest to have some banks that are perceived to be “too big to fail” and to ever re-run any version of the last two years.

The ABA should be discussing and addressing this issue.  Instead, it is making all banks unpopular by opposing sensible legislation aimed at protecting consumers – look at the public relations context provided, for example, by Citi’s recent move on credit cards. 

The ABA’s leadership needs to quickly rethink its approach.

By Simon Johnson

Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”

This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)

The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.

The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.

One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”

By James Kwak

A reader pointed me to this story in The Guardian citing Goldman insiders saying this could be the investment bank’s most profitable year ever.

Staff in London were briefed last week on the banking and securities company’s prospects and told they could look forward to bumper bonuses if, as predicted, it completed its most profitable year ever. Figures next month detailing the firm’s second-quarter earnings are expected to show a further jump in profits.

A couple months back I said that it would be unlikely for the banks to repeat their spectacular first-quarter results in the second quarter, because it depended on fixed-income revenues being even higher than during the peak of the boom. It looks like I was wrong.

Like most things, there are two ways to interpret this. For the optimists, if some of the big banks are making big profits, that gets us back to a normally functioning financial sector sooner and reduces the chance that they will face a panic in the short term. As many people have pointed out, including us, this is basically the Obama Administration’s strategy.

For the pessimists, the phoenix-rising-from-the-ashes profitability of the big banks is a direct result of massive government aid in the form of cheap money, liquidity programs, and let’s not forget the bailout of AIG; it’s also the result of reduced competition resulting from the consolidation of Bear Stearns into JPMorgan, the failure of Lehman, and the weakened state of Citigroup and Bank of America/Merrill. So the government bought a partially healthy banking sector (the big question is what Citi and B of A will report) with public funds, the few winners (Goldman, JPMorgan) are more powerful than ever, and the government is hoping to get an anemic regulatory reform package through Congress in exchange.

By James Kwak

Slides for speech to World Bank conference (Lessons from East Asia and the Global Financial Crisis), Tuesday in Seoul (1pm local time), are attached.  This post summarizes my main points.

There are two views of the global financial crisis and – more importantly – of what comes next.  The first is shared by almost all officials and underpins government thinking in the United States, the remainder of the G7, Western Europe, and beyond.  The second is quite unofficial – no government official has yet been found anywhere near this position.  Yet versions of this unofficial view have a great deal of support and may even be gaining traction over time as events unfold.

The official view is that a rare and unfortunate accident occurred in the fall of 2008.  The heart of the world’s financial system, in and around the United States, suddenly became unstable.  Presumably this instability had a cause – and most official statements begin with “the crisis had many causes” – but this is less important than the need for immediate and overwhelming macroeconomic policy action.

The official strategy, for example as stated clearly by Larry Summers is to support the banking system with all the financial means at the disposal of the official sector.  This includes large amounts of cash, courtesy of Federal Reserve credits; repeated attempts to remove “bad assets” in some form or other, and – the apparent masterstroke – regulatory forbearance, as signaled through the recent stress tests.

But most important, it includes a massive fiscal stimulus implying, when all is said and done, that debt/GDP in the United States will roughly double (from 41% of GDP initially, up towards 80% of GDP). 

Not surprisingly, funneling unlimited and essentially unconditional resources into the financial sector has buoyed confidence in both that sector and at least temporarily helped shore up confidence in financial markets more broadly.

And now, in striking contrast to the dramatic action they call for on the macroeconomic/bailout front, the official consensus claims relatively small adjustments to our regulatory system will be enough to close the case – and presumably prevent further recurrence of problems on this scale.  If the exact causes and presumed redress are lost in mind-numbingly long list of adjustments, so much the better.

This is, after all, a crisis of experts – they deregulated, they ran risk management at major financial firms, they opined at board meetings – and now they have fixed it.

Maybe.

The second view, of course, is rather more skeptical regarding whether we are really out of crisis in any meaningful sense.  In this view, the underlying cause of the crisis is much simpler – the economic supersizing of finance in the United States and elsewhere, as manifest particularly in the rise of big banks to positions of extraordinary political and cultural power.

If the size, nature, and clout of finance is the problem, then the official view is nothing close to a solution.  At best, pumping resources into the financial sector delays the day of reckoning and likely increases its costs.  More likely, the Mother of All Bailouts is storing up serious problems for the near-term future.

 We’ll double our national debt (as a percent of GDP), and for what?  To further entrench a rent-seeking set of firms that the government determined are “too big to fail,” but will not now take any steps to break up or otherwise limit their size.

We need to disengage from a financial sector that has become unsustainably large (see slides before and after #19; the cross-country data should be handled with care). 

We can do this in various ways; there is no need to be dogmatic about any potential approach – if it works politically, do it.  But the various current proposals for dealing with this issue – both from the administration and the leading committees of Congress – would make essentially zero progress.

As moving in this direction does not seem imminent, the probable consequences or –  if you prefer – collateral damage looks horrible.  You can see it as higher taxes in the future, lower growth, a bigger drag on our innovative capacity, fewer startups, and less genuinely productive entrepreneurship.  Plenty of people will be hurt, and they are starting to figure this out – and to think harder about what needs to be done and by whom.

“Small enough to fail” may well prevail eventually – at least sensible ideas have won through in past US episodes – but it will take a while.  The official consensus always seems immutable, right up until the moment it changes completely and forever.

By Simon Johnson