A week ago, Simon wrote his “Confusion, Tunneling, and Looting” post, which argued that the confusion created by crises helps the powerful and well-positioned siphon assets out of institutions and out of the government. The revelations that much of the AIG bailout money has gone straight to its large bank counterparties in the form of collateral could fall under this heading.
The looting theme has gone mainstream, with David Leonhardt in The New York Times. I think Leonhardt’s article is good, but it describes looting (taking advantage of implicit government guarantees to take excessive risks) as a cause of the mess we are now in – and as something we’ll need to worry about in preventing crises in the future. But, as Simon argued, it’s also something to worry about right now. As long as the Too Big To Fail doctrine holds, the banks’ implicit government guarantee is more explicit than it ever has been. So whatever perverse incentives helped bring on the crisis are even stronger today.
The Baseline Scenario 
Now, can we go to wprk on “kleptocracy”?
James,
Yesterday at lunch the overriding theme among my colleagues was depression at the situation and skepticism that working as hard as we do is worth it, given the wealth transfers we are seeing. I’m not much for either Ayn Rand or anecdotes, but it felt like an Atlas Shrugged sort of moment to me. The cultural implications of this bailout (the first to happen in the internet age, where everyone can see) will end up being a serious problem.
Also, Dave Goldman continues to hammer on the insurer/bank link. See here:
http://blog.atimes.net/?p=722
I’d be interested to hear the baseline’s take on this.
He also argues that, with spreads as absurdly high as they are right now, banks should be able to earn their way out of their current hole in a few years, if we just suspend mark-to-market in the interim.
Boy that doesn’t appeal to me.
Cheers,
Carson
From Bloomberg:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKqHkkFlnvfM
“Most U.S. bank debt is held by insurers and foreign investors, with a small portion owned by mutual funds, said FTN’s Darst. The Investment Company Institute, a trade group representing mutual funds, doesn’t keep statistics on fund ownership of bank debt, spokeswoman Ianthe Zabel said.
Investors shouldn’t increase holdings that lack explicit government guarantees because “extreme losses” could force senior creditors to share in bailout costs, JPMorgan Chase & Co. said in a March 6 report by Srini Ramaswamy. While the scenario remains remote, owning the banks’ senior debt isn’t attractive when there’s concern about systemic risk, Ramaswamy wrote.
“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” Mehernosh Engineer, a London-based strategist at BNP Paribas SA, said this week. “There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”
Look at who owns this debt: Insurers, Foreign Investors.
Let’s say we allow defaults on this. Who are the insurers? Will we simply have to then prop them up instead? Have you seen any recent headlines about insurers being the next big problem?
Foreign investors? Try this:
http://blogs.cfr.org/setser/2009/01/29/read-dean-areddy-and-ng-on-the-management-of-chinas-reserves-during-the-crisis/
“It turns out that one of China’s main criticism of US policy is simple: the government didn’t stand by institutions that China expected the US to support. Lehman. Wamu. And the Reserve Primary Fund. Dean, Areddy and Ng:
“Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking. …
Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac.”
….. The Reserve issue “is causing a lot of concern with a lot of financial institutions in China,” said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. “If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system,” the official said.”
Why does this bother me? Because this shifts the focus to Treasuries. From Buiter:
“In addition to (1) and (2) being met, there must be sufficient ‘fiscal spare capacity’ – confidence and trust in the financial markets and among permanent-income consumers, that the government will raise future taxes or cut future public spending by the same amount, in present discounted value terms, that they want to boost spending or cut taxes today. Without this confidence and trust, financial markets and forward-looking consumers will be spooked by the spectre of unsustainable fiscal deficits. Fear of future monetisation of public debt and deficits, or of future sovereign default will cause nominal and real long-term interest rates to rise. Ultimately, the sovereign will be rationed out of its own debt market. The US government (and the US economy as a whole) will encounter a ’sudden stop’.
These are not tales to frighten the children. I am deeply concerned that, when the US Federal government starts to run Federal budget deficits of 14 percent of GDP or over, the markets will get spooked and will simply refuse to fund the US authorities at any interest rate. Summers’ naive proposal for expansion now, virtue later, is simply not credible given the political economy of the US budget, now and in the foreseeable future.”
We’re in a bind. Either we default on these bonds, leading foreign investors to suspect that we’re default happy, or we guarantee the bonds, possibly adding to our debt. In all honesty, it might be better to guarantee the debt, and pray we don’t have to honor it.
Since I consider looting ( govt guarantees ) and fraud, negligence, collusion, and fiduciary mismanagement, as the main causes of this crisis, I don’t like giving in. But it’s important to consider that, in this case, we’re giving in to foreign investors who we need, and insurers who will probably come calling as well with lobbying debts in tow. The one benefit is that it would make seizure easier.
So, let’s guarantee the bondholders, and seize the big banks, and remember that this isn’t going to be a battle quickly won.
Just one view.
Well, Sheila Bair seems to know more about how to price the assets than the market does. From a marketplace.org interview yesterday:
“Ryssdal: There is a supposition here, isn’t there, that the toxic assets will eventually become non-toxic (for want of a better word) at some point, right?
BAIR: Well, I think they will certainly be worth more than the current valuations. I think that is the assumption. And I think that’s true. I mean, at the FDIC we sell troubled bank assets all the time. You know, when banks have to be closed, we take over as a receiver, so we’re pretty familiar with the market right now. So we think that that is absolutely true that the assets are worth more than the current market conditions assign to them. And so that, yes, over time there will be significant profits from these.”
This sounds like the old Paulson talking points. Until the government gives up this line, taxpayers are in great danger.
Makes one long for the days of lynch mobs and public hangings.
Hey Carson,
I haven’t thought about this enough to write a whole post about it, but here are my quick thoughts on Dave Goldman’s issue. For those who haven’t followed Carson’s link, Goldman is saying that the government has to guarantee bank liabilities, because the people holding those liabilities are life insurers, and if people lose confidence in their life insurance policies then they will panic even further.
First of all, not many people are saying that bank creditors should be stiffed. Krugman himself (contrary to what Goldman implicitly attributes to him) says that he thinks the government should probably guarantee all bank liabilities.
Second, and here’s where I’m not so sure about the details – in most states, insurance policies are guaranteed by the state. You may not get 100% back, and there are limits, but you are probably insured.
Third, if bank debt is not fully honored, it is probably subordinated debt that gets shorted. Insurers should be holding the senior stuff (there are regulations that determine what types of securities they are allowed to hold), and most probably are, although I guess the really big ones may have been gambling and lost.
I think if a regulator were going to take over a large bank, before they make that announcement, they have to study who holds its liabilities and figure out what the collateral damage of not guaranteeing the liabilities would be. All of us out here are just speculating on what that collateral damage would be.
Eh… Give it time.
“The confusion created by crises helps the powerful and well-positioned siphon assets out of institutions and out of the government. The revelations that much of the AIG bailout money has gone straight to its large bank counterparties in the form of collateral could fall under this heading.”
That seems a bit harsh. (Yeah, I know: you can’t be too harsh on the guys who got us into this mess, but I’m trying to be reasonable here.)
The banks hedged their credit exposures by buying swaps from AIG, a AAA-rated insurance company and (formerly) one of the world’s largest financial institutions. Maybe they should have understood they were buying insurance on the Titanic from someone on the Titanic, but it wasn’t like they were trying to earn fat returns by applying insane amounts of leverage or exploiting regulatory loopholes (that was AIG’s job). The banks were just trying to hedge their risks — the putatively legitimate role of the CDS market.
Now the defaults are happening and the banks are looking to those contracts to do what they were supposed to do (and what their premiums paid for), which is limit their losses. So AIG is being forced to pay out. So the feds are being forced to pay out, in order to prevent another systemic panic.
That doesn’t sound like “looting” to me, unless AIG is still writing swaps and banks are still buying them, which I don’t think is the case. It’s the bailout doing what the bailout is designed to do. If that’s looting, then the entire TARP is the biggest looting binge since the Goths sacked Rome.
Which may be true, but doesn’t seem to be what Kwak has in mind.
Consider the focus shifted. From Bloomberg today:
http://www.bloomberg.com/apps/news?pid=20601087&sid=a.z1.V13_8G0&refer=home
“March 13 (Bloomberg) — China, the U.S. government’s largest creditor, is “worried” about its holdings of Treasuries and wants assurances that the investment is safe, Premier Wen Jiabao said.
“We have lent a huge amount of money to the United States,” Wen said at a press briefing in Beijing today after the annual meeting of the legislature. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”
Akerlof & Romer (http://tinyurl.com/4z39l8) were careful to distinguish between “going for broke” scenarios that had high expected returns despite a high probability of failure, and “going broke” strategies, or “looting” that could not actually make money under any likely economic scenario.
The paper is only too relevant to today, filled with useful tidbits such as how poor monitoring by regulators break the Modigliani Miller assumptions that Greenspan was counting on.
I personally believe the era where anybody can incorporate in Delaware for a couple of thousand dollars, and potentially stiff the public with multi-billion failure costs, because of the expense of monitoring for risk or fraud, (aka asymmetric information) should end.
Not that I have a good alternative to propose.
The CDS market blew up because these banks piled on counterparty risk, mostly with AIG, that could only be supported by the balance sheet of the US government. It was a complete breakdown of the so-called “risk management” they all tout, and a particularly rapacious example of tunneling after it became apparent they all were holding contracts that could not possibly be honored by AIG. They ran to Hank Paulson, their guy on the inside, so that these contracts would be abrogated by fiat (no court action required), and the US government would step in for AIG and pay the banks and FIBs off. Hank and his treasury colleagues, many pulled from Goldman (his alma mater), made sure the banks and FIBs were kept whole.
That the banks and FIBs knew this with absolute certainty, as did the market, is easy to demonstrate: their equity was driven to a level slightly higher than zero as the whole debacle was unfolding. There are even counterparty spats with AIG demonstrating 1) AIG did not properly value these swaps, and 2) the counterparties knew it. Yet they all continued to pile the risk on. This was recklessness of historic proportion. It went on for years. Read this. It rings so true it’s scary:
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom
This wasn’t about hedging. This was about fraud. These firms destroyed global capital markets and the trust in banks and FIBs, without which the markets cannot operate. These banks and FIBs were looking for the biggest sucker to take the hot potato in the lead-up to this debacle, and after it became self-evident their own wealth (i.e., the stock they all held in their companies) would be wiped out in short order. At the end of the day, it is the banks’ customers that were burned along with taxpayers. Now the banks and FIBs are issuing 2- and 3-year debt fully guaranteed by the federal government 1) because no one trusts anything they report in their financial statements, and 2) they are insolvent. In addition, Level 3 assets are > or = market cap for most of these guys. Who would take their paper?
These people — the managements that destroyed the capital and trading markets worldwide — cannot be trusted, nor can they be allowed to continue to run these banks and FIBs. They should stand trial for reckless disregard of their fiduciary obligations to shareholders and customers. As should those who aided and abetted the tunneling and looting of the US Treasury. These people are not only a threat to trading markets: They have demonstrated they are a real and present danger to global stability and to democratic and capitalistic societies worldwide.
Use the stimulus to fund a new and completely solvent bank. Have that government bank offer higher interest rates on deposits. Get a bank runs on deposits from the other banks. Stop bailing them out. Force them to sell their assets to the government bank at fire sale prices. Privatize this bank at a later time at a huge profit to the taxpayer. Shore up the fiscal situation and keep long term interest rates low.
That should take a bite out of moral hazard.