Month: April 2010

The Role of Government

By James Kwak

Last week Simon gave a talk sponsored by Larry Lessig’s center at Harvard. Afterward there was a dinner and then another question-and-answer session. Jedediah Purdy (another person to write a book while at Yale  Law School; he is now a professor at Duke’s law school) asked a question that I have rephrased as follows (the words are mine, not Purdy’s; I may have also distorted his original question so much that it is also mine):

“You’ve criticized the government for withdrawing from the economic and particularly financial sphere and allowing private sector actors to do whatever they wanted. Do you think the government should simply act so as to correct the imperfections in free markets? Or do you see a positive role for government in determining what kind of an economy we should have?”

Continue reading “The Role of Government” →

Update on ABACUS

Read the “synthetic, synthetic CDO” post first if you haven’t already.

The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed. I think this is true to a degree, but not to the degree that Goldman needs it to be true.

Take an ordinary synthetic CDO. Back in 2005-2006, a bank might create one of these because it knows there is demand on the buy side for higher-yielding (than Treasuries) AAA assets. To do this, the CDO has to sell CDS protection on its reference portfolio to someone. That someone could in the first instance be the bank. But then the bank’s “short” position goes into its huge portfolio of CDS, which may overall be long or short the class of securities (say, subprime mortgage-backed securities) involved.The bank is constantly hedging that portfolio via individual transactions with other clients or other dealers, so there’s no one-to-one correspondence between the long side of the new CDO and any specific party or parties on the short side.

Let’s say for the sake of argument that the bank, prior to the new CDO, was exactly neutral on this market. The new CDO makes it a little bit short. So the bank will go out and hedge its position by finding someone else to lay the short position onto. But first of all, there’s a good chance it will divide up the short position and hedge pieces of it with different people. Those people may be buying the short position not because they want the subprime market to collapse; they might be partially hedging their own long positions in that market. Second, there’s an even better chance that it won’t sell off exactly the short position it just picked up from the CDO; it will buy CDS protection on a bunch of RMBS that are similar to the ones it just sold CDS protection on (which ones will depend on what the market is interested in), so in aggregate it comes out more or less the same.

So ultimately the “short” side of the CDO gets dispersed between the bank’s existing CDS portfolio and the broader market. So yes, there must be a short interest out there that is exactly equivalent to the long interest. But there doesn’t have to be a party or even an identifiable set of parties who have exactly the short side of the new CDO and want it to collapse, let alone a party that helped structure the CDO because it wanted to be on the short side. There’s a big difference between the market as a whole and one hedge fund.

Now, are things different with a synthetic synthetic CDO, as I have called it? Maybe. The pro-Goldman argument would be that ABACUS was so highly structured — basically, each tranche was a single complex derivative with a long side and a short side — that the long investors must have realized that there was a single party, or a small number of parties, on the other side. But that doesn’t necessarily hold. Just like a synthetic CDO, Goldman could have whipped this thing together because it thought it could sell it, and Goldman could have planned to hedge it the usual way — partially with its inventory and partially through a lot of small transactions dispersed throughout the market.

As always, I draw on Steve Randy Waldman.

Frank Luntz Hasn’t Read 13 Bankers (And That’s A Good Thing)

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

Frank Luntz is the midst of making one of the great mistakes of modern American politics.  He seems to have completely missed the change in plot line on financial reform over the past few months – ever since Ted Kaufman waded into the fray, started to bring other key figures with him, and really moved mainstream thinking (as manifest, for example, in the Goldman Sachs hearing this week).

This is about the “arc of the fraud”.  The financial system committed fraud during the boom (liar loans and misrepresentation to customers of all kinds); fraud during the bailout (“if you ruffle our feathers, we will collapse”); and now fraud during the serious attempts at reform (e.g., the astroturf/fake grassroots nonsense.)

Luntz thinks this is about higher costs being passed on to consumers and wants to fight in November on “the Democrats are just about special interests”.  That would be terrific – for the Democrats – and Mr. Luntz should be encouraged in this endeavor. Continue reading “Frank Luntz Hasn’t Read 13 Bankers (And That’s A Good Thing)” →

To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF

By Peter Boone and Simon Johnson

When Mr. Trichet (head of the European Central Bank, ECB) and Mr.  Strauss-Kahn (head of the International Monetary Fund, IMF) rushed to Berlin this week to meet Prime Minister Angela Merkel and the German parliament, the moment was eerily reminiscent of September 2008 – when Hank Paulson stormed up to the US Congress, demanding for $700bn in relief for the largest US banks.  Remember the aftermath of that debacle: despite the Treasury argument that this would be enough, much more money was eventually needed, and Mr. Paulson left office a few months later under a cloud.

The problem this time is bigger.  It is not only about banks, it is about the essence of the eurozone, and the political survival of all the public figures responsible.  If Mr. Trichet and Mr. Strauss-Kahn were honest, they would admit to Ms. Merkel “we messed up – more than a decade ago, when we were governor of the Banque de France and French finance minister, respectively”.  These two founders of the European unity dream helped set rules for the eurozone which, by their nature, have caused small flaws to turn into great dangers. 

The underlying problem is the rule for printing money:  in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros.  The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits.  The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.  Continue reading “To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF” →

ABACUS: A Synthetic, Synthetic CDO

By James Kwak

I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.

An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.

A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)

ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1  (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”

Continue reading “ABACUS: A Synthetic, Synthetic CDO” →

Wake The President

By Simon Johnson, co-author 13 Bankers

Most days we can coast along, confident that tomorrow will be much like yesterday.  On a very few days we need to look hard at the news headlines, click through to read the whole story, and then completely change a large chunk of how we thought the world worked.  Today is such a day.

Everything you knew or thought you believed about the European economy – and the eurozone, which lies at its heart – was just ripped up by financial markets and thrown out of the proverbial window.

While you slept, there was a fundamental repricing of risk in financial markets around Europe – we’ll see shortly about the rest of the world.  You may see this called a “panic” and the term conveys the emotions involved, but do not be misled – this is not a flash in a pan; financial markets have taken a long hard view at the fiscal and banking realities in Europe.  They have also looked long and hard into the eyes – and, they think, the souls – of politicians and policymakers, including in Washington this weekend.

The conclusion: large parts of Europe are no longer “investment grade” – they are more like “emerging markets”, meaning higher yield, more risky, and in the descriptive if overly evocative term: “junk”. Continue reading “Wake The President” →

Three Modest Proposals For Goldman Sachs

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

At this stage in the proceedings, the Goldman Sachs’ public relations people must be feeling more than a little down.  The firm’s lawyers are still breathing fire, Lloyd Blankfein trod the fine line between not being apologetic and actually saying “it’s capitalism, stupid”, and the more junior executives interrogated today did not say anything blatantly incriminating.  But the public image of the firm around the world – including with finance ministers and pension funds – has taken a severe beating.

In the interests of finding a more positive and cooperative way forward, here are three suggestions for the PR team to take up with senior management – once they are in mood to think long-term about their “franchise value” again. Continue reading “Three Modest Proposals For Goldman Sachs” →

What Did Goldman Know And When Did It Forget It?

By Simon Johnson

There is a live blog on the Goldman Sachs hearing now on the Lehrer NewsHour website, including comments by Paul Solman and me.  The interaction between Goldman and the Senators – Democratic and Republican – is fascinating.

The Goldman executives so far seem to be struggling to recall exactly what happened.  The Senators are pressing them hard.  This is much more than theater.  This is (some) people trying to figure out exactly who did what to whom.

The Republicans Help Reform, Inadvertently

By Simon Johnson, co-author of 13 Bankers

No one can publicly oppose what is widely perceived to be “financial reform” – the polls are quite clear on this point.  If you want to help Wall Street, your options are:

1)      Oppose the Dodd bill, claiming that it would create a more dangerous situation than what exists today.  But Senator Mitch McConnell already tried this and was thoroughly debunked, e.g., by Senator Ted Kaufman.  There will be rhetorical posturing along these lines, to be sure, but there is no sign of any real traction.

2)      Run a comprehensive “astro turf” disinformation campaign, pretending to be the voice of “true reform.”  But these efforts are too obvious at this point – and too obviously fraudulent, so this actually helps the pro-reform narrative.

3)      Stall for time in terms of preventing the Dodd bill from coming to the floor of the Senate, while working out a backroom compromise that will greatly gut the substance (on consumer protection, derivatives, and/or the resolution authority).  This appears to be what the Republicans are focusing on, with Senator Richard Shelby in the lead.

But there is a potential weak point in this Republican strategy. Continue reading “The Republicans Help Reform, Inadvertently” →

When Will Senator Dodd Start Taking Yes For An Answer?

By Simon Johnson, co-author of 13 Bankers

Senator Chris Dodd is a tactical legislative genius – keep this clearly in your mind during the days ahead.  In terms of maneuvering for the outcomes he seeks, managing the votes, and controlling the floor, you have rarely seen his equal.

Senator Dodd wants some financial reform – enough to declare victory – but not so much as to seriously undermine the prevalence of megabanks on Wall Street.  You can take whatever view you like on his motivation – but Senator Dodd himself is quite open about his thinking and intentions.

Given the mounting pressure from many sides – including Federal Reserve Bank presidents – to implement significantly more reform (see also David Warsh’s Sunday evening assessment), for example using some version of the Brown-Kaufman SAFE banking act, how exactly will Senator Dodd prevail? Continue reading “When Will Senator Dodd Start Taking Yes For An Answer?” →

The Washington Post Makes A Major Factual Error

 By Simon Johnson, co-author of 13 Bankers

Of all the weak, ill-informed, and misleading pieces written on the “resolution authority” – a central tenet of the Dodd bill – by far the most disappointing is the Washington Post editorial in Sunday’s paper.

I fully appreciate that these are complex issues and I understand that journalists frequently write under great time pressure. 

But honestly, if you don’t know the answer to a question – you should really just call Treasury, the White House or Senator Dodd’s people.  What even they will tell you, in my experience – if you press them hard enough (i.e., don’t fall for the initial spin) is that it is incorrect, or at least significantly incomplete and misleading, to say that the Dodd bill will create: Continue reading “The Washington Post Makes A Major Factual Error” →

The Sickening Abuse Of Power At The Heart of Wall Street

By Simon Johnson, co-author of 13 Bankers

Here’s where we stand with regard to democratic discourse on the future our financial system: leading bankers will not come out to debate the issues in the open (despite being approached by reputable intermediaries after our polite challenge was issued) – sending instead their “astro turf” proxies to spread KGB-type disinformation.

Even Larry Summers, who has shifted publicly onto the side the angels (surprising and rather late, but welcome anyway), cannot – for whatever reason – bring himself to recognize the dangers inherent in our unstable and too-big-to-manage banks.  Or perhaps he is just generating excuses that will justify not bringing the Brown-Kaufman amendment to the floor of Senate?

So let’s take it up a notch. Continue reading “The Sickening Abuse Of Power At The Heart of Wall Street” →

Rewarding Teacher Performance? Resist the Temptation to “Race to Nowhere”

This guest post is contributed by Kathryn McDermott and Lisa Keller. McDermott is Associate Professor of Education and Public Policy and Keller is Assistant Professor in the Research and Evaluation Methods Program, both at the University of Massachusetts, Amherst.

On March 29, the U.S. Department of Education announced that Delaware and Tennessee were the first two states to win funding in the “Race to the Top” grant competition.  A key part of the reason why these two states won was their experience with “growth modeling” of student progress measured by standardized test scores, and their plans for incorporating the growth data into evaluation of teachers.  The Department of Education has $3.4 billion remaining in the Race to the Top fund, and other states are now scrutinizing reviewer feedback on their applications and trying to learn from Delaware’s and Tennessee’s successful applications as they strive to win funds in the next round.

One of the Department’s priorities is to link teachers’ pay to their students’ performance; indeed, states with laws that forbid using student test scores in this way lost points in the Race to the Top competition.  A few months ago, James pointed out some of the general flaws in the pay-for-performance logic; here, our goal is to raise general awareness of some statistical issues that are specific to using test scores to evaluate teachers’ performance.

Using students’ test scores to evaluate their teachers’ performance is a core component of both Delaware’s and Tennessee’s Race to the Top applications.  The logic seems unassailable: everybody knows that some teachers are more effective than others, and there should be some way of rewarding this effectiveness.  Because students take many more state-mandated tests now than they used to, it seems logical that there should be some way of using those test scores to make the kind of effectiveness judgments that currently get made informally, on less scientific grounds.

The problem is that even if you accept the assumption that standardized tests convey useful information about what students have learned (which we both do, in general), measuring the performance gains (or losses) of students in a particular classroom is far more complicated than subtracting the students’ September test scores from their June test scores and averaging out the gains.  We’re concentrating on the statistical issues here; there are other obvious challenges in test-based evaluation, such as what to do for teachers who teach grade levels where students do not take tests and/or subjects without standardized tests.

Continue reading “Rewarding Teacher Performance? Resist the Temptation to “Race to Nowhere”” →

Two Senators And Larry Summers On Bank Size

By Simon Johnson, co-author of 13 Bankers

Bank size is suddenly the issue of the day – with politicians lining up to oppose any meaningful restriction on the size of our largest banks.  Their reasoning is varied and all quite flawed, particularly when they insist there must be no Senate floor debate on the Brown-Kaufman amendment.

Senator Dick Durbin may be right to say that the Brown-Kaufman amendment is “a bridge too far” and will not pass in this legislative cycle – presumably this sounds like a tactical political assessment.  Surely in that case he would not oppose bringing it to the floor of the Senate and allowing that body to prove him right (or wrong).

Senator Chris Dodd opposes the amendment, but his reasoning is rather vague.  Here’s what he says in his interview with Ezra Klein, which appeared yesterday,

“It’s not size; we’re preoccupied with size.  And I’m not suggesting that any size is okay, but it’s really risk, it’s these other elements in here.  A relatively innocuous product line in a relatively small company can pose huge, systemic risk.  That said, in our bill, we provide the authority to break up companies.  That is clearly in the bill, the authorization to do that under certain circumstances.  But I’m not sure that we ought to become so preoccupied with it.  And again, I’ve looked at the 13 Bankers book, and so forth, that approach, and hear this, by the way, not just from them, but from CEOs of major corporations.  This is not some left/right question.  But I just don’t think that it makes a lot of sense.  I don’t think it’ll prevail.” Continue reading “Two Senators And Larry Summers On Bank Size” →