Month: March 2014

The Desperation of the Vanishing Middle Class

By James Kwak

I recently finished reading Pound Foolish, by Helaine Olen, which I discussed earlier (while one-third of the way through). The book is a condemnation of just almost every form of personal financial advice out there, from the personal finance gurus (Suze Orman, Dave Ramsey) to the variable annuity salespeople to the peddlers of real estate get-rich-quick schemes to Sesame Street‘s corporate-sponsored financial education programs. (Of them all, Jane Bryant Quinn is one of the few who generally come off as more good than evil.)

A lot of what’s going on is just semi-sleazy entrepreneurs trying to make a buck, taking “advice” that is equal parts routine, wrong, and contradictory and packaging it into attractive-looking books, TV shows, and in-person events. A lot of the rest is marketing by the real financial industry, which either (a) wants to make a show of promoting financial education so people will think they are good or (b) wants to teach people that they need their products. (You pick.)

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Perhaps The Most Boring Important Topic In Economics

By Simon Johnson

International economic policy making is a contender for the title of “most boring important topic” in economics. And within the field there is nothing quite as dull as the International Monetary Fund (IMF). Try getting an article about the Fund on the front page of any newspaper.

And even for aficionados of the Fund, the issues associated with reforming its “quota” and “voting rights” seem arcane – and are fully understood by few.

Dullness in this context is not an accident – it’s a protective wrapping against political interference, particularly by the US Congress.

Now, however, the IMF needs a change in its ownership structure, and the sole remaining holdup is Congress.

The Obama administration let this issue slide for a long while, and then attempted to link it with financial aid being extended to Ukraine. That attempt failed last week.

In a column for Project Syndicate, I discuss why this matters and what comes next. Try not to fall asleep.

The Chinese Boom-Bust Cycle

By Simon Johnson

Should we fear some sort of financial crash in China, along the lines of what we saw in 2008 in the US or after 2010 in the euro area?

Given the rate of growth in credit and the expansion of the so-called shadow banking sector over the past five years in China, some sort of financial bust seems hard to avoid.

But this need not be the hard landing seen in more developed countries – and the impact on the world economy will likely be much more moderate. At the same time, however, bigger problems await in the not-too-distant future.

Peter Boone and I review the details in a column for NYT.com’s Economix blog.

Stress Tests, Lending, and Capital Requirements

By James Kwak

Despite the much-publicized black eye to Citigroup’s management, the bottom line of the Federal Reserve’s stress tests is that every other large U.S. bank will be allowed to pay out more cash to its shareholders, either as increased dividends or stock buybacks. And pay out more cash they will: at least $22 billion in increased dividends (that includes all the banks subject to stress tests), plus increased buyback plans.

Those cash payouts come straight out of the banks’ capital, since they reduce assets without reducing liabilities. Alternatively, the banks could have chosen to keep the cash and increase their balance sheets—that is, by lending more to companies and households. The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities.

This puts the lie to the banks’ mantra that capital requirements will constrain lending and therefore reduce growth (made most famously in the Institute of International Finance’s amateurish report claiming that increased regulation would make the world’s advanced economies 3 percent smaller). Capital isn’t the constraint on bank lending: it’s their willingness to lend.

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A Book That Needed To Be Written

By James Kwak

I have previously written about (here, for example) what I call economism, or excessive belief in the little bit that you remember from Economics 101. The problem is twofold. First, Economics 101 usually paints a highly stylized, unrealistic view of the world in which free markets always produce optimal outcomes. Second, most people in the world who have taken any economics have only taken first-year economics, and so they never learned that, from a practical perspective, just about everything in Economics 101 is wrong. (Complete information? Rational actors? Perfectly competitive markets?) This produces a nation of people like Paul Ryan, who repeats reflexively that free market solutions are always good, journalists who repeat what Paul Ryan says, and ordinary people who nod their heads in agreement.

The problem is not the economics profession per se. These days, to make your mark as an economist, it helps to be arguing (or, better yet, proving) that the free market caricature of Economics 101 is wrong. The problem is the way it is taught to first-year students, which pretty much assumes that Joseph Stiglitz, Daniel Kahnemann, Elinor Ostrom, and many others had never existed.

What we need, I have often thought, is a companion book for students in Economics 101, one that points out the problems with the standard material that is covered in the textbook. For a while I was thinking of writing such a book, but I decided against it for a number of reasons, one of them being that I am not actually an economist. Fortunately, John Komlos, who really is an economist, has written a book along these lines, titled What Every Economics Student Needs to Know and Doesn’t Get in the Usual Principles Text.

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More on Wasting Shareholders’ Money

By James Kwak

A few weeks ago I wrote a post about my most recent “academic” paper, on the issue of whether corporate political contributions might constitute a breach of insiders’ fiduciary duty toward shareholders. The thrust of that paper was that some political contributions could be contested as breaches of the duty of loyalty—for example, if a CEO causes the corporation to give money to a candidate who promises to lower the CEO’s individual income taxes—which would result in the courts applying a higher standard of review.

Joseph Leahy, another law professor, recently directed me to a paper that he wrote last year (but is still being edited for publication in the Missouri Law Review) on basically the same topic. He argues first that corporate political contributions do not qualify as “waste” (which has a precise legal definition), barring the kind of extreme facts that you only see in law school hypotheticals. I agree with that, although my only discussion of the point was in a footnote (79).

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Stopping Russia

By Simon Johnson

The rhetoric of confrontation with Russia seems to be escalating, including with the remarkable suggestion – from Mike Rogers, the chairman of the House Intelligence Committee – that the US provide “small arms and radio equipment” to Ukraine.

Encouragement for a military confrontation is not what Ukraine needs. As Peter Boone and I have argued in a pair of recent columns for the NYT.com’s Economix blog, Ukraine needs economic reform (with a massive reduction in corruption as the top priority). This reform requires, above all, a massive and immediate reduction in – or elimination of – corruption.

Throwing a lot of external financial assistance at Ukraine’s government, for example with a very large loan from the International Monetary Fund, is unlikely to prove helpful. Based on recent prior experience, such lending may even prove counterproductive.

And this seems to be exactly the path that our foreign policy elite has placed us on.

Skew

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

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Whiskey Costs Money

By James Kwak

A few days ago I wrote a post that began with New York Fed President William Dudley talking tough about banks: “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” The thrust of that post was that I’m not very encouraged when regulators talk about culture and the “trust issue” but don’t indicate how they are going to actually affect industry behavior.

As they say, talk is cheap, whiskey costs money. What’s more important than what regulators say is what they do—and don’t talk about. Peter Eavis (who wrote the earlier story about bank regulators that my previous post was responding to) wrote a new article detailing how that same William Dudley has delayed the finalization of the supplementary leverage ratio: the backup capital standard that requires banks to maintain capital based on their total assets, not using risk weighting.

Dudley has said, “I do not feel that I in any way hold any allegiance or loyalty to the financial industry whatsoever.” That may be true; he certainly made enough at Goldman that he has no real financial incentive to continue to make nice with Wall Street.* Yet at the same time he appears to be parroting concerns raised by some of the big banks, raising a concern about the leverage rule that Felix Salmon calls “very silly” and that, according to Eavis, the Federal Reserve mother ship in Washington didn’t consider significant.

In the grand scheme of banks and their allies weakening and slowing down new regulation, this is probably not a particularly momentous battle. But it does put things in perspective.

* Of course, we know that among some people (many of whom live in New York and work in finance), no amount of money is ever enough.

You Don’t Say

By James Kwak

Last week Peter Eavis of DealBook highlighted a statement made last year by New York Fed President William Dudley (formerly of Goldman Sachs, then a top lieutenant to Tim Geithner): “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” There was a point, say in 2008, when many people probably thought that our largest banks were just guilty of shoddy risk management, dubious sales practices, and excessive risk-taking. Since then, we’ve had to add price fixing, money laundering, bribery, and systematic fraud on the judicial system, among other things.

Eavis also tried to make something positive out of a couple of other recent comments. Dudley said, “I think that trust issue is of their own doing—they have done it to themselves,” while OCC head Thomas Curry said, “It is not going to work if we approach it from a lawyerly standpoint. It is more like a priest-penitent relationship.”

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Insurance Companies and Systemic Risk

By James Kwak

The systemic risk posed by insurance companies is something that I’ve never been entirely clear about. I know it’s an enormous issue for large insurers who want to avoid additional oversight by the Federal Reserve. I’m well aware of the usual defense, which is that insurers are not subject to bank runs because their obligations are, in large measure, pre-funded by policyholder premiums, and policyholders must pay a price in order to stop paying premiums. But this has never seemed entirely convincing to me, because some insurers are enormous players in the financial markets, and the nature of systemic risk seems to be that it can arise in unusual places.

So I find very helpful Dan and Steven Schwarcz’s new paper discussing the ins and outs of systemic risk and insurance. Because it’s written for a law review audience, it covers all the basics, so you can follow it even if you know little about insurance. They cover the usual arguments for why insurers do not pose a threat to the financial system, but then posit a number of reasons for why they could pose such a threat.

A big reason is that insurers make up a large proportion of the buy side, especially for particular markets—owning, for example, one-third of all investment-grade bonds. Furthermore, insurers tend to concentrate their purchases within certain types of securities that provide them with regulatory benefits (sound familiar?)—such as the structured products that promised higher yield while providing the investment-grade ratings that insurers needed. The big fear is that large numbers of insurers could be forced to dump similar securities at the same time, causing prices to fall and harming other types of financial institutions. This may seem unlikely, since insurers only have to make cash payouts when insurable events occur (houses burn down, people die). But insurers have to meet capital requirements just like banks, so falling asset values will require them to adjust their balance sheets.

Another major problem is that it’s not clear that insurers are prepared for those insurable events. For example, insurers are not prepared for a global pandemic, just like they weren’t prepared for large-scale terrorist attacks prior to September 11, 2001.

Finally (and I’m skipping several factors), it’s possible that entire segments of the insurance industry are under-reserving for certain types of risks. This stems from the usual cause: companies compete for market share, and the way to win share is to charge lower prices, and the way to charge lower prices is to underestimate risk. This is all good in the short term, resulting in larger bonuses, and bad in the long term, when the risk actually materializes. Yet it seems that insurance regulators are shifting to “a process of principles-based reserving (‘PBR’), which would grant insurers substantial discretion to set their own reserves based on internal models of their future exposures.” For even a casual observer of the last financial crisis, this sounds like the system is taking on a large amount of model risk and regulatory competency risk, and we know how that story ended last time.

Schwarcz and Schwarcz conclude that the federal government should play a larger role in monitoring systemic risk in the insurance industry, which will make them just about the least popular people in most insurance circles. Given the downside risks, though, it seems like pretending that there’s no reason to worry about insurers is not a good long-term strategy.

The Cost of Comp Plans

By James Kwak

Enterprise software is the industry that I know best. Both of the real companies I worked for (sorry, McKinsey is a fine institution in many ways, but it isn’t a real company) were in enterprise software: big, complicated, expensive software systems for midsize and large companies that can take years to sell.

Although the development of enterprise software is (often) highly sophisticated, sales is typically governed more by tribal custom. One trait we probably shared with other big ticket, business-focused industries is the “comp plan”: the system for calculating salespeople’s commissions on sales. The comp plan is just about the most important thing to any red-blooded salesperson. (Its only competition would be the territory assignment, which determines what companies he is allowed to sell to—or, more specifically, for sales to what companies he will earn a commission.) It is the source of months of lobbying, the subject of intense executive- and even board-level scrutiny, and the target of almost every complaint.

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It Keeps Getting Better

By James Kwak

Remember when Steve Schwarzman said that taxing carried interest was “like when Hitler invaded Poland in 1939”? Or when Lloyd Blankfein said he was doing “God’s work”? Apparently, titans of finance can’t stop themselves from giving good copy. The latest is in Max Abelson’s Bloomberg article in Bloomberg on Wall Street’s search for a Republican presidential candidate who will wave their flag: low individual taxes and a rollback of financial regulation. John Taft, U.S. CEO of RBC Wealth Management, “likened his fear for the country to ‘hiding under my desk during air-raid drills because of the Cuban missile crisis,’ when ‘literally the future of humanity hung in the balance,'” before beginning a suggestion, “If I were God.”

More seriously, the financial sector expects to be able to choose the next Republican presidential nominee. In the words of one political strategist, with Chris Christie on the rocks, “The establishment is now looking for another favorite. . . . And by the establishment, I mean Wall Street.” At the moment, the big money is desperate enough to be looking at fringe candidates like Rand Paul, Ted Cruz, and Marco Rubio (although what they most long for is the third coming of Bush). Basically, there are huge piles of cash looking for a friendly political home, and the level of hysteria is likely to surpass what we saw in 2012. We should at least get some entertaining quotes out of it.

The Free Market’s Weak Hand

By James Kwak

“Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.”

That was Alan Greenspan back in 2003. This is little different from another of his famous maxims, that anti-fraud regulation was unnecessary because the market would not tolerate fraudsters. It is also a key premise of the blame-the-government crowd (Wallison, Pinto, and most of the current Republican Party), which claims that the financial crisis was caused by excessive government intervention in financial markets.

Market discipline clearly failed in the lead-up to the financial crisis. This picture, for example, shows the yield on Citigroup’s subordinate debt, which is supposed to be a channel for market discipline. (The theory is that subordinated debt investors, who suffer losses relatively early, will be especially anxious to monitor their investments.) Note that yields barely budged before 2008—despite the numerous red flags that were clearly visible in 2007 (and the other red flags that were visible in 2006, like the peaking of the housing market).

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