Author: James Kwak

Further Proof That Nothing Has Changed

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

Who Needs Big Banks?

At a panel discussion at the Pew Charitable Trusts (captured for posterity by Planet Money), Alice Rivlin floated the idea of breaking up big banks. Luckily for us, Scott Talbott of the Financial Services Roundtable (a lobbying group for big banks) was there to slap that idea down.

Talbott: “We need big companies, and they can be managed, and they are being managed …”

Alex Blumberg (Planet Money): “But why, why do we need big companies?”

Talbott: “They provide a number of benefits across the globe. We have a global economy, and these institutions can handle the finances of the world. They can also handle the finances of large, non-bank institutions like General Electric or Johnson & Johnson. They need these institutions [that] can handle the complex transactions. Simply breaking them up … then you’re discouraging a company from achieving the American Dream, working hard, earning money, producing products, and getting bigger.”

There are two things I object to strongly. The second is easy. The American Dream is for people, not companies. And people dream of working hard, being successful, making money, and having an impact on the world. The American Dream does not imply any particular company size. There are situations in which your products are just so much better than anyone else’s that your company becomes big as a result; Google comes to mind. But Citigroup is the product of no one’s American Dream. When Talbott says “American Dream,” what he really means is “American Bank CEO’s Dream” — because, as we all know, CEO compensation in the financial sector is extremely correlated with assets.

Continue reading “Who Needs Big Banks?” →

What Is Risk Adjustment?

I think I know what it is, and if I’m right it’s very important to health care reform, but it hasn’t gotten a lot of attention.

Risk adjustment is the solution to the following problem. Imagine you tell all the health insurers that they have to accept the healthy and the sick, and they have to charge each the same insurance premium. You may not have to imagine for much longer; this is at the core of all the proposed health care reform bills. (In the Finance Committee bill you can discriminate based on a small number of factors, like age and tobacco usage, but that’s it.)

If you’re a profit-maximizing insurer, what do you do? You try to cherry-pick the healthy, since the revenues will be the same as for the sick and the costs will be lower. If you can do this successfully — say, by only advertising in gyms and in Runner’s World, or maybe by offering additional benefits that only the healthy will want — then you can dump the sick on someone else. That someone else will eventually (after all the private insurers get smart or go out of business) be the public option or the non-profit cooperative, whichever we end up with, which will end up losing money; the net effect is a transfer from taxpayers to private insurers. Now, the fact that insurers participating on exchanges have to take everyone should mitigate this problem, but it won’t go away. In effect, insurers will compete by marketing in ways that attract the healthy and hide from the sick, instead of competing to offer better health care at lower cost.

Continue reading “What Is Risk Adjustment?” →

What’s Wrong with a Phone Call?

Yesterday Simon pointed out the AP story highlighting Tim Geithner’s many contacts with a few key Wall Street executives — primarily Jamie Dimon, Lloyd Blankfein, Vikram Pandit, and Richard Parsons — while leading the government’s rescue efforts as Treasury secretary. It’s certainly useful for the nation’s top economic official to talk to people in the banking industry, and it’s also useful for him to talk to banks that are being bailed out by the government. But the AP story did come up with a few important distinctions. Geithner talked to these Wall Street executives more than the key people in Congress — Barney Frank and Christopher Dodd — that he needs to pass his regulatory reform plan. And he talked to them much more than to, say, Bank of America, which is equally big and equally in debt to the government. So to be clear, Geithner is talking to these people more than dictated by the requirements of his job (or he’s not talking to Ken Lewis enough).

Still, you could say, what’s wrong with that? Can’t Tim Geithner talk to whomever he wants to talk to?

Continue reading “What’s Wrong with a Phone Call?” →

What Is Consumer Freedom?

This guest post was contributed by Lawrence B. Glickman, who teaches history at the University of South Carolina. He put the fight for the Consumer Financial Protection Agency in historical perspective in his previous post on this blog.

A recent ad taken out by the “The Center for Consumer Freedom” marks the latest assault by business lobbyists and conservatives on the idea of consumer protection. This organization’s motto — Promoting Personal Freedom and Protecting Consumer Choice — defines consumer freedom as “the right of adults and parents to choose how they live their lives, what they eat and drink, how they manage their finances, and how they enjoy themselves.”

Continue reading “What Is Consumer Freedom?” →

Casey Mulligan’s Straw Man

Casey Mulligan argues that bank recapitalization under TARP was a failure because it did not lead to increased bank lending. He argues that this was a necessary outcome, because (a) public purchases of bank capital crowd out private purchases of bank capital, and (b) new capital does not necessarily flow into lending, and concludes: “This episode is an expensive example of public policy promises that were doomed to failure because they were known at the outset to defy economic theory.”

I have often argued that there were many things wrong with TARP. But this is not one of them.

Continue reading “Casey Mulligan’s Straw Man” →

The Problem with Securitization

The New York Times has a story on “Paralysis in the Debt Markets” which says, basically, that credit has dried up because of lack of demand for asset-backed securities. In English, that means that since no one wants to invest in securities that are made out of home mortgages, the people who originate mortgages have no place to sell the mortgages to, so they don’t have any money to lend. And this is also true of commercial real estate, student loans, and so on. For example, “A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.”

The response of the Fed has been to prop up the securitization market by buying the stuff itself when no one else will buy it. But that program is reaching its provisional limit — according to the times, the Fed has bought $905 billion out of a budget $1.25 trillion in securities — and with the Fed hawks on the warpath, it is likely to be pulled before the private market recovers.

Continue reading “The Problem with Securitization” →

Imbalances, Schmalances

We’ve been at first amused but more recently alarmed at how “global imbalances” are becoming many people’s preferred explanation of the financial crisis. At first you could brush it off this way: “global imbalances (read: ‘blame China’) . . .” But this explanation is going mainstream, not least because it is always more convenient for policymakers and bad actors to blame someone far away. For example, Dealbook (New York Times) kicked off a roundtable on the causes of the financial crisis this way:

“There is a conventional view developing on the financial crisis. The Federal Reserve’s policy of historically low interest rates spurred a worldwide search for higher risk and return. Concurrently, the entrenched United States trade imbalance led to a huge transfer of dollar wealth to Asian and commodity-based countries. The unwillingness of Asian economies, particularly China, to stimulate their own domestic consumption led these countries to reinvest the proceeds into the United States. This further contributed to lower American interest rates and further fueled the search for return.”

(Mortgage securitization gets mentioned, but only in the fourth paragraph!)

Simon and I took this on in our Washington Post online column this week, but I thought it was interesting enough to repost here in full, below.

***

The time is here for our nation to actually do something about the recent financial crisis — that is, do something to prevent it from happening again. But instead, many people are finding it easier to pass the buck than to, say, regulate the financial sector effectively.

The recent Group of 20 conference in Pittsburgh was replete with talk about “global imbalances,” which means — in the spirit of the “South Park” movie — “blame China!”

Continue reading “Imbalances, Schmalances” →

Cash for Trash: Better Never than Late

The following guest post was written by Linus Wilson, a finance professor at the University of Louisiana at Lafayette, the media’s go-to guy on calculating the value of transactions between the government and the banks, and an occasional commenter on this blog. Linus also analyzes government-bank transactions at Seeking Alpha.

The U.S. government does few thing better than create debt. After a year of talking about it, the government is going to have the chance to throw their good debt, Treasury bills notes and bonds, after bad, non-performing toxic loans and securities. The Federal Deposit Insurance Corporation (FDIC) and the U.S. Treasury are going their separate ways on their cash for trash schemes at this point. Accountants and investors should be wary of the big prices they see coming from the FDIC’s auctions, but taxpayers should be afraid of the U.S. Treasury’s efforts to re-inflate the securitization bubble.

Continue reading “Cash for Trash: Better Never than Late” →

Shareholder Value for Beginners

Ever wondered how the private equity industry works? The New York Times has the story for you. (Thanks to a reader for pointing it out to me.) Yves Smith has a summary of the juicy bits.

The game is basically this. Thomas H. Lee Partners bought Simmons in 2003 for $327 million in real money and $745 million in debt. But that’s debt issued by Simmons, not by THL. To buy the company, they needed to pay the previous owners $1.1 billion in real money. The previous owners didn’t care where the money came from, so as long as THL could find banks or bond investors willing to lend $745 million to Simmons, the deal could go through. Since THL put up 100% of the equity in the new version of Simmons, they owned 100% of the company.

In 2004, Simmons borrowed more real money (by issuing new debt) and promptly gave $137 million of that real money to THL as a special dividend. In 2007, Simmons borrowed $300 million more in real money and paid $238 million of it to THL. So THL got $375 million in special dividends in exchange for its $327 million investment (plus an additional $28 million in fees). Simmons is now going into bankruptcy, unable to pay off all that debt, a casualty of the collapse in the housing market (houses => beds).

Continue reading “Shareholder Value for Beginners” →

Fed Chest-Thumping for Beginners

I generally avoid writing about monetary policy, since every economics course I’ve taken since college has been a micro course, and besides Simon is a macroeconomist, among other things. But since just about everyone in my RSS feed has been linking to Tim Duy’s recent article on the Fed, I thought I would try to put in context for all of us who don’t understand Fed-speak.

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Continue reading “Fed Chest-Thumping for Beginners” →

How to Waste 45 Minutes (Like I Just Did)

Start here. Then keep reading. It has nothing to do with economics, but a lot to do with statistics.

Or don’t, if you need to get something done this morning.

Update: One reader writes in:

“I beg to differ that this link has nothing to do with economics: The same technique it uses to detect possible making-up of poll numbers was used in a recent paper to detect possible making-up of National Accounts statistics in some developing countries in a widely used economic dataset:

http://www.bepress.com/bejm/vol7/iss1/art17/.”

By James Kwak

Good-Bye, Vanilla Option

I realized I didn’t say anything about the death of the vanilla option from the Consumer Financial Protection Agency proposal. I was going to right something targeted and biting, but it ended up as a much broader column for the Washington Post about the Obama Administration’s commitment to regulatory reform.

Mike Konczal, fortunately, has two good posts on the topic: one a eulogy for plain vanilla, one on the underlying problems that plain vanilla would have helped solve. He also points out at least three ways the federal government can achieve some of the same goals through other means:

Banning prepayment penalties on mortgages
(Citing Alyssa Katz): using the government’s historically large and now even bigger influence in the secondary market to encourage plain vanilla mortgages
(Citing Steve Waldman): a government charge card (think “public option”)

All of those posts are worth reading. If we’re not going to have plain vanilla, we need other new ideas about how to channel innovation into things that provide consumer benefit and put a floor under the quality offered by the private sector. More disclosure won’t work (that already failed).

Update: The Raven compares the Obama administration to the Johnson administration, each with its “devil’s bargain.”

By James Kwak

Back-Door Resolution Authority

Tyler Cowen quotes from Robert Pozen’s yet-to-be-released book:

“In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.”

Back when people cared about these things, I wrote a couple of posts on the issue of selective protection of creditors.

Continue reading “Back-Door Resolution Authority” →

Real Problems, No Easy Solutions

On Monday I wrote a post criticizing the sloppy way that Robert Shiller argued for financial innovation, which focused primarily on the use of metaphor and secondarily on the use of a valid example (people are overly cautious about some financial products) to make an invalid general point (people are overly cautious about all financial products. Then I threw in a sloppy paragraph, because I wanted to get to the end of a long post:

“From there, the article actually gets better, because Shiller gives us examples of areas where he thinks financial innovation would be good. And here I don’t really disagree with him that much. I agree with him that reliance on housing as an investment vehicle is bad. I don’t really agree that target-date mutual funds are such a good idea (since as far as I can tell the conventional wisdom about switching from stocks to bonds as you age is the equivalent of an old wives’ tale), but they are probably better than many of the things people are currently invested in. Retirement annuities, another thing he recommends, would definitely be useful if you could get them at a decent price. (I believe now they suffer from a significant adverse selection problem.)

“For the sake of argument, I am willing to concede that these are useful innovations that would make people better off.”

Felix Salmon rightly points out that I shouldn’t have conceded it for the sake of argument. Really, what I should have said was that I agreed with Shiller that people face real problems — relying on housing for investment is bad, and it “would definitely be useful” if you could get inflation-adjusted annuities for retirement. (I don’t like target-date funds, and I said so.) But since I had already made my main point (the one about metaphor), I didn’t look into the specific innovations that Shiller was proposing to solve these problems. Salmon points out accurately that the proposed solutions rely on embedded options that ordinary consumers are likely to get screwed by. I recommend reading his post.

By James Kwak