Last Wednesday I wrote a highly critical post about the agreement between Bank of America(BAC) and the government (Treasury, the Fed, and the FDIC) to terminate BAC’s asset guarantee agreement in exchange for a payment of $425 million. I’ve learned some more about this and I think I can reconstruct the government’s perspective on this issue, with the help of someone knowledgeable about the transaction.
Author: James Kwak
Robert Shiller and the Danger of Metaphors
Financial commentators use metaphors* all the time. Derivatives are “financial weapons of mass destruction,” for example. Actually, people use metaphors all the time. But what is the substantive content of a metaphor? More technically, if A is (like) B, then why should we believe that A has some attribute that B has?
I’ve been meaning to write about this for a while, but then Robert Shiller handed me a perfect example in the Financial Times, in his “defense of financial innovation:”
“The advance of civilisation has brought immense new complexity to the devices we use every day. A century ago, homes were little more than roofs, walls and floors. Now they have a variety of complex electronic devices, including automatic on-off lighting, communications and data processing devices. People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.
“Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.
“Why have financial products remained mostly so simple? I believe the problem is trust. People are much more likely to buy some new electronic device such as a laptop than a sophisticated new financial product. People are more worried about hazards of financial products or the integrity of those who offer them.”
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When a Nudge Becomes a Shove
Richard Thaler, co-author of Nudge, wrote an op-ed in The New York Times this weekend arguing that we should change the default option for organ donation. Reading the article helped crystallize for me a vague concern I’ve had with all this behavioral economics-inspired, benevolent-paternalistic behavior modification that has gotten so much attention lately among the smart set. But I’m getting ahead of myself.
Escape from Punchbowlism
This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.
Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.
Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)
Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines). How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)
More on Managing Systemic Risk
David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”
The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.
Just Baffling
PPIP finally launches, Mike Konczal lays bare the subsidy, everyone just move along … hey, wait a second!
From the Times article: “[FDIC] officials announced that they had reached a deal to sell $1.3 billion in mortgages from Franklin Bank, a Houston-based lender that failed last November and was taken over by the F.D.I.C.”
Bank of America $4 Billion, Taxpayers $425 Million
I’m trying to figure out if I should be infuriated about the agreement allowing Bank of America to walk away from the asset guarantees it got as part of its January bailout in exchange for a payment of $425 million. I can piece together part of the story from The New York Times, Bloomberg, and NPR, but the complete story is a bit hazy.
The initial deal was that Treasury, the FDIC, and the Fed would guarantee losses on a $118 billion portfolio of assets; B of A would absorb the first $10 billion and 10% of any further losses, so the government’s maximum exposure would be about $97 billion. Part of that guarantee was a non-recourse loan commitment from the Fed, basically meaning that the Fed would loan money to B of A, take the assets as collateral, and agree to keep the assets in lieu of being paid back at B of A’s option. In exchange, the government would get:
(a) An annual fee of 20 basis points on the Fed’s loan commitment, even when undrawn (if B of A drew down the loan, which it didn’t, it would pay a real interest rate). The loan commitment could be interpreted to be only $97 billion, so this comes to $194 million per year.
(b) $4 billion of preferred stock with an 8% dividend. That’s a dividend of $320 million per year; B of A can buy back the preferred stock by paying $4 billion.
(c) Warrants on $400 million of B of A stock. B of A was at $7.18 the day the bailout was announced and yesterday it closed at $17.61, so if Treasury had gotten an exercise price of $7.18, those warrants would be worth about $580 million now.
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The Good Part of the Baucus Bill
I’ve been generally critical of the Baucus Bill, primarily because of the reduced subsidies, which I see as an increased tax on the currently uninsured middle class. But luckily Ezra Klein has been providing detailed coverage of what’s good about it – notably, the proposed reforms to the health care delivery system. See his interview with Peter Orszag and his post about Chris Jennings and most of his other posts from yesterday. On my reading, the Baucus Bill will kick off a number of initiatives that will test different ways of reducing costs or improving quality, such as ways of linking payments to outcomes.
I think this is promising because, as I’ve said before, even though we have a general idea of what the problem is – economic incentives that are cut loose from outcomes – we’re not sure how to solve it. As a result, any master plan to reduce costs without sacrificing quality is easy to attack, and given the political dynamics people will be eager to attack it. The answer is that, in the medium term, we have to figure out what does work, and the way to do that is to try lots of different things. This is exactly what a smart business would do, so it’s good to see the government doing it.
By James Kwak
Health Care Reform and Fairness
Over at the Washington Post this week, it’s back to health care reform, and our topic is fairness. Specifically, somebody has to pay if we’re going to have near-universal coverage. Do you think it should be the people who benefit immediately (the uninsured middle class*) or do you think the payment mechanism should have nothing to do with the beneficiaries (like Medicare and, to an extent, Social Security)? I think this comes down to two concepts of what government programs are for. If the former, you probably want low (or zero) subsidies; if the latter, you probably want to tax the rich, tax gasoline, auction off emission permits, or something like that.
* This is a simplification, I know. But basically, the very poor have Medicaid and will still have Medicaid after reform; most of the insured middle class have employer-based coverage or Medicare, and that isn’t going anywhere in the short term. In the long term, as we’ve argued elsewhere, everyone benefits (except the super-rich) because of increased health care security.
By James Kwak
Financial Regulation, a Slightly Optimistic View
The big news on the regulatory front last week was the Wall Street Journal’s revelation that the Federal Reserve will give its regulators the ability to reject any pay package for any bank employee that encourages excessive risk-taking. The Fed is apparently claiming this authority on the grounds that as a safety-and-soundness regulator, it has the right to prohibit any bank practices that threaten the safety and soundness of the bank. Sounds good to me.
Now, there are certainly reasons to be skeptical, which Yves Smith abundantly outlines. This could be a ploy to gain some populist credentials and head off more Congressional oversight of the Fed. The Fed has been willing to trust banks to tell it what their risks are, so it is not equipped to identify compensation packages that create excessive risk. TheFed will be looking (according to the WSJ) for outliers among the group of the top 25 banks – so as long as all 25 banks are engaged in the same silly compensation practice, the Fed will let it go.
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Financial Regulation, the Pessimistic View
Satyajit Das, who knows more about derivatives than I know about anything, has a guest post on naked capitalism about derivatives regulation. The quick summary? Don’t bet on it.
“‘Holy water’, ‘hosanna’s’ or other utterances (based on particular religious convictions) will be sprinkled or said in the form of initiatives to improve disclosure, increase capital and a new centralised counterparty (‘CCP’) to reduce the risk of a major dealer failing. Fundamental issues – the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems – will not be substantively addressed.”
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Regulatory Arbitrage 2.0
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.
Good for You, Barney
With the waves of criticism that come out of this website, I wanted to acknowledge someone for doing the right thing. Bloomberg reports that Barney Frank, chair of the House Financial Services Committee, barred Michael Paese, a former committee staff member and now Goldman Sachs lobbyist, from lobbying anyone on the Democratic side of the committee until the end of 2010. Paese was already barred from lobbying his old committee for one year after he left the staff in September 2008, so Frank is effectively extending the ban for another year and a bit.
The government-lobbyist revolving door has been around for a long time, and a one-year prohibition is just not long enough; it shifts the incentives too far to the side of using government service as a way to build friendly contacts in industry. Conceptually, I think the ban should be longer and pay for government employees should go up, in order to push the incentives the other way. But I’m not holding my breath.
By James Kwak
Voodoo Cost Savings
If you really want to know about Max Baucus’s bill, head on over to Ezra Klein’s blog, which is all Baucus, all day. If you want to complain about fake cost-saving measures, stay here.
A major selling point of the Baucus bill (can’t really call it the Group of Six bill with zero Republican support; can’t call it the Democratic bill with questionable Democratic support), at least in the media, is its lower cost – $860 billion according to Baucus, $770 billion according to the CBO. This compares to the $1 trillion cost of the House bill. But this is a meaningless number, for two reasons.
The CFPA and Small Banks
To be clear, I favor the Consumer Financial Protection Agency. I favor it because I think it will be good for consumers. I also like to think that it will be good for small banks relative to big banks. My main argument for this is that should not harm the main competitive advantages of smaller banks, which should be customer service and local underwriting. But I’m still in favor of the CFPA even if it doesn’t help small banks.
John Pottow (hat tip Mike Konczal) agrees on the small bank point. His main argument is that the CFPA should lower fixed regulatory costs by making it easier to get approval for basic products. He also adds this point:
“The current credit market, with its indecipherable multi-page contracts, is not competitive. Actually, that’s not true: It’s perniciously competitive — the competition focuses on better hiding fees in small print. Burying terms in legal documents is an activity where larger banks again hold the advantage. By contrast, a true plain vanilla market would remove the obfuscation and refocus the competition on price. Once more, smaller lenders would benefit from this increased transparency and leveled playing field.”
The Baseline Scenario 