Author: James Kwak

The Little Pension Funds That Could?

Those following the Chrysler bankruptcy know that the final holdouts are a set of Indiana pension funds, who have appealed the bankruptcy judge’s approval of the restructuring plan, attempting to force the company to explore other alternatives under a trustee who is independent of the government. They were lustily cheered on by The Wall Street Journal, elated to find good sturdy workingmen and -women willing to stand up to the Obama Administration and its “disdain for legal contracts,” and who could not be dismissed as speculators.

Well.

The pension funds in question bought the Chrysler debt in question last July for 43 cents on the dollar. (They stand to get 29 cents on the dollar in the restructuring.) I guess the difference between that and speculation is that “speculation” is something that bad people do; when pension funds by distressed debt, it’s called “investment.” I have no problem with pension funds buying modest amounts of risky investments, but they are taking the same risks that hedge funds are taking, and if they lose money on bad investments, that’s the fault of the pension fund managers.

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Legacy Loan Program Called Off

New York Times:

The Federal Deposit Insurance Corporation indefinitely postponed a central element of the Obama administration’s bank rescue plan on Wednesday, acknowledging that it could not persuade enough banks to sell off their bad assets. . . .

Many banks have refused to sell their loans, in part because doing so would force them to mark down the value of those loans and book big losses. Even though the government was prepared to prop up prices by offering cheap financing to investors, the prices that banks were demanding have remained far higher than the prices that investors were willing to pay.

I don’t think I’ve ever done this before, but . . . Simon and I, March 24:

The problem in the market today is that the prices demanded by the banks are much higher than the prices that private buyers (hedge funds, private equity firms, sovereign wealth funds) are willing to pay. The government has no way to bring down the banks’ minimum sale prices . . .

The subsidy may not be sweet enough to close the deal. According to one analysis, a specific mortgage-backed security was held on a bank’s books at 97 cents, while its market price was about 38 cents. Even if you limit the buyer’s potential loss to the capital he put in, it’s unlikely he will raise his bid from 38 cents to anything near 97 cents. . . .

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The View from the Top

One of our longtime readers recommended “The Death of Kings,” Nick Paumgarten’s “notes from a meltdown” in The New Yorker (subscription required, or $5 for this issue alone) a few weeks back. The article is mainly color rather than analysis; it’s a series of portraits of people on “Wall Street,” ranging from the merely rich to the astoundingly rich, and what they think of the crisis. Paumgarten paints a picture of people who know that we are all screwed but regard the phenomenon with a mix of intellectual superiority, self-righteousness, and resignation. The vignettes are certainly not representative; I’m sure most bankers and traders, though perhaps not working quite as hard as in 2005, are still scrambling to make the next killing. But they are still a window into a world most of us will never see.

There are two passages in the article I thought were particularly . . . “insightful” isn’t the quite word . . . maybe “poetic” is better. The first is a quotation from Colin Negrych, a successful money manager and the article’s Voice of Wisdom:

“What constituency is there for pessimism? People believe optimism is necessary, an American right. The presumption of optimism is the problem. That’s what creates the debt we have now.”

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Help: Why Are SUVs More Profitable?

Many discussions of auto company economics include the assertion that SUVs and pickup trucks are more profitable than small cars, and so a shift from the former to the latter – as discussed by Felix Salmon, for example – will not be good for the auto companies, particularly GM and Chrysler (since they are in the news these days). I accept that as a historical statement, but I don’t understand why that is the case.

Textbook micro tells you that price equals marginal cost, so the gross margin on every product is zero; that’s clearly no help here. Profit margins should be higher in product segments with less competition, but basically every manufacturer makes a small, midsize, and large SUV, so I don’t think that’s the explanation.

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Explicit and Implicit Guarantees

Note: I wrote this post on May 18 but somehow forgot to publish it; I just found it in my drafts. It’s a bit out of date, but I think the point still stands.

I’m not sure if it’s official, but it’s been widely rumored that large banks that want to repay their TARP money will have to be able to sell new debt without the FDIC guarantee they got back in October. As a result, banks are falling over themselves with new, non-guaranteed debt offerings. The idea, I guess, is that banks that can raise money without the guarantee are showing that they are sound enough to operate without government support.

But I think all we’ve done is replace an explicit guarantee with an implicit guarantee. In October, no one was sure whether the U.S. government would bail out bank creditors in a pinch; after all, Lehman creditors got back less than 10 cents on the dollar, and AIG creditors took a big haircut because the Fed’s credit line came in senior to them. So the explicit guarantee was necessary for banks to issue debt.

Since then, however, the government has shown in many ways that it isn’t going to let major banks fail or force a restructuring (indeed, it insists that it can’t force a restructuring). The message of the stress tests, ultimately, was that Treasury is standing by to provide whatever capital is needed. In that situation, what risk do bank creditors face? Virtually none, except maybe political risk (the risk that the government’s policy will change). So the banks get to raise money without the stigma of a guarantee, they don’t have to pay a premium to the FDIC, then they get to pay back their TARP money, and the government can say that the banking sector is healthy. Everyone’s happy.

And if things go badly, the taxpayer is still there to make good on all those non-guaranteed bonds – at least for the banks that are, still, too big to fail.

By James Kwak

Posner, Part 1: Two Conceptions of Blame

A few readers have asked us for our thoughts on Richard Posner’s recent writings on the economic crisis, beginning with his new book and continuing with his epic blogging for The Atlantic. (To read his account from the beginning you need to find the well-hidden Archives section in the right-hand sidebar of the blog.) The challenge is that every time I try to catch up Posner has written another couple of thousand words. So I’m going to have to do this in pieces.

Posner is a giant of legal scholarship and in the theoretical branch of law and economics, which (judging from my own education) is the dominant paradigm for several fields of law, including torts and contracts. To simplify his importance greatly, he helped shift the legal profession, including both the academy and the courts, from a focus on justice – law should redress the harm suffered by the victim – to a focus on incentives – law should create incentives that will produce the greatest good for society in the future. For example, in general, firms should only be held liable for injuries they negligently cause if the expected total damages they cause exceed the cost of preventing those injuries; if we require firms to conduct inspections whose cost exceeds the cost of the injuries that those inspections would prevent, then we are reducing aggregate utility.

As you might guess, Posner is also generally a pragmatic conservative, who thinks that free markets usually lead to better societal outcomes than government intervention, and that public policy should focus on making sure that independent rational actors have the right incentives to behave in ways that will benefit society as a whole. Not surprisingly, his account of the crisis focuses not on the actions of people in the financial industry but on the failings of people in government.

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When Market Incentives Lead to Bad Outcomes

One of our readers recommended a fascinating and important article on health care economics, “The Cost Conundrum,” in The New Yorker. It’s by Atul Gawande, a surgeon and a professor of public health and surgery at Harvard.

Gawande contrasts McAllen, Texas, which has some of the highest health care costs in the country, with El Paso, Texas, a demographically similar city with moderate health care costs, and with low-cost communities such as Rochester, Minnesota (home of the Mayo Clinic) and Grand Junction, Colorado. To simplify greatly, his conclusion is that the medical community in McAllen practices medicine as a business, while the community in Rochester or Grand Junction practices it as a way of improving health. But the aberration isn’t the profit-loving doctors of McAllen; it’s all the doctors who are not out there maximizing profits.

The real puzzle of American health care, I realized on the airplane home, is not why McAllen is different from El Paso. It’s why El Paso isn’t like McAllen. Every incentive in the system is an invitation to go the way McAllen has gone.

And the prognosis is not good:

In the war over the culture of medicine—the war over whether our country’s anchor model will be Mayo or McAllen—the Mayo model is losing. In the sharpest economic downturn that our health system has faced in half a century, many people in medicine don’t see why they should do the hard work of organizing themselves in ways that reduce waste and improve quality if it means sacrificing revenue.

In short, we have a health care system that motivates doctors to behave like businessmen and maximize their revenues from patients. In the long run, those incentives are wearing down whatever ethic of professionalism or feelings of altruism lead doctors to behave differently. But while the pursuit of profit in the free market is supposed to benefit the public – and probably does in most areas – here it has led to an explosion of costs with no measurable improvement in health care outcomes.

Let’s go out on a long excerpt designed to motivate you to read the whole article:

We are witnessing a battle for the soul of American medicine. Somewhere in the United States at this moment, a patient with chest pain, or a tumor, or a cough is seeing a doctor. And the damning question we have to ask is whether the doctor is set up to meet the needs of the patient, first and foremost, or to maximize revenue.

There is no insurance system that will make the two aims match perfectly. But having a system that does so much to misalign them has proved disastrous. As economists have often pointed out, we pay doctors for quantity, not quality. As they point out less often, we also pay them as individuals, rather than as members of a team working together for their patients. Both practices have made for serious problems.

Providing health care is like building a house. The task requires experts, expensive equipment and materials, and a huge amount of coördination. Imagine that, instead of paying a contractor to pull a team together and keep them on track, you paid an electrician for every outlet he recommends, a plumber for every faucet, and a carpenter for every cabinet. Would you be surprised if you got a house with a thousand outlets, faucets, and cabinets, at three times the cost you expected, and the whole thing fell apart a couple of years later? Getting the country’s best electrician on the job (he trained at Harvard, somebody tells you) isn’t going to solve this problem. Nor will changing the person who writes him the check.

By James Kwak

Regulatory Capital Arbitrage for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Arnold Kling helpfully pointed out a 2000 paper on regulatory capital arbitrage by David Jones, an economist at the Fed. In his post, Kling said, “In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.” Having finally read the paper, I have little to add in the way of analysis. But I thought it provided a useful basis for a discussion of what regulatory capital arbitrage (RCA) is and why it is a helpful way of thinking about the financial crisis.

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The Importance of Compensation

In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.

Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed. However, I’m not optimistic about his solution:

It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . . The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Why am I not optimistic? Disney.

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Feel-Good Story of the Day

Calculated Risk reports that Citigroup is livid that S&P would have the audacity to downgrade the senior tranches of commercial mortgage-backed securities.

Citigroup commented that the changes were “a complete surprise”, “flawed”, lacked “justification” and the “S&P methodology changes do not seem rational or predictable”. Ouch.

It’s nice to see that the banks – who spent the last decade shopping for favorable ratings from the rating agencies, and overwhelming them with thousands of complicated offerings backed with sophisticated models – and the rating agencies – who spent the last decade giving AAA ratings to the banks’ models and are now claiming that it was all the banks’ fault – are getting along so nicely. Some marriages truly are forever.

By James Kwak

Sheila Bair Listens to Me

Yesterday I said that Tim Geithner or Sheila Bair should come out and slap down the idea that banks will be allowed to bid on their own assets. And today she did! Rolfe Winkler, in a guest post at naked capitalism, did the hard work transcribing the audio of the press conference.

Although banks cannot buy their own assets, Bair did say, “I think there have been separate issues about whether banks can be buyers on other bank assets and I think that’s an issue that we continue to look at.” As I said yesterday, and as Winkler also said, I think this is also a bad idea. Even if you successfully deter outright collusion, you can still have outcomes where the industry as a whole is using subsidies to overpay for its own assets and shift the loss onto the government.

And no, I don’t actually think that Sheila Bair reads this blog, much less listens to what I have to say.

By James Kwak

Banks Want Government Subsidies to Buy Assets from Themselves

From the headlines of the Wall Street Journal: “Banks Aiming to Play Both Sides of Coin — Industry Lobbies FDIC to Let Some Buy Toxic Assets With Taypayer Aid From Own Loan Books (subscription required, but Calculated Risk has an excerpt). I thought the headline had to be a mistake until I read the article.

To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.

Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.

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We’re on Kindle

At the request of a few readers, we’re now publishing the blog to Kindle. I have a suspicion that block quotes in some posts may not work properly. (I used to use a simple indent for block quotes; now I use the <blockquote> tag to try to solve this problem.)

I have never seen or touched a Kindle, so I have no way of testing it. Please let me know if you try this out and if you have any problems.

By James Kwak

“I Have 13 Bankers in My Office”

The Washington Post (hat tip Mark Thoma) has a profile of Brooksley Born, who has been credited by dozens of commentators (including us) for unsuccessfully attempting to increase regulation of derivatives in the late 1990s while serving as the head of the Commodity Futures Trading Commission. There’s much to admire, including being the first female president of the Stanford Law Review, making partner while working part-time, and, most importantly, this:

Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. “I’m very happily retired,” she says. “I’ve really enjoyed getting older. You don’t have ambition. You know who you are.”

Then there are the frightening flashbacks to the regulatory battles we are sure to relive this fall:

Greenspan had an unusual take on market fraud, Born recounted: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”

Translation: Imperfections in free markets are logically impossible.
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Feldstein on the Economy

What does it mean that Martin Feldstein (hat tip Mark Thoma) is now one of my favorite economists, when it comes to commenting on the current economic crisis? Feldstein’s analysis:

Evidence of recovery so far is thin.
The stimulus package will kick in and provide a short period of growth.
But as the stimulus wears off, growth will fade away again.
The Obama Administration’s policies are pointed in roughly the right direction but not big enough to turn the tide.

Here’s his conclusion:

The positive effect of the stimulus package is simply not large enough to offset the negative impact of dramatically lower household wealth, declines in residential construction, a dysfunctional banking system that does not increase credit creation, and the downward spiral of house prices. The Obama administration has developed policies to counter these negative effects, but, in my judgment, they are not adequate to turn the economy around and produce a sustained recovery.

Having said that, these policies are still works in progress. If they are strengthened in the months ahead – to increase demand, fix the banking system, and stop the fall in house prices – we can hope to see a sustained recovery start in 2010. If not, we will just have to keep waiting and hoping.

By James Kwak