Author: James Kwak

Grading on a Curve

Mark Thoma has a great analogy for the stress tests. He picks up on this statement by Tim Geithner:

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

Then this is Thoma:

I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too. . . .

If we choose a score of “70” as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test: how the items on the balance sheets – the answers to the questions – are interpreted.

The whole thing is a fun read. I don’t think it’s a crucial point, but I like this part of the analogy:

Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to “negotiate” a grade can affect the percentage passing the class, particularly when – as with the stress tests – there aren’t a lot of students/banks taking the test.

By James Kwak

Help

Has anyone figured out how to make the numbers in Table 3 (PDF p. 10) in the stress test results add up? I understand what all the lines mean individually, but the presentation seems incomplete. Looking at Citi for example, I know that they expect 104.7 in losses on existing assets, but they expect Citi to make 49.0, for a net loss of 55.7. Common capital on 12/31/08 was 22.9, and 22.9 – 55.7 = -32.8, so absent recapitalization that would leave Citi at -32.8 on 12/31/10. The “SCAP buffer” (which seems like the opposite of a buffer, but whatever) is 92.6, so with the buffer Citi would have 59.8 on 12/31/10. But 59.8 is well over 4% of Citi’s risk-weighted assets of 996.2.

Maybe the model has Citi’s assets climbing up to $1.5 trillion? Or maybe the losses and “resources to absorb losses” do not have a dollar-for-dollar effect on common capital?

Anyway, it seems like at least one number is missing. If you can explain this, or link to someone who can, I will . . . be grateful.

Update: The most common theory is that 59.8 is 6% of 996.2. But I don’t think that is the explanation, for the reasons I cite in this comment reply and that Nemo also flagged. Also, Erich Riesenberg points out that the fact that this works out to 6% for Citi is a pure coincidence, if you look at the same calculation for other banks.

By James Kwak

GMAC Arithmetic

Calculated Risk has a table listing all of the leaked stress test figures so far. As a percentage of assets, the big banks need between 0% and 1.4% in additional capital. But there is one outlier: GMAC, with $189 billion in assets, needs $11.5 billion in capital.

This implies that GMAC is not just low on capital, it has negative capital. If you were to give GMAC $11.5 billion in new cash, it would have $200 billion in assets. The minimum tangible common equity requirement being used for the stress tests is probably in the 3-4% range. If it’s 4%, then the post-recapitalization GMAC would have $8 billion in tangible common equity – which means that right now it has negative $3.5 billion in tangible common equity. (The situation is slightly worse if you assume that it will be recapitalized through a preferred-to-common conversion, or if the threshold is 3%.)

The thing that confuses me is that, on paper, you can’t recapitalize a company with a negative net worth. No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion. (You can recapitalize a company that is under-capitalized: if it has $5 billion in capital and needs another $5 billion, then the new investors get 50% of the company.) This is why it is important (from the government perspective) for the stress tests to show that some banks are low on capital, but not that they have negative capital.

Maybe there’s some clever accounting mechanism or financial wizardry I’m missing.

Update: OK, now that I read the stress test document (I must be the last economics blogger to do so), I see there’s a mistake above. According to the stress test, GMAC is sufficiently capitalized now; the problem is that under the “more adverse” (realistic) scenario, its 2009-10 losses will be greater than its capital. So its expected capital at the end of 2010, absent recapitalization in the interim, would be negative.

It is not arithmetically impossible to recapitalize such a company, because we don’t know that this outcome will occur with certainty. I might pay $11.5 billion to own a company that, in the more adverse scenario, will be worth less than $11.5 billion at the end of two years – if I think that the possibility of a better outcome makes the bet worthwhile. Put another way, even if its end-2010 expected value is negative, its current value is still at least a little positive, because of option value. Still, though, it’s a pretty dodgy investment, so GMAC will probably have a difficult time raising new capital by selling common stock to the private sector.

The comment Nemo made below about the difference between market value and book value is true, but I also think my response is true: if anything, market values are below book values these days.

Finally, Felix Salmon also noticed that GMAC is the outlier on the bad end.

By James Kwak

Failure Is Good

Regular readers will know that we are fans of Thomas Hoenig, president of the Kansas City Fed (see here). I was catching up on the week’s news via Calculated Risk and came across Hoenig’s recent op-ed in the Financial Times, which I recommend as a follow-up to (or shorter version of) our previous post. Nor surprisingly, Hoenig argues that large bank holding companies should be allowed to fail, meaning:

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible.

Hoenig provides a list of arguments in support of this position. He starts with moral hazard, which would not have been at the top of my list. But I particularly like these:

So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role.

A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable.

Here’s a link to the whole thing again.

By James Kwak

Stress Tests and The Nationalization We Got

The post was co-authored by Simon Johnson and James Kwak.

When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.

What happened?

Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.

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Pollution, Race, and Poverty

Under a common conception of free-market capitalism, firms should do whatever they can – legally – to maximize value for shareholders, which often means maximizing profits. As long as firms do not bear the costs of the externalities they create – like air pollution – they will continue to create them. That’s all taken as a given.

What is a little more sinister, yet still completely legal, is where they will create them. Even in the absence of cash costs per ton of pollution, the effective costs to polluters will vary from place to place; those costs show up in the political difficulty of getting permits to build and operate facilities, the degree of environmental regulation, the likelihood of local muckraking journalists writing unpleasant exposes, the ability of the local populace to bring political pressure to bear, and so on. The net effect is that the low-cost places to put pollution tend to be communities with relatively less political power – in this country, communities of minorities and the poor.

A team of researchers from the University of Massachusetts-Amherst and USC recently released a new report, “Justice in the Air,” that quantifies the disparate environmental impact of toxic air pollution on minorities and the poor, by firm and by facility. Michael Ash and Jim Boyce also have a working paper that describes the data sources and the methodology.

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Comment Etiquette

I am surprised and a little impressed, but not happy, about the lengths some people will go to to promote their views in our comments. I’ve noticed two disturbing bits of behavior recently. One is “replying” to the first comment on a long comment stream in order to boost your own comment up to the top of the page, when you are not responding to that first comment substantively. The second is posting comments under multiple identities in order to agree with yourself or, worse, to insult or attack other commenters. On one recent post, one person posted eight comments under five different names, only two of which were substantive.

There are various measures I could take to try to solve this problem, but all of them will create overhead for the community as a whole. So please stop.

Guest Post: Size Really Does Matter

This guest post was contributed by Lawrence Baxter, a member of the faculty at Duke Law School and formerly a divisional executive in a large banking organization. He takes a look inside the large mergers that created the behemoth financial institutions we know today, and the assumptions that encouraged and allowed those mergers.

A friend recently observed to me that he had maintained zero interest in banks and banking all his life—until the past year. Now everyone is engaged in a swirl of emotions and punditry as we focus as experts, taxpayers or consumers on almost every dimension of the financial crisis, from bailouts to complex executive compensation schemes. Yet throughout the commotion we have not lost our faith in one quintessential American value: bigger is better. How quickly we forget such disasters as Daimler Chrysler and Travelers-Citicorp, even as we hail Chrysler-Fiat.

True, a consequence of great scale has informed the public policy debate on banks: what do we do with a financial institutions that is “too big to fail”? Yet answers to this question have, for the most part, turned on whether a particular company should be allowed to fail, or be propped up by government action. The underlying pathology receives only passing attention. Why do we let these institutions get so large in the first place? Is it not likely that many of the institutions requiring massive injections of public capital and other forms of subsidization and public assistance are, and have been for some time, simply too big to manage?

America’s obsession with bigness has led us to assume glibly that organizational growth, vertical and lateral, is a natural consequence of business success and must be respected, even celebrated. Armies of consultants, lawyers and investment bankers devote their businesses to the science of corporate enlargement, encouraged by economists who celebrate not only economies of scale, but even “economies of super scale.” Ken Thompson, then CEO of one of the most venerated banks in the United States, Wachovia, spoke for an industry when he declared in 2006, at the very moment the company was making its fatal acquisition of Golden West Financial, that ““[c]onsolidation continues to make economic sense. Done right, size enhances competitive power. With economies of scale, a company can better afford the technology and longer branch hours that customers demand.”*

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Stress Tests for Beginners

The big news on the banking front this week will be the public release of the stress test results, currently scheduled for Thursday (originally it was supposed to be today). Over at The Hearing, I wrote an overview post recapping the context for the stress tests and the current dilemma the administration faces: whether to keep quiet about the details, and risk undermining the credibility of the exercise, or whether to release signficant bank-specific information, and risk undermining the reputation of certain weak banks.

There is nothing wrong with the concept of the stress tests, and arguably regulators should have been doing them constantly as the crisis worsened, so that this particular iteration would not create such a political challenge. The idea is that not only do you want to know how much capital a bank has right now, but you want to know how much capital it will have left if the economy continues to get worse. If you did this analysis in a way that was credible with the market, it would go a long way toward restoring confidence in the financial system, since the current lack of confidence is based on people’s not trusting the information they are getting.

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The Need for New Antitrust Laws

The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.

Theodore Roosevelt, “Address at Providence,” 1902 (emphasis added)

By “creatures of the State,” Roosevelt meant not that corporations were created by the state, but that their existence and power existed because of and in concert with the state. A few years ago, someone reading this quotation would have probably thought first of Halliburton; today, it evokes the large banks that are too big to fail.

That quotation was pointed out to us by Zephyr Teachout, a law professor at Duke, who has been proposing new antitrust laws aimed at reducing the political power of large firms.

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Bankruptcy Cramdowns Defeated in Senate

President Obama, he of the 68% approval rating, asked Congress to allow bankruptcy judges to reduce the principal amounts of mortgages on primary residences (they can already modify almost all other loans in bankruptcy). The goal was to pressure mortgage lenders, or the investors who now own those mortgages, to modify the mortgages themselves to give homeowners a better option than foreclosure. Because, you know, we have a housing foreclosure crisis going on. But after passing the House, the measure got only 45 votes in the Senate, with zero Republican support and twelve Democrats defecting.

Banks campaigned against the measure by – get this – threatening that it would destabilize financial markets. The New York Times reported:

A letter signed by 12 industry organizations this week to senators warned that the legislation would “have the unintended consequence of further destabilizing the markets.”

Translation: banks are weak; weak banks are dangerous; therefore Congress should not do things that might be bad for banks.

According to the Washington Post:

[Senator Richard] Durbin negotiated with Bank of America, J.P. Morgan Chase and Wells Fargo for weeks, hoping their support would bridge the gap. Even after the proposal was weakened significantly, the financial services industry refused to sign on.

I know the main legitimate argument against bankruptcy cramdowns: it increases the riskiness of mortgages, and therefore mortgage rates would have to go up a little for everyone. (Which sounds fine with me.) But the way this issue played out had nothing to do with what would be best for the country as a whole; it had everything to do with what the banks wanted.

Instead of bankruptcy cramdowns, the Times reports that the banks got a reduction in the insurance premiums they will pay the FDIC for deposit insurance – which is like a group of car owners voting themselves lower premiums on their auto insurance. But because there is zero chance the government will let insured depositors lose money, any shortfall in the premiums paid by banks to the FDIC will be made up by the taxpayer.

Not that this should surprise anyone.

By James Kwak

GDP Growth Rates for Beginners

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

My post about French sociology got a wide range of comments, ranging from “Without a doubt, your best post yet” to “Reading this post made me think, for the first time, of ignoring Baseline Scenario from now on,” which I guess indicates we have a wide range of readers. In any case, for today I’m returning to something much more mundane: GDP growth rates. Like many Beginners articles, this one starts out with some basics, and then gets (a little) more interesting, but its main goal is to help you decipher the news that you already read.

To a casual reader, yesterday’s GDP announcement was that Gross Domestic Product (an aggregate measure of economic activity) fell by 6.1% or, more precisely, at an annual rate of 6.1%. What does this mean?

For those of you who have never visited the BEA website, this is what the raw numbers look like. (They give you columns B and E, I calculated the rest.) Note that this is all in 2000 dollars, so inflation has been taken out.

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The Importance of Battlefield Nuclear Weapons

I’ve been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.

The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.

But there’s a much bigger, slower game going on at the same time, and the administration’s basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how “a growing number of banks are resisting the Obama administration’s proposals for fixing the financial system.” It didn’t have a lot of new information, but it summarized the outlines of the game.

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Pierre Bourdieu, Tim Geithner, and Cultural Capital

France in the 1960s and 1970s was the source of a tremendous amount of new philosophical, literary, and critical thinking – Foucault, Derrida, Lévi-Strauss, Baudrillard, Barthes, etc. But in my opinion, the most important member of that intellectual generation was the sociologist Pierre Bourdieu. In Distinction, Bourdieu’s best-known work, he described how economic class is reinforced by cultural capital: economic elites create cultural distinctions, and pass on to their children the ability to make those distinctions, in order to use cultural sophistication as a means of perpetuating class dominance. This may sound abstract, but think about the example that is the subject of Bourdieu’s The Love of Art: museums. Upper-class parents take their children to fine art museums and teach them how to talk about Rembrandt, Monet, and Picasso; later in college, job interviews, and cocktail parties, the ability to talk about Rembrandt, Monet, and Picasso is one of the markers that people use, consciously or unconsciously, to identify people as being from their own tribe. (Note that democratizing museums – making them open to anyone – doesn’t undermine cultural capital, because the key is not looking at paintings, but learning how to talk about them.)

We used the term “cultural capital” in our Atlantic article as a way of describing the influence of Wall Street over Washington. By this, we meant that one of the primary means by which Wall Street got its way in Washington was by creating and propagating the understanding – among sophisticated, educated, cultured people, as opposed to “populists” or the “rabble” that showed up at anti-globalization protests – that what was good for Wall Street was good for the country as a whole. We didn’t mean to say that old-fashioned campaign contributions and lobbying did not play an important role. (We did, however, say that we thought out-and-out corruption of the Jack Abramoff variety was probably a minor factor – not because we have any insider knowledge one way or the other, but simply because such criminal behavior was simply unnecessary given the other levers available.) But I don’t think that implicit quid pro quo bargaining is a sufficient explanation, because I believe it entirely possible that there are honest politicians and civil servants who really, truly believe that they are acting in the public interest when they come to the aid of the largest banks.

Tim Geithner may very well be such a man.

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Guest Post: Too-Big-To-Fail and Three Other Narratives

This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.

In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.

Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.

Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern. But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”

Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”. The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.

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