Category: Commentary

Financial Reform for the Long Term

By James Kwak

The news these days is largely about the financial reform bill on the floor of the Senate. I think you know my opinion about that: many good things, not enough to solve the root problems, but still better than nothing.

Here’s a simplified way of thinking about things. There are two general problems with the financial sector today, which were the subject of two consecutive columns by Paul Krugman. The first problem, according to Krugman: “Much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors.” This is what we see in the SEC-Goldman suit, the Magnetar trade, and so on. The financial reform bill is largely (but not exclusively) aimed at this problem; that’s why there are a consumer protection agency, new trading and clearing requirements for derivatives, etc. These reforms, I think, have a reasonable chance of doing good.

Continue reading “Financial Reform for the Long Term” →

Expect Nothing

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

After months of denial, the European policy elite finally begins to understand that something is seriously wrong in the eurozone.

But the prevailing definition of the problem is still too narrow – the consensus in France and, even more, in Germany is that “this is a Greek problem”. Even the most negative still think that Portugal and Spain can easily escape serious damage.

This is a major misconception, as we pointed out last week – and as we have been emphasizing, to anyone who would listen, for more than a year. Continue reading “Expect Nothing” →

More Ignorant Senators

By James Kwak

So apparently a JPMorgan Chase analyst thinks that senators showed “an unnerving ignorance of fundamental principles of market economics.” Senator Charles Grassley went one better and showed an unnerving ignorance of how the government’s own budget works.

In a hearing on the administration’s proposal to recover the net costs of TARP through a tax on large banks, Grassley said,

“If a TARP tax is imposed and the money is simply spent, that doesn’t repay taxpayers one cent for TARP losses. It’s just more tax-and-spend big government, while taxpayers foot the bill for Washington’s out-of-control spending.”

Grassley apparently thinks that when the government “spends” money, it doesn’t benefit taxpayers. What does he think the government does? Burn it? Give it to Martians?

Continue reading “More Ignorant Senators” →

Download the Blog – New and Improved!

By James Kwak

I finally came up with a better way to create a downloadable blog archive (always available via the “Download the Blog in PDF” link under Navigation in the right-hand sidebar). Now the archive is up to date (through April 2010) and you can download it in PDF, Kindle, or EPUB format. And it has clickable bookmarks for each individual post.

Thanks go to Joss Winn, Martin Hawksey, Feedbooks, and Yahoo! Pipes. See the archive page itself for a technical description.

Why Do Harvard Kids Head to Wall Street?

By James Kwak

That’s the title of a post a couple weeks ago by Ezra Klein, in which he interviewed a friend of his who went to Wall Street after Harvard. Having seen this phenomenon from a couple of different angles, I’d say the interview is right on. This is how Klein summarizes the central theme:

“The impression of the Ivy-to-Wall Street pipeline is that it’s all about the money. You’re saying that it’s actually more that Wall Street has constructed a very intelligent recruiting program that speaks to the anxieties of the students and makes them an offer that there’s almost no reason to refuse.”

When I graduated from college, I had no interest in investment banking or its close cousin, management consulting. But I went to McKinsey for reasons that were only slightly different than those of the typical Ivy League undergrad; after getting a Ph.D. in history, I discovered that I was unlikely to get a good academic job and was pretty much unqualified for anything else, and McKinsey was one of the few places that would hire me into a “good” job with no discernible qualifications (other than academic pedigree). Now that I’m at Yale Law School, where maybe 15% of students (my wild guess) come in wanting to be corporate lawyers but 75% end up at corporate law firms (first job after law school, not counting clerkships), I’m seeing it again.

Continue reading “Why Do Harvard Kids Head to Wall Street?” →

Fake Debate: The Senate Will Not Vote On Big Banks

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown. This post also appears on pbs.org/needtoknow – as part of that new TV program’s coverage of the week’s issues.

There is widespread agreement that the financial crisis which broke out in September 2008 was our most severe in over 50 years. There is also a consensus that, whatever other factors may have been involved, the excessive risk-taking and general mismanagement of huge banks at the center of our economy played a significant role in what happened. (Yes, of course the largest banks themselves deny any responsibility – including most recently using insulting language.)

The financial reform package now on the Senate floor puts surprisingly little constraint on the activities of our largest banks going forward – preferring instead to defer to regulators to tweak the rules down the road (despite the fact that this approach has gone badly over the past 20-30 years).

A growing number of senators insist we should do more to reduce the size and limit the leverage of megabanks (i.e., the amount that banks can borrow), arguing that this would constitute an important additional failsafe – on top of all other efforts to establish “more effective regulation”.

Senator Ted Kaufman (D, DE) has led the charge on this issue, pounding away for months – and giving another powerful speech on the floor of the Senate yesterday.

Yet, astonishingly, it seems increasingly likely there will be no real Senate debate on this issue. Continue reading “Fake Debate: The Senate Will Not Vote On Big Banks” →

Who’s Got Those Pitchforks?

By James Kwak

The Huffington Post Books section is hosting a discussion of 13 Bankers; there are links to all the posts so far here. Mike Konczal, usually of Rortybomb, weighed in with a post that included this chart:

People from the 90th to the 95th percentile make about 11% of total income; people from the 95th to the 99th percentile make about 15%; and people in the top percentile make about 23% (in 2006, presumably). But mainly, look at the way that black line shoots up relative to the others since 1980 (along with financial sector profits and per-employee banking compensation).

Continue reading “Who’s Got Those Pitchforks?” →

“Most Observers” Do Not Agree With Larry Summers On Banking

By Simon Johnson

What is the basis for major policy decisions in the United States? Is it years of careful study, using the concentration of knowledge and expertise for which this country is known and respected around the world? Or is it some unfounded assertions, backed by no data at all?

At least in terms of the White House policy towards megabanks, it is currently “no discussion of data or facts, please”.

Speaking on the Lehrer NewsHour last week, Larry Summers said, with regard to the Brown-Kaufman SAFE banking act – which would restrict the size of our largest banks (putting them back to where they were a decade or so ago): Continue reading ““Most Observers” Do Not Agree With Larry Summers On Banking” →

Why Do Senators Corker And Dodd Really Think We Need Big Banks?

By Simon Johnson

On Friday, Senator Bob Corker (R, TN) took to the Senate floor to rebut critics of big banks. His language was not entirely senatorial: “I hope we’ll all come to our senses”, while listing the reasons we need big banks. And Senator Chris Dodd (D, CT) rose to agree that (in Corker’s words) reducing the size of our largest banks would be “cutting our nose off to spite our face” and that by taking on Wall Street, “we may be taking on the heartland.”

Unfortunately, all of their arguments in favor of our largest banks remaining at or near (or above) their current scale are completely at odds with the facts (e.g., as documented in our book, 13 Bankers).

The senators led with the idea that our nonfinancial sector needs huge, complex, global banks in order to remain competitive internationally. But this is completely untrue – in fact, Senator Dodd conceded as much to Ezra Klein recently when he said that he had heard the arguments of 13 Bankers against big banks also from “CEOs” (presumably of nonfinancial companies). Continue reading “Why Do Senators Corker And Dodd Really Think We Need Big Banks?” →

The Role of Government

By James Kwak

Last week Simon gave a talk sponsored by Larry Lessig’s center at Harvard. Afterward there was a dinner and then another question-and-answer session. Jedediah Purdy (another person to write a book while at Yale Law School; he is now a professor at Duke’s law school) asked a question that I have rephrased as follows (the words are mine, not Purdy’s; I may have also distorted his original question so much that it is also mine):

“You’ve criticized the government for withdrawing from the economic and particularly financial sphere and allowing private sector actors to do whatever they wanted. Do you think the government should simply act so as to correct the imperfections in free markets? Or do you see a positive role for government in determining what kind of an economy we should have?”

Continue reading “The Role of Government” →

Update on ABACUS

Read the “synthetic, synthetic CDO” post first if you haven’t already.

The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed. I think this is true to a degree, but not to the degree that Goldman needs it to be true.

Take an ordinary synthetic CDO. Back in 2005-2006, a bank might create one of these because it knows there is demand on the buy side for higher-yielding (than Treasuries) AAA assets. To do this, the CDO has to sell CDS protection on its reference portfolio to someone. That someone could in the first instance be the bank. But then the bank’s “short” position goes into its huge portfolio of CDS, which may overall be long or short the class of securities (say, subprime mortgage-backed securities) involved.The bank is constantly hedging that portfolio via individual transactions with other clients or other dealers, so there’s no one-to-one correspondence between the long side of the new CDO and any specific party or parties on the short side.

Let’s say for the sake of argument that the bank, prior to the new CDO, was exactly neutral on this market. The new CDO makes it a little bit short. So the bank will go out and hedge its position by finding someone else to lay the short position onto. But first of all, there’s a good chance it will divide up the short position and hedge pieces of it with different people. Those people may be buying the short position not because they want the subprime market to collapse; they might be partially hedging their own long positions in that market. Second, there’s an even better chance that it won’t sell off exactly the short position it just picked up from the CDO; it will buy CDS protection on a bunch of RMBS that are similar to the ones it just sold CDS protection on (which ones will depend on what the market is interested in), so in aggregate it comes out more or less the same.

So ultimately the “short” side of the CDO gets dispersed between the bank’s existing CDS portfolio and the broader market. So yes, there must be a short interest out there that is exactly equivalent to the long interest. But there doesn’t have to be a party or even an identifiable set of parties who have exactly the short side of the new CDO and want it to collapse, let alone a party that helped structure the CDO because it wanted to be on the short side. There’s a big difference between the market as a whole and one hedge fund.

Now, are things different with a synthetic synthetic CDO, as I have called it? Maybe. The pro-Goldman argument would be that ABACUS was so highly structured — basically, each tranche was a single complex derivative with a long side and a short side — that the long investors must have realized that there was a single party, or a small number of parties, on the other side. But that doesn’t necessarily hold. Just like a synthetic CDO, Goldman could have whipped this thing together because it thought it could sell it, and Goldman could have planned to hedge it the usual way — partially with its inventory and partially through a lot of small transactions dispersed throughout the market.

As always, I draw on Steve Randy Waldman.

Frank Luntz Hasn’t Read 13 Bankers (And That’s A Good Thing)

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

Frank Luntz is the midst of making one of the great mistakes of modern American politics. He seems to have completely missed the change in plot line on financial reform over the past few months – ever since Ted Kaufman waded into the fray, started to bring other key figures with him, and really moved mainstream thinking (as manifest, for example, in the Goldman Sachs hearing this week).

This is about the “arc of the fraud”. The financial system committed fraud during the boom (liar loans and misrepresentation to customers of all kinds); fraud during the bailout (“if you ruffle our feathers, we will collapse”); and now fraud during the serious attempts at reform (e.g., the astroturf/fake grassroots nonsense.)

Luntz thinks this is about higher costs being passed on to consumers and wants to fight in November on “the Democrats are just about special interests”. That would be terrific – for the Democrats – and Mr. Luntz should be encouraged in this endeavor. Continue reading “Frank Luntz Hasn’t Read 13 Bankers (And That’s A Good Thing)” →

To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF

By Peter Boone and Simon Johnson

When Mr. Trichet (head of the European Central Bank, ECB) and Mr. Strauss-Kahn (head of the International Monetary Fund, IMF) rushed to Berlin this week to meet Prime Minister Angela Merkel and the German parliament, the moment was eerily reminiscent of September 2008 – when Hank Paulson stormed up to the US Congress, demanding for $700bn in relief for the largest US banks. Remember the aftermath of that debacle: despite the Treasury argument that this would be enough, much more money was eventually needed, and Mr. Paulson left office a few months later under a cloud.

The problem this time is bigger. It is not only about banks, it is about the essence of the eurozone, and the political survival of all the public figures responsible. If Mr. Trichet and Mr. Strauss-Kahn were honest, they would admit to Ms. Merkel “we messed up – more than a decade ago, when we were governor of the Banque de France and French finance minister, respectively”. These two founders of the European unity dream helped set rules for the eurozone which, by their nature, have caused small flaws to turn into great dangers.

The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels. Continue reading “To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF” →

ABACUS: A Synthetic, Synthetic CDO

By James Kwak

I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.

An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.

A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)

ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1 (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”

Continue reading “ABACUS: A Synthetic, Synthetic CDO” →

Wake The President

By Simon Johnson, co-author 13 Bankers

Most days we can coast along, confident that tomorrow will be much like yesterday. On a very few days we need to look hard at the news headlines, click through to read the whole story, and then completely change a large chunk of how we thought the world worked. Today is such a day.

Everything you knew or thought you believed about the European economy – and the eurozone, which lies at its heart – was just ripped up by financial markets and thrown out of the proverbial window.

While you slept, there was a fundamental repricing of risk in financial markets around Europe – we’ll see shortly about the rest of the world. You may see this called a “panic” and the term conveys the emotions involved, but do not be misled – this is not a flash in a pan; financial markets have taken a long hard view at the fiscal and banking realities in Europe. They have also looked long and hard into the eyes – and, they think, the souls – of politicians and policymakers, including in Washington this weekend.

The conclusion: large parts of Europe are no longer “investment grade” – they are more like “emerging markets”, meaning higher yield, more risky, and in the descriptive if overly evocative term: “junk”. Continue reading “Wake The President” →