What happened to the global economy and what we can do about it
Category: External perspectives
By James Kwak
On my way to and from New Haven, I listen to podcasts, including a lot of TED Talks. Today I listened to a talk by Esther Duflo, the recent winner of the Clark Medal (top economist under forty), from earlier this year. The topic was using randomized experiments to test alternative social policies and determine what measures of fighting poverty are more effective than others. It was probably the best and most inspiring economics talk I’ve heard in a long time.
By James Kwak
Actually, two things, both by Steve Randy Waldman.
Part of Goldman’s defense is that it was in the nature of CDOs for there to be a long side and a short side, and the investors on the long side (the ones who bought the bonds issued by the CDO) must have known that there was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does. Since a synthetic CDO by construction mimics the characteristics of a non-synthetic CDO, the same thing holds. (While the credit default swaps that go into constructing the synthetic CDO have long and short sides, the CDO itself doesn’t have to.) Here’s the conclusion:
“Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading ‘against’ short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors.”
Waldman follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its own fee). The point here is that Goldman could have simply put Paulson and the buy-side investors together and had Paulson buy CDS on RMBS directly — but that would have affected the price of the deal, because Paulson wanted to take a big short position. So instead, they created the CDO (a new entity) and then drummed up buyers for it, in order to avoid moving the market against Paulson. The advantage of thinking about it this way is it shows what the function of a market maker is and how that differs from the role Goldman played in this transaction.
The posts are long, so sit back and enjoy.
Update: Nemo points out that I misinterpreted Waldman’s post, and Nemo is right, although I think I got the substance of Waldman’s point right. Here is what Waldman says:
“There is always a payer and a payee, and the payee is ‘long’ certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. . . . The existence of a long side and a short side need imply no disagreement whatsoever.”
So I was clearly wrong when I said, “a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does.”
But — and I don’t think I’m engaging in sophistry here — Waldman’s underlying point is that even though there is a short position, that doesn’t mean that the long and short investors have diametrically opposed interests. That’s true of stocks, and it’s also true of CDOs. And so it’s disingenuous of Goldman to imply that buyers of any CDO always know that there is someone who is actively betting on it to go down in value.
By James Kwak
The Big Short is a good story and provides some illuminating lessons about Wall Street. Lewis doesn’t really come out and say what he thinks about Wall Street; he lets his characters do that for him. But in his recent interview with Christopher Lydon, he really lets loose. Here are some direct quotations.
Lewis: “The people who were responsible for orchestrating the crisis, because they’re on top and they’re in the middle of it, they’re the only ones who are sort of fluent in the language of it. I mean, who’s to question Tim Geithner, the secretary of the treasury, about this or that, because he’s the only with the information . . . even though he is clearly culpable in what happened.”
Lydon: “Not to mention Larry Summers and Bob Rubin and all the other architects of the deregulation. They’re still calling the shots in a new administration after a change of party management. It’s unreal.”
Lewis: “It is unreal, because basically all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure. And I don’t know if that’s going to work. When you look at what Alan Greenspan did, or what Larry Summers did, or what Bob Rubin did, there are individual mistakes they made, like for example not regulating the credit default swap market, preventing that from happening. But the broader problem is just the air they breathe. The broader problem is just the sense they all seem to have that what’s good for Goldman Sachs is good for America.”
***
Lewis: “The question is how does Washington move away from those institutions and make decisions that are in the public interest without regard for the welfare of these institutions. It’s a hard question because . . . this is the problem. Essentially the public and their representatives have been buffaloed into thinking that this subject — financial regulation, structure of Wall Street — is too complicated for amateurs. That the only people who are qualified to pronounce on this are people who are in it. And there are very very few people who aren’t in it in some way who have the nerve to stand up and fight it. . . .
“The elected representatives look at the financial system, I’m sure, and they think, it’s too complicated for me to understand, I’m going to be quickly exposed as a know-nothing if I take the lead on regulation, and in the bargain I’m going to miss out on all these campaign contributions from the financial industry because I’ll alienate them.”
***
Lewis, on Barack Obama: “He’s been captured by his banker, just like the ordinary American’s captured by their stockbroker. He’s been buffaloed by the complexity of it all, he doesn’t have time to sort it out for himself, and he has to trust the people who seem to know. The alternative is for him to set off on his own in a quixotic quest to reform the financial system without having any experience of the system. It’s sort of like the presidential version of regulatory capture, that he is at the mercy of the people who really don’t have probably his long-term best interests at heart but who seem to know what they’re talking about.”
By James Kwak
Robert Litan of Brookings wrote a paper on the derivatives dealers’ club — the small group of large banks that control most of the market for certain types of derivatives, notably credit default swaps. It’s a blunt analysis of how these banks can and will impede derivatives reform in order to maintain their dominant market position and the rents that flow from it.
I haven’t had time to do it justice, so I recommend Mike Konczal’s analysis in parts one and two (but particularly one). As Konczal says, “In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have.”
And note that Litan is no bomb-thrower; most recently he mounted a defense of most financial innovation (my comments here).
By James Kwak
Andrew Haldane (of “doom loop” fame) has another provocative paper, “The $100 Billion Question,” delivered in Hong Kong last week. A central theme of the paper is what Haldane sets up as a debate between taxation and prohibition as approaches to solving the problem of “banking pollution” — the systemic risk externality created by the banking industry. Taxation is higher capital and liquidity requirements; prohibition is structural reforms that limit the size or scope of financial institutions. Drawing on work by Weitzman and Merton, Haldane discusses when one approach would be superior to the other.
The advantages of prohibition include modularity (ability of a system to withstand a collapse of one component), robustness (likelihood that regulations will work when needed), and better incentives (since tail risk is a function of banker behavior — not weather patterns — the risk-seeking nature of banking means that no capital level will necessarily be high enough).
By James Kwak
Many of you have probably already seen Shahien Nasiripour’s interview with Thomas Hoenig, president of the Federal Reserve Bank of Kansas City and the most prominent advocate of simply breaking up big banks. (Paul Volcker is more prominent, but his views are more nuanced; the famous Volcker limit on bank size, it turns out, would not affect any existing banks, at least as interpreted by the Treasury Department.) It largely elaborates on Hoenig’s positions that we’ve previously applauded in this blog, so I’ll just jump to the direct quotations:
On megabanks:
“I think they should be broken up. . . . We’ve provided this support and allowed Too Big To Fail and that subsidy, so that they’ve become larger than I think they otherwise would. I think by breaking them up, the market itself would begin to help tell you what the right size was over time.”
By James Kwak
ProPublica has a long and detailed story of Magnetar, the hedge fund that helped fuel the subprime bubble by providing the equity for new subprime collateralized debt obligations — precisely so that it could then go and short the higher-rated tranches. In other words, Magnetar wanted to short some really, really toxic CDOs. But either there weren’t enough toxic CDOs to short, or they weren’t toxic enough. So they provided the equity necessary to manufacture more toxic CDOs. Then they shorted them. Yes, the math works out.
Yves Smith told the story of Magnetar in her book ECONned
By James Kwak
The Center for Responsible Lending has a great comic strip titled “If Anti-CFPA Folks Ran Toyota Today?” with classic lines like “Fixing these cars will raise the price of cars in the future, and hurt deserving drivers.” I’m pretty sure it was directly inspired by one of my favorite posts, “If Wall Street Ran the Airlines . . .,” but that’s perfectly fine by me. We have to keep saying the same things over and over because they’re true.
By James Kwak
Yes, Mark Thoma is generally Democratic-leaning when it comes to policy. But his blog is justly popular because it presents a wide range of views through extensive quotations and relatively little editorial commentary. So I think it’s revealing that he provides the following postscript to an article by Jamie Galbraith:
“Every day that goes by with unemployment higher than it needs to be means that people are struggling needlessly. People need jobs. And not at some point in the future when Congress gets around to it (if they ever do), this can’t wait another day. It should have been done months and months ago.
“Congress ought to have the same urgency in dealing with the unemployment problem as it had when banks were in trouble. Collectively the unemployed are too big to remain jobless, and the millions of individual struggles among the unemployed shouldn’t be tolerated. But Congress doesn’t seem to be in much of a hurry to do anything about it, or give any sign that it much cares.”
American Banker is running an article by Bill Wade (subscription required, but free trial available), a former banker . . . explaining why the banking industry should be in favor of a Consumer Financial Protection Agency. Wade repeats many of the arguments made by consumer advocates such as Elizabeth Warren:
“A Consumer Financial Protection Agency can be the vehicle that restores consumer confidence in our products, our services and our institutions. The customers we serve will always need credit and other banking products . . . What they want is simple, clearly explained products and the comfort that someone is looking out for their best interests when financial products are developed and marketed. . . .
By James Kwak
Jeff Sachs:
“Policy paralysis around the US federal budget may be playing the biggest role of all in America’s incipient governance crisis. The US public is rabidly opposed to paying higher taxes, yet the trend level of taxation (at around 18% of national income) is not sufficient to pay for the core functions of government. As a result, the US government now fails to provide adequately for basic public services such as modern infrastructure (fast rail, improved waste treatment, broadband), renewable energy to fight climate change, decent schools, and health-care financing for those who cannot afford it.
“Powerful resistance to higher taxes, coupled with a growing list of urgent unmet needs, has led to chronic under-performance by the US government and an increasingly dangerous level of budget deficits and government debt.”
That’s part of a longer article, “Obama in Chains,” on the challenges presented by political polarization. Sachs seems generally sympathetic to Obama, although he criticizes him for his pledge of no new taxes on the “middle class” and ruling out a value-added tax.
Unfortunately, Sachs isn’t long on practical solutions: he prescribes an end to the Iraq and Afghanistan wars, increased taxes, and lobbying reforms. But that’s in part because the problem is hard to solve.
There has been a lot of talk about the financial crisis over the past year and a half, and I obviously think that will remain an important subject, at least until we have a truly reformed financial system. Preventing the next financial crisis should be high on our society’s priority list. But as the months and years wear on, I suspect we will see more articles like Don Peck’s recent 8,000-word article in The Atlantic, “How a New Jobless Era Will Transform America.”
Peck’s article is not about what caused the recent crash and recession, but what its societal consequences will be. And the article is almost unremittingly bleak. Even before 2008, we had already lived through a decade of stagnant median income and sluggish job growth; the recession pushed some unemployment levels, such as the underemployment rate (people out of work, working part-time for economic reasons, or too discouraged to look for work) to levels not seen since the Great Depression. It’s not particularly clear where growth will come from, as manufacturing remains in decline, services are becoming increasingly outsourceable, and other countries take the lead in the most plausible major new industry (alternative energy). According to Nobel laureate Edmund Phelps, “the new floor for unemployment is likely to be between 6.5 percent and 7.5 percent (for several reasons, including “a financial industry that for a generation has focused its talent and resources not on funding business innovation, but on proprietary trading, regulatory arbitrage, and arcane financial engineering”).
I spend a lot of time in the car driving to and from school, so I end up listening to a lot of podcasts (mainly This American Life, Radio Lab, Fresh Air, and Planet Money). I was catching up recently and wanted to point out a few highlights.
Last week on Fresh Air, Terry Gross interviewed Scott Patterson, author of The Quants, and Ed Thorp, mathematician, inventor of blackjack card counting (or, at least, the first person to publish his methods), and, according to the book, also the inventor of the market-neutral hedge fund. These are some of Thorp’s comments (around 24:20):
“As far as you can tell now, how are quants being used on Wall Street? Are these mathematical models being relied on as heavily now after the stock market crash as they were before?”
On Tap takes on the often-used fiction that investment banks have done nothing wrong because they were simply dealing with professional investors who knew what they were getting into. He uses the always reliable device of taking aim at something on the Wall Street Journal op-ed page (a column by Holman Jenkins, in this case)–not only do people actually believe these things, but they get column-inches in one of America’s best newspapers.
To Jenkins, OT responds:
“Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principal . . . Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties.”
OT also takes on the argument that banks are always betting against their clients, and the clients should know that.
By James Kwak
Alan Greenspan has gotten innumerable takedowns, most notably in person by Henry Waxman. Binyamin Appelbaum and David Cho of the Washington Post are working on Ben Bernanke. Appelbaum and Ellen Nakashima already got James Gilleran (and, of course, there is the Photo). Now Zach Carter has nailed John Dugan. Some of the guns aren’t as smoking as one might like–Dugan only became head of the OCC in 2005, meaning he had less time to do serious damage, although he had established his bank-loving credentials long before. But he did what he could, such as preventing state regulators from gathering information (information!) from federally-chartered banks. Now, of course, he is lobbying Congress to protect his turf and kill the CFPA.
Why the Obama administration even acknowledges his existence is a mystery. I mean, Geithner is a centrist technocrat; I may disagree with him, but I see why he’s there. Dugan seems like the Stephen Johnson of banking regulation.
And to all a good night.
By James Kwak
The Baseline Scenario 