Category: External perspectives

First Buy High; Then Sell Low

On Monday last week, Old National Bancorp bought back the warrants it had granted Treasury as part of its participation in TARP, after buying back its preferred stock on March 31. Today, the New York Times ran a story saying that Old National only paid $1.2 million to buy back the warrants, while the warrants were almost certainly worth more.

The main authority cited by the Times was Linus Wilson, a finance professor at the University of Louisiana, Lafayette and a sometime commenter on this blog, so let’s go straight to the source.

Continue reading “First Buy High; Then Sell Low” →

Bankers Will Be Boys

Apparently, Anne Sibert has written an article at VoxEU describing three types of bad behavior committed by bankers that helped produce the crisis:

They committed cognitive errors involving biases towards their own prior beliefs; too many male bankers high on testosterone took too much risk, and a flawed compensation structure rewarded perceived short-term competency rather than long-run results.

I say “apparently” because I can’t get through to VoxEU despite trying three different browsers and two different computers (can’t ping it, either). But there’s a long summary over at naked capitalism.

Everything she says sounds right, although the classification of three behaviors is a little frustrating, because they fall into three different categories. Confirmation bias is just part of the human condition; I’m not sure what we can do about that, short of inventing Cylons (and we know where that leads). Testosterone is part of the male branch of the human condition; so the potential solution is to have more female bankers. And flawed compensation structures are completely human creations, so we can definitely do something about them.

Continue reading “Bankers Will Be Boys” →

New Forms of Internet Communication

Arnold Kling has developed a new form of communication across the Internet: he wrote a blog post entitled “Paging Simon Johnson and James Kwak,” pointing to a 2000 paper by a Federal Reserve economist on the usage of securitization and off-balance sheet entities to effectively lower banks’ capital requirements for the same level of asset exposure. According to Kling, “the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.”

I haven’t sprung for the $31.50 to download the full article yet, but it is going on my reading list.

Kling also said he is “researching the history of capital regulation,” which is something I would also look forward to reading.

Update: One of my friends pointed out that my university has online access to lots of journals, including the one this paper was published in, so I now have a copy.

By James Kwak

Stress Tests: The Questions Continue

From Felix Salmon:

Why did Treasury switch from TCE to the even-more-obscure common capital metric? Quite possibly to help Bank of America and Citigroup get the amount of capital they needed to raise down to a number within the realms of possibility. After all, these tests were designed so that they couldn’t be flunked. And that might have seemed a real possibility back when Treasury was still using TCE.

By James Kwak

Chrysler and Bankruptcy Law in Gory Detail

I was talking to an old friend last night about the Chrysler bankruptcy and, in particular, whether Chrysler (and Treasury, and the UAW) will be able to get around the order of priority of creditors in bankruptcy – which ordinarily would favor the senior secured lenders who are trying to block the proposed plan. I thought I would do a little research, but then (again via Calculated Risk) I found Steve Jakubowski’s analysis of precisely this issue, which apparently everyone on the Internet has already been linking to. It’s actually Part 3 of a series; you may want to start with Part 1.

My summary, for those who don’t like reading citations from court opinions: The issue with the “restructuring initiative” agreed-upon by Chrysler, the government, Fiat, and the UAW, is that it only pays the senior secured creditors $2 billion in cash for $6.9 billion in secured debt; since secured creditors’ claims should come first, they argue they would get more from a liquidation. In particular, the VEBA created to fund retiree benefits is owed $8.5 billion; it is getting $4.6 billion debt and 55% of the equity in New Chrysler.

Continue reading “Chrysler and Bankruptcy Law in Gory Detail” →

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

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

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.

Continue reading “Pollution, Race, and Poverty” →

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.”*

Continue reading “Guest Post: Size Really Does Matter” →

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.

Continue reading “The Need for New Antitrust Laws” →

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.

Continue reading “Guest Post: Too-Big-To-Fail and Three Other Narratives” →

More Convergence of Views

Yesterday I highlighted an op-ed written by Desmond Lachman, a veteran of the IMF and Salomon Smith Barney (and currently at the American Enterprise Institute), comparing the United States and the current crisis to an emerging market crisis.

Saturday evening, Nicholas Brady, Secretary of the Treasury from the end of the Reagan administration through the entire Bush I administration, gave a speech at the Institute of International Finance – comparing the current crisis in the United States to an emerging market crisis, only in that case the banks were in the U.S. and the bad assets were in the emerging markets.

There are uncanny parallels between the situation we find ourselves in today and the one the Bush administration confronted a generation ago. . . . First of all there was a serious LDC [Least Developed Country] debt crisis. It’s easy to forget that in 1988 our banking system was in dire straits because the commercial banks held billions of dollars of loans in countries whose economic prospects had ground to a halt.

The solution, according to Brady, was identifying the fundamental problems and forcing all parties to recognize them.

Among the indisputable points we laid out were that new money commitments had dried up in the past 12 months and that many banks were negotiating private sales of LDC paper at steep discounts while maintaining their claim on the countries that the loans were still worth 100 cents on the dollar. There were more, and they were equally sobering. We used these irrefutable facts as a starting point in all subsequent meetings. Our rule was that no suggestions were permitted to be discussed if they didn’t accept the Truth Serum. They were off the table. Goodbye. Don’t waste time. . . . [W]e persuaded the international commercial banks—at first with great difficulty—to write down the stated value of the loans on their books to something close to market value in exchange for that lesser amount of host-country bonds backed by U.S. zero-coupon Treasuries.

Continue reading “More Convergence of Views” →

IMF Emerging Markets Veteran on the U.S.

One of the central themes of our Atlantic article was that the current crisis in the U.S. is very similar to the crises typically seen in emerging markets, and that resolving the crisis will require (some of) the measures often prescribed for emerging markets. This, Simon said, would be the assessment of IMF veterans who had worked on emerging markets crises.

At the exact same time that we were writing that article, Desmond Lachman – who worked at the IMF for 24 years, and then worked on emerging markets for Salomon Smith Barney for another seven years – was writing an article for the Washington Post saying many of the same things.* Here are the first three paragraphs:

Back in the spring of 1998, when Boris Yeltsin was still at Russia’s helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to “emerging markets” throughout Asia, Eastern Europe and Latin America, and I thought I’d seen it all. Yet I still recall the shock I felt at a meeting in Russia’s dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia’s economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia’s economic czar at the time.

Continue reading “IMF Emerging Markets Veteran on the U.S.” →

A View from the Inside

If you haven’t picked up on one of the dozens of recommendations from other blogs, I recommend reading Phillip Swagel’s long and detailed account of the view of the financial crisis from his seat as assistant secretary for economic policy at the Treasury Department. It’s particularly useful for people like me who make a habit of criticizing government officials.

The writing is dry, but much of the subject matter is fascinating. It often explains or defends Treasury’s actions during the crisis, but Swagel certainly owns up to plenty of mistakes or shortcomings. For example, discussing the emergency guarantee program for money market funds, he writes, “Nearly every Treasury action there was some side effect or consequence that we had not expected or foreseen only imperfectly.”

Continue reading “A View from the Inside” →

Unions and Business

One of the themes of the GM debate goes like this. On the one hand, the UAW is the problem, because it’s the high cost of union labor (and in particular, union retiree health benefits) that is crippling U.S. automakers. On the other hand, the UAW negotiated for those benefits fair and square, giving up higher current wages as part of the bargain, so it’s the fault of management for making promises they couldn’t keep. On the third hand, the UAW should have realized that when you negotiate for retirement benefits from a private corporation, one of the risks you take is that that corporation might go bankrupt. (For one example of these arguments, see Room for Debate at the NYT.)

Instead of touching that question any more than I already have, I wanted to raise the larger issue of whether unions are bad for business – which is what you would assume, given the lengths many companies go to in order to prevent unions from gaining collective bargaining rights. In general, this is a hard question to answer empirically. While you can observe differences between companies with unions and companies without unions, there is a huge problem of selection bias: since companies with unions are unlike companies without unions in many ways, you can’t say whether any differences in outcomes are due to the effect of the unions themselves, or due to the effect of other factors that would be there regardless of the unions.

John DiNardo and David Lee have an elegant way of getting around this problem in a 2004 paper, “Economic Impacts of New Unionization on Private Sector Employers: 1984-2001.” (The real economists out there probably know this paper already.) Instead of comparing all companies with unions to all companies without unions, they focus on companies where the union certification vote either barely won or barely lost, since these two companies are very similar to each other except for the treatment effect (having collective bargaining rights). This isolates the effect of unionization from other characteristics of the companies in question. They find that unions that barely win an election are successful in obtaining a collective bargaining agreement. Otherwise, however, the effect of successful unionization is insignificant on the company: differences in wages, employment, productivity, and output are all insignificant.

The UAW, historically, is a special case which people can debate for as long as they want. But the evidence is that in recent decades unions are not dangerous to firm survival.

Update: I forgot to add a link to a shorter summary of the work.

By James Kwak