Our Fate Is in Their Hands?

Last month, Representative John Shimkus spoke out against regulating carbon dioxide emissions on the grounds that carbon dioxide is plant food. “So if we decrease the use of carbon dioxide, are we not taking away plant food from the atmosphere?” Shimkus is on the House Subcommittee on Energy and Environment, which means he has a vote on these issues.

In the wake of a financial and economic crisis of at least generational magnitude, our government will be rewriting the rules of the financial industry. And “our government” includes not just the pedigreed scholars in the executive branch (Larry Summers, Christina Romer, Austan Goolsbee, etc.), but Congressional representatives like John Shimkus – “like” in the sense that they were selected for their jobs, and for their committee seats, in exactly the same way that Shimkus ended up discussing the crucial role of fossil fuels in sustaining plant life on this planet. And when it comes to legislation, Summers, Romer, and Goolsbee have exactly zero votes between them; Shimkus has one.

Continue reading “Our Fate Is in Their Hands?” →

New Day, New Bank, Worse Story

It’s a beautiful day today, and after Goldman and JPMorgan, I don’t feel like diving deep into Citigroup’s earnings release. But judging from the Bloomberg article, it’s a similar story, just not as good.

1. All the good news was in fixed income trading: $4.7 billion in fixed income trading revenues; falling revenues in credit cards, consumer banking, and private client.

2. Assets continue to deteriorate: $5.6 billion in new writedowns in trading accounts; $3.1 billion in charge-offs and reserves for bad credit card debt.

3. Accounting fictions save the day (the new bit): $0.6 billion in losses that don’t have to be classified as other-than-temporary (and therefore affect the income statement) thanks to FASB; $2.5 billion in “profits” because of the fall in the value of Citigroup’s own debt. The theory behind the latter is that Citi could go into the market and buy back all of its distressed debt, which would be cheaper than paying it off at 100 cents on the dollar. Also: $0.4 billion in litigation expenses avoided (previously reserved) and tax benefits from an IRS audit.

Point 3 adds up to $3.5 billion, which dwarfs Citi’s $1.6 billion profit. Why is everyone so optimistic about banks these days?

By James Kwak

Financial Innovation for Beginners

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

Kevin Drum pointed me to Ryan Avent’s insightful review of Ben Bernanke’s recent speech on financial innovation. (How’s that for the Internets in action?) Bernanke’s brief was simple: to defend financial innovation in general while acknowledging that at the margin it can be counterproductive and may need to be more closely regulated. “I don’t think anyone wants to go back to the 1970s,” he said in a line that was clearly supposed to make his point. Unfortunately for Bernanke, Avent was listening closely. His rejoinder:

neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in…the 1970s.

With one exception:

Tasked with defending deregulation as a source of financial innovation, Bernanke reached for subprime lending.

This helped at least partially crystallize some thoughts I have had floating around about financial innovation for a while.

Continue reading “Financial Innovation for Beginners” →

Who Had This Good Idea First? (A Weekend Comment Competition)

In early February, James proposed that bankers’ bonuses be paid out in “toxic assets” – after all, the industry was arguing that these would definitely rebound (“it’s just a liquidity problem”) and that their “true” value was substantially above current market value. The idea was well received by our readers but not so much by the banking or insurance industry.

Someone quickly pointed out that – back in December – Bloomberg reported Credit Suisse would actually use a version of the same idea. And, in the whirlwind of the fall, I now vaguely remember this same point coming up even earlier in some bigger discussion.

So in the spirit of proper attribution (also because a reader asked and I’d like to know the answer), here is our first ever weekend “comment competition”.

Who really originated this (very good) idea, either in private discourse or – easier to document – in a public comment, blog post, corporate document, or the like? We’d also welcome updates on where any form of this idea is being used in practice.

By Simon Johnson

The Department Of Justice Is On Line Two

I don’t generally overreact to news (from the NYT this morning, on the AIG-Goldman connection that runs through Edward Liddy’s stock ownership), but this has gone far enough.

Have we completely lost of sense of what is and is not a conflict of interest? Have we really built a system in which greed fully overshadows responsibility? Is it not time for a complete rethink of what constitutes acceptable executive behavior?

One of our country’s leading corporate attorneys made a telling point to me on Wednesday night, “the only way to control executive behavior is to criminalize it,” i.e., civil penalties do not change behavior – the prospect of jail time has to be on the table. His broader point was that antitrust action can make a difference in today’s world, but only if this includes potential criminal charges. Continue reading “The Department Of Justice Is On Line Two” →

New Day, New Bank, Same Story

JPMorgan Chase reported its quarterly earnings today. The headline was $2.1 billion in net income, beating analysts’ estimates. Behind the headlines, it was similar to the story that Goldman told earlier this week: a huge jump in fixed-income trading, status quo everywhere else, and continuing writedowns. For example, if you look at the breakdown of revenue by type of activity (not line of business) on page 4 of the supplement, you’ll see that revenue was flat or down in every category except one: principal transactions, where it jumped from a loss of $7.9 billion to a gain of $2.0 billion. That $9.9 billion improvement more than explains the entire increase in pretax profit from negative $1.3 billion to positive $3.1 billion.

As with Goldman, it was clearly a good quarter for JPMorgan; making money beats losing money any day. But the question to ask is whether it is sustainable, either for JPMorgan or for the banking industry as a whole. To answer that question, here are some pictures.

Continue reading “New Day, New Bank, Same Story” →

Forecasting The Official Forecasts, Spring 2009 Edition

Our forecast of official growth forecasts back in the fall turned out to be fairly accurate. My update of this assessment – for the new IMF numbers due out next week – is now online at NYT.com.

Many officials seem to have bought into some version of the “it’s a V!” take on the global recession. To me, this looks like wishful thinking. Whether or not you support the “V” view fully, officials should surely be spending more time preparing for worse scenarios.

Just in case – why not prepare properly for the cross-border resolution issues that would arise from the failure of a major global bank? Why did the G20 decline to take on this issue properly? Even the IMF’s baseline, I expect, will suggest potentially serious problems ahead.

Bring In The Antitrust Division (On Banking)

In early February I suggested there was a showdown underway between the US Treasury and the country’s largest banks. Treasury (with the Fed and other regulators) is responsible for the safety and soundness of the financial system, the banks are mostly looking out for their own executives, and the tension between these goals is – by now – quite evident.

As we’ve been arguing since the beginning of the year, saving the banking system – at reasonable cost to the taxpayer – implies standing up to the bankers. You can do this in various ways, through recapitalization if you are willing to commit more taxpayer money or pre-packaged bankruptcy if you want to try it with less, but any sensible way forward involves Treasury being tough on the biggest banks.

The Administration seems to prefer “forbearance”, meaning you just ignore the problem, hope the economy recovers anyway, and wait for time or global economic events to wash away banking insolvency concerns. But this strategy is increasingly being undermined by the banks themselves – their actions threaten financial system stability, will likely force even greater costs on the taxpayer, and demonstrate fundamentally anticompetitive practices that inflict massive financial damage on ordinary citizens. Continue reading “Bring In The Antitrust Division (On Banking)” →

Is Goldman Really That Good?

Goldman Sachs released its quarterly earnings yesterday, and the headline was net income of $1.8 billion, doubling analysts’ estimates. I would say this is definitely good news for Goldman; whether it’s good news for the banking sector as a whole is more uncertain.

First, as Bruce Wayne, one of our readers, pointed out, the quarter-over-quarter comparisons left out December. Because Goldman just changed its fiscal year end, its previous quarter ended in November and its latest quarter ended in March. December was reported separately and – surprise, surprise – Goldman took a net loss of $0.8 billion. So if they had mashed December into Q1, they would have had a four-month “quarter” with $1.0 billion in profits.

Second, the positive results probably reflect a better mix of businesses than other banks enjoy. Although Goldman has made big one-sided bets, its trading operation traditionally hedged many of its positions and made a lot of its money on volume. Its positive Q1 results were largely due to strong performance in fixed income, currencies, and commodities (FICC) trading, which reflects the fact that Q1 was a busy quarter – in part because of the massive unwind at AIG – and, as Goldman’s CFO politely said, “Many of our traditional competitors have retreated from the marketplace.” With fewer players in town, the oligopoly profits go up – another reason why the big banks are even more powerful than they were before the crisis.

When it comes to the value of its own investments, Goldman seems to have done less well. Its net revenues for principal investments, mainly “Other corporate and real estate gains and losses,” were negative $1.4 billion in Q1 and negative $0.8 billion in December. While Goldman was able to more than offset this with trading gains, I wonder what the implication is for commercial banks that are not dominant players in trading.

(The FT also raised an eyebrow at the fact that per-employee compensation in Q1 was much higher than in the year-earlier period. That actually doesn’t worry me, because I’m guessing those compensation expenses are bonus accruals – the better the quarter you have, the more money you have to set aside for year-end bonuses.)

By James Kwak

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

The Bank Run Next Time (Frankenstein’s Monster)

Think about the current and potential future pressure on our largest banks like this. The underlying problems are deep, but the “run” comes from the credit default swap market, and presumably from experienced professional investors – many of whom used to work in the largest banks.

The big banks helped set up these markets. They trained many of the people who are now engaged in speculative attacks on these banks. And the excessive bonuses of yesterday form the capital base for many hedge funds that now lead the attack.

In my Economix column at NYT.com this morning, I explore the ironies and emphasize the dangers. The system may have a tendency to self-destruct, but don’t think that the costs to the rest of us will be anything less than huge.

Calling All Shareholders

If you cast your mind back to when executive compensation and bonus limits first reached the mainstream debate, you may recall people saying these would be ineffective and the issue is a red herring.

These points do not now seem compelling. People who work at the big banks are quite irked by what they see as unjustified limits on their bonuses. Some of the “talent” is jumping ship. Big bank leadership is lobbying hard to remove the restrictions or, failing that, for the right to pay back government TARP funds in order to escape the bonus cap – leading firms, such as Goldman Sachs, seem poised to raise new capital to that end.

This is a remarkable moment. Excessive risk taking in large firms was based on inappropriate bonus structures (take risk and get compensated now; face the consequences of that risk down the road), facilitated by a deep failure to understand/control risk inside these organizations and probably made possible by the implicit put option from being too big or too complex to fail (i.e., Wall Street insiders own the upside; taxpayer owns the downside). We have all focused of late on the costs for taxpayers, which of course are horrible, and going forward – with the implicit option now explicit – who can believe this will lead to anything other than further massive bailouts?

But think about this arrangement from the perspective of shareholders. Are we looking at the greatest tunneling scheme in the history of organized finance? Continue reading “Calling All Shareholders” →

$3.5 Million or $5 Million?

In the midst of a severe economic crisis that is, among other things, depressing federal tax revenues and adding to the national debt, the debate over the estate tax has flared up again. The basic question is whether the exemption will be raised from $1 million – where it was in 2002-03 and where it is scheduled to return after the Bush tax cuts expire – to $3.5 million (Obama) or $5 million (Lincoln-Kyl) per person; there is also disagreement over whether the marginal rate should be 35% or 45%. (Note that even with Obama’s proposed 45% tax rate, the average effective tax rate on estate would be 19%, because of the $3.5 million exemption.)

There is plenty of debate over this already, so I will confine myself to three points.

Continue reading “$3.5 Million or $5 Million?” →

Why Bail Out Life Insurers?

That’s the question I woke up with this morning. Sad, isn’t it.

The Wall Street Journal reported this week that Treasury will soon announce that it will use TARP funds to invest in life insurers, or at least those who snuck under the federal regulatory umbrella by buying a bank of some sort. The argument for the bailout is a version of the “No more Lehmans” theory: the failure of a large financial institution could have ripple effects on other financial markets and institutions that could cause systemic damage. For a bank, the ripple effect is primarily caused by two things: (a) defaulting on liabilities hurts bank creditors, and (b) defaulting on trades (primarily derivatives) hurts bank counterparties, if they aren’t sufficiently collateralized (think AIG).

My thought this morning was that life insurance policies are long-term liabilities that are already guaranteed by state guarantee funds, so we don’t have to worry about (a), and hopefully most life insurers were not doing (b) – large, one-sided bets on credit risk like AIG. So why not just let them fail and let the states take over their subsidiaries? But then I checked the facts, and it turns out that the limits on state guarantee fund payouts are pretty low. So the scenario is this: you hear bad things about your life insurer, you decide to redeem your policy (usually at a significant loss to yourself), turning it into a short-term liability, and then the insurer has to start dumping assets into a lousy market, pushing the prices of everything further down and hurting everyone holding those assets. Would this really cause a systemic crisis worse than we’ve already got? I don’t know, but no one in Washington wants to take that risk.

Continue reading “Why Bail Out Life Insurers?” →

The Economy and Popular Democracy

One of the central themes of the current economic crisis has been the cozy relationship between “Wall Street” and Washington that resulted from both ideological convergence and old-fashioned campaign contributions. Another theme, as Simon discussed yesterday, has been the absence of a simple left-right axis for opinions to coalesce around. If you think that fixing the banking sector requires a government conservatorship and forcible balance sheet cleanup – rather than periodically dribbling large amounts of cash into institutions and management teams that have already failed by any free-market measure – it’s not clear who your advocates in government are.

Tomorrow, however, you can stand up and be counted. A New Way Forward is organizing demonstrations all around the country, most at 2 PM Eastern Time. The basic message is simple: “If it’s too big to fail, it’s too big to exist. Dismantle the power of the financial elite and make policies that keep a new crop from springing up. We want our economy and politics restored for the public.”

And don’t forget your pitchfork. (Just kidding.)