Tag: regulation

Making Creditors Suffer

Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.

I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.

Continue reading “Making Creditors Suffer”

Gaming the Legacy Loan Auctions

My colleague Ilya Podolyako is back with a comment on the Geither Plan to buy toxic assets, as well as an update to his previous post about the constitutionality of government takeovers of private property. He discusses in particular the possibility (also suggested by one of our readers) that the government could “seize” toxic assets and pay “just compensation,” even in the absence of a bankruptcy or a takeover. Ilya is a 3rd-year student at the Yale Law School and, among other things, an executive editor of the Yale Journal on Regulation. The post below is by Ilya.

PPIP for Legacy Loans = Free Put Options for Banks

I finally got a chance to read through the PPIP plan in detail. I noticed one curious point: under the program as announced, auctions for the legacy loans do not appear to be binding on the contributing entity.

The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:

. . .

Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

This is quite odd, since, if I read it correctly, it turns the entirety of the program into a put option for participating banks. That is, they could identify certain assets, put them up for auction seemingly risk-free, check the result, and reject anything below their internal valuation without any further capital contribution.

Continue reading “Gaming the Legacy Loan Auctions”

Does Size Matter?

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

Big and Small

Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

  1. Increased power and regulatory centralization to deal with the problem of systemic risk
  2. Increased protections for consumers and investors buying financial products
  3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
  4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk – the topic he focused on yesterday – I kept thinking it had been too long since he read Frog and Toad to his children.

Continue reading “Big and Small”

Frog, Toad, Cookies, and Financial Regulation

My two-year-old daughter loves Frog and Toad.

There is a Frog and Toad story called “Cookies.” It is the only Frog and Toad story I remember from my childhood. Toad bakes some cookies and takes them to Frog’s house. They are very good. Frog and Toad eat many cookies, one after another. They try very hard to stop eating cookies, but as long as the cookies are in front of them, they cannot help themselves.

So Frog puts the cookies in a box. Toad points out that they can open the box. Frog ties some string around the box. Toad points out that they can cut the string. Frog gets a ladder and puts the box on a high shelf. Toad points out .  . .

Finally Frog takes down the box, cuts the string, opens the box, and gives all the cookies to the birds.

“Read more, Daddy,” my daughter says.

“One moment, I have to tell all the nice people the moral to the story.”

Continue reading “Frog, Toad, Cookies, and Financial Regulation”

What’s Plan B?

One of the determinants of how you feel about the Geithner Plan is what you think will happen if it fails. By “fails,” I mean that the buyers’ bids are lower than the sellers’ reserve prices, so the toxic assets don’t actually get sold.

Brad Delong, for example, is moderately in favor of the plan, even though he thinks it is insufficient. In his words, “I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul [Krugman] thinks that the longer Obama delays proposing bank nationalization the lower it’s chances become.” (“Voinovich” is DeLong’s hypothetical 60th senator, whose vote would be needed in the Senate.) In other words, DeLong thinks that if this plan fails, the administration will be more likely and able to go forward with nationalization.

Paul Krugman, by contrast, is strongly against the plan, first because he thinks it has no chance of succeeding, and second because he thinks there is no Plan B. “I’m afraid that this will be the administration’s only shot — that if the first bank plan is an abject failure, it won’t have the political capital for a second.”

Continue reading “What’s Plan B?”

Potential Constitutional Obstacles to Nationalization and the Economic Rescue Plan

The more aggressive the government’s responses to the economic crisis become, the more likely that they will end up in the courts. Changes in regulation can be interpreted as constraints on the ownership of property – especially by the people who own that property – and therefore such changes have occasionally ended up in the Supreme Court. The article below is by Ilya Podolyako, a third-year student at the Yale Law School and the co-chair (with me) of a reading group on law, economic policy, and the economic crisis.

As the New York Times reported today, Geithner and Bernanke were on Capitol Hill to ask for greater power to wind down non-bank financial entities like AIG. During the hearing:

[Representative Barney] Frank said the different fates of Lehman Brothers and A.I.G. illustrate the need for options beyond the “all or nothing” approach. “One was the Lehman Brothers example, where they were allowed totally to fail and there was no help to any of the creditors,” Mr. Frank said. “The other is the A.I.G. example, where there was help for all of the creditors. Neither one is what we should be doing going forward.”‘

Geithner and Bernanke largely concurred. Basically, the key actors want to be able to apply a receivership/conservatorship-type system that currently covers members of the FDIC, Savings and Loan institutions, and Fannie/Freddie to any entity whose financial activity poses a systemic risk to the economy.

James has pointed out that proponents of nationalization for Citigroup and Bank of America have essentially the same thing in mind: have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not. Baseline Scenario has consistently and persuasively argued that such an approach would be prudent. Indeed, it would avoid the awkward political fallout of the type that arose when AIG disclosed that $60+ billion worth of federal aid went directly to its various derivatives counterparties. The problem is, this policy might not be constitutional.

Continue reading “Potential Constitutional Obstacles to Nationalization and the Economic Rescue Plan”

Modifying Securitized Mortgages

Amidst the gallons of ink spilt, here and elsewhere, over the nationalization debate, the AIG collateral payments, and the AIG bonuses, I neglected to comment on the details of the new housing plan, which were released on March 4. When the initial plan was announced in February, I was concerned about the seeming lack of any provision that would enable servicers of securitized mortgages to modify those mortgages without being sued by the investors who bought the securities. (In brief, the problem is that the pooling and servicing agreements (PSAs) that govern those securitizations may not allow loan modifications, or may require the servicer to gain the consent of all of the investors, which is practically impossible.) People who know housing better than I said there was something in there.

If it is, I still can’t find it in the March 4 documents (fact sheet, guidelines, modification guidelines). In any case, an important question is whether the plan will do enough to encourage servicers to modify securitized mortgages, as opposed to mortgages they own. “A New Proposal for Loan Modifications,” a short (13-page) paper by Christopher Mayer, Edward Morrison, and Tomasz Piskorski that will appear in the next issue of the Yale Journal on Regulation, describes the problem clearly and makes three proposals to solve it. (A longer version with appendices is available here.)

Continue reading “Modifying Securitized Mortgages”

Bernie Madoff Day

As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.

A little late to close the barn door.

While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people – investors and officials alike – to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.

Continue reading “Bernie Madoff Day”

Regulatory Arbitrage in Action

From the Washington Post:

[Scott] Polakoff [acting director of the Office of Thrift Supervision] acknowledged that his agency technically was charged with overseeing AIG and its troublesome Financial Products unit. AIG bought a savings and loan in 1999, and subsequently was able to select the OTS its primary regulator. But that left the small agency with the enormous job of overseeing a sprawling company that operated in 130 countries.

Is there another side to this story or is it really as simple as that?

Update: ProPublica had a good story on this back in November. Here’s one short excerpt:

Examiners mostly concurred with the company’s repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG’s huge capital base . . . and because securities underlying the swaps had top credit ratings.

Was It The Hedge Funds? (Diane Rehm Show at 11am)

Hedge funds have been nominated as a prime culprit in the current financial disaster.  European governments, in particular, seem keen to impose greater regulation on hedge funds, including more transparency and compliance requirements.  In fact, this is will be one of the main deliverables they seek at the G20 summit on April 2nd.

I’m not opposed to stronger regulation, and hedge funds have obviously disappointed investors – especially with their illiquidity under pressure.  But are hedge funds really responsible for the depth of the crisis?  They were present at the scene of the crime, in terms of buying and trading what we now call “toxic assets,” but surely their role was minor relative to supposedly “regulated” US and European banks. Continue reading “Was It The Hedge Funds? (Diane Rehm Show at 11am)”

YLS Conference on the Financial Crisis

If you are a true crisis junkie (or you are having trouble falling asleep tonight and need more to read), my own Yale Law School held a conference on the financial crisis, its causes, and potential solutions (including better regulation) on Friday. There were a number of famous names present, including Lucian Bebchuk, Christopher Mayer (of the Hubbard-Mayer proposal), Anil Kashyap, and others. You can look at the agenda or check out the readings for sessions one, two, three, and four (each includes links to PDFs of the papers).

And where was I during all of this? I was home with my daughter.

(Let me know if you find something particularly important that I should read – I’m finding it impossible to keep up.)

The Importance of Accounting

Or, as I thought of titling this post, SEC does something useful!

Accounting can seem a dreadfully boring subject to some, but it gets its moment in the sun whenever there is a financial crisis . . . remember Enron? This time around is no exception. During the panic of September, some people were calling for a suspension of mark-to-market accounting, and while they did not get what they wanted, they succeeded in inserting a provision in the first big bailout bill to study the relationship between mark-to-market accounting and the financial crisis.

A brief, high-level explanation of the dispute: Under mark-to-market accounting, assets on your balance sheet have to be valued at their current market values. So if you have $10 million worth of stock in Microsoft, but that stock falls to $5 million, you have to write it down on your balance sheet and take a $5 million loss on your income statement. The criticism was that mark-to-market was forcing financial institutions to take severe writedowns on assets whose market values had fallen precipitously, not because of their inherent value, but because nobody was buying these assets – think CDOs – and that banks were becoming insolvent because of an accounting technicality. Under this view, banks should be able to keep these assets at their “true” long-term values, instead of having to take writedowns due to short-term market fluctuations.

I am instinctively skeptical of this view, and in favor of mark-to-market accounting, because I believe that while market valuations may not be perfect, they are generally better than the alternative, which is allowing companies to estimate the values themselves, subject only to their auditors and regulators. But the issue is considerably  more complicated than either the simple criticism or my simple defense would imply.

Earlier this week, the SEC released its study of mark-to-market accounting as required by the bailout bill. Their conclusions are simple:

fair value [mark-to-market, as will be explained] accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.

Continue reading “The Importance of Accounting”

Managing Financial Innovation

Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.

Free Market Ideology, Epilogue

In the most recent post in the Causes series, I expressed a fair amount of agreement with Joseph Stiglitz’s criticism of an excess of faith in the free market and the lax regulation that results. With the Bernard Madoff scandal (New York TimesWSJ has more information but requires subscription), Felix Salmon is asking, where were the regulators?

(By the way, if you’re wondering how the Madoff fraud was possible, remember that a hedge fund is like a bank in the sense that you put your money in and you generally leave it there for a while, and although you may take some out now and then you may also put some more in now and then, and other people are putting it in, and so on. With a bank, not all depositors can get their money out at the same time because it is tied up in long-term loans that the bank can’t call in. With Madow’s fund, investors couldn’t get their money out because he had, effectively, burned it. They had been getting periodic paper statements showing returns, but there were no real returns, and hence no assets behind that paper.)