The New Decembrists

Other Voices – January 5, 2009

noreply@blogger.com (The Epicurean Dealmaker) — Tue, 05 Jan 2010 17:06:00 +0000

IMF study links lobbying by US banks to high-risk lending, guardian.co.uk (Jan 4). Three IMF economists conclude that extensive lobbying and political contributions by financial institutions were highly correlated with naughty behavior in the mortgage markets:

The paper, written by a trio of high-profile IMF economists, established that firms who spend more on buying access to politicians are more likely to engage in risky securitisation of their loan books, have faster-growing mortgage loan portfolios as well as poorer share performance and larger loan defaults.

The landmark paper will increase pressure on US politicians to regulate the mortgage industry, which Washington insiders say has so far been immune from meaningful financial reform in the aftermath of the bank crisis.

Highlighting 33 pieces of federal legislation that would have tamed predatory lending or introduced more responsible banking but were the target of intense lobbying, the IMF found that the efforts by banks to resist the legislation overwhelmingly succeeded.

"Our analysis suggests that the political influence of the financial industry can be a source of systemic risk," Deniz Igan, Prachi Mishra and Thierry Tressel wrote in their conclusion. "Therefore, it provides some support to the view that the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand better the incentives behind it."

More evidence from the archives of the Department for the Obvious Department on the capacity of directed influence and money to piss in the policy well. Is it time to reevaluate campaign contributions and directed lobbying as "protected speech" yet?

Fannie, Freddie, and the New Red and Blue, Matt Taibbi (Jan 4). The scourge of vampire squiditude and plutocracy everywhere sets his frame a little wider. In it, he comes to the conclusion, inter alia, that: 1) everyone was to blame for the financial crisis; 2) our entire socioeconomic system is endemically if not irretrievably corrupt; and 3) the mainstream media is incapable of interpreting these events and problems outside the lens of Red State–Blue State politics.

To me all of these people were equally guilty of making bad decisions to benefit themselves in the here and now at the expense of the whole in the future. When it comes to bubbles, It Takes a Village ...

My prediction? Taibbi will rapidly tire of a fight in which there are so many combatants—many of whom, unlike Goldman Sachs, will have no compunction about fighting back without restraint. He will retire to the country and write clever hatchet jobs about despicable people and institutions who, because they do not gaze back when you look in the mirror, are much easier and far more entertaining for his readers to hate.

The Devil Is in the Details

noreply@blogger.com (The Epicurean Dealmaker) — Thu, 17 Dec 2009 17:21:00 +0000

Mike Konczal at Rortybomb disagrees with Economics of Contempt's recent post in these pages about the proper regulatory structure for derivatives trading:

To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!

I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.

Even better, Mike is not content just to hurl brickbats and criticism. He explains in an accompanying post exactly what it is he is looking for in derivatives trading reform:

Let’s define some terms. Many people are comfortable forcing OTC derivatives to be forced into clearing (though I don’t think the author above does). I like that, but I and others worried about financial reform want to see more. Let’s talk about exchanges versus clearing. Now as opposed to the FT article, I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world. What I am worried about is that the swap execution facility will move away from a formal “trading facility” definition towards a vague nebulous definition of whatever people can get away with.

So what are the features that I want to see? I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.

Right now people will tell you that clearing derivatives still gives market prices, and these prices can be transparent with a few tweaks. However a clearinghouse only sees one price, the price at which the deal was struck, and it only sees that price after the deal is completed. So yes, this is a history, but it is only a partial history. A fuller price history will give us information available for use by many different parties to carry out their own transactions, the very heart of what prices are supposed to do in a market.

Now some argue that some financial instruments, say a CDS contract, can’t be forced into clearing, since it would be unprofitable to post the margins and collateral necessary to clear. Your response should be: fantastic! This is an example of where sunlight is the best disinfectant. If an instrument trades only because people are uncertain about how it will ever get paid off, or if an instrument trades only because there’s an implicit (and nowadays, explicit) government guarantee of using taxpayer money, and without this guarantee nobody would be involved, then you don’t actually have a market.

Why is all this important? Well, as you might suspect, Mike says it's because it all comes back to the most pressing issue in systemic risk: Too Big to Fail:

The OTC market needs to change. To whatever extent it had problems before, the battle cry of “No More Lehmans!” has given everyone a perverse incentive to participate with Too Big To Fail banks. How can a small dealer compete in this new landscape?

... we can’t make Too Big To Fail progress without substantial new OTC derivatives regulation. Living wills, et al only make sense in the context that counterparty risk is more clearly defined, and that the playing field is leveled for more players.

I believe the prosecution has concluded its summation. Do we have a response from the defense?

Related reading:
Rortybomb: EoC On The Lynch Amendment (December 17, 2009)
Rortybomb: An Argument for Exchanges and Swap Execution Facilities (December 17, 2009)
Economics of Contempt: The Lynch Amendment: Bizarre and Confused (December 15, 2009)

“Wake Up, Gentlemen”

noreply@blogger.com (The Epicurean Dealmaker) — Tue, 15 Dec 2009 15:59:00 +0000

[This post originally appeared at The Baseline Scenario on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as-we-know-it is valuable and must be preserved. Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth. Responding to a Wall Street insiders‘ Future of Finance “report“, he was quoted in the WSJ yesterday as saying: “Wake up gentlemen. I can only say that your response is inadequate.”

Volcker has three main points, with which we whole-heartedly agree:

“[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”
“I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy”

and most important:

3. “I am probably going to win in the end”.

Volcker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money.

This is entirely reasonable – although we can surely argue about details, including whether a very large “regulated” bank would be able to escape the limits placed on its behavior and whether a very large “trading” bank could (without running the payments system) still cause massive damage.

But how can Mr. Volcker possibly prevail? Even President Obama was reduced, yesterday, to asking the banks nicely to lend more to small business – against which Jamie Dimon will presumably respond that such firms either (a) are not creditworthy (so give us a subsidy if you want such loans) or (b) don’t want to borrow (so give them a subsidy). (Some of the bankers, it seems, didn’t even try hard to attend – they just called it in.)

The reason for Volcker’s confidence in his victory is simple - he is moving the consensus. It’s not radicals against reasonable bankers. It’s the dean of American banking, with a bigger and better reputation than any other economic policymaker alive – and with a lot of people at his back – saying, very simply: Enough.

He says it plainly, he increasingly says it publicly, and he now says it often. He waited, on the sidelines, for his moment. And this is it.

Paul Volcker wants to stop the financial system before it blows up again. And when he persuades you – and people like you – he will win. You can help – tell everyone you know to read what Paul Volcker is saying and to pass it on.

By Simon Johnson

The Lynch Amendment: Bizarre and Confused

noreply@blogger.com (The Epicurean Dealmaker) — Tue, 15 Dec 2009 15:22:00 +0000

[This post originally appeared at Economics of Contempt on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:

[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.

This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal.

Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.)

Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That's what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they're going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse's risk management practices. A dealer is unlikely to trade through a clearinghouse if it's prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it's exactly the kind of aligning of economic interests that we're looking for!

The Lynch amendment would effectively prevent a given clearinghouse from having more than 2 or 3 dealers as clearing members. This would make the clearinghouse much less effective in mitigating the systemic risk of OTC derivatives. When a clearing member defaults, the clearinghouse can generally transfer big chunks of the defaulting member's open positions to other clearing members—like the FDIC does when it resolves commercial banks—minimizing the disruption to counterparties and preventing contagion from spreading. If a clearinghouse only has 2 or 3 dealers as clearing members, and one of those dealers defaults, the clearinghouse wouldn't be able to transfer most of the defaulting member's open positions to other clearing members, because there would only be a couple other clearing members who, under the best of circumstances, have the balance sheet capacity to assume significant chunks of the defaulting member's derivatives book. This would greatly increase the strain on the clearinghouse's guaranty fund. By contrast, if all of the dealers are clearing members and one of the dealers defaults, there's a good chance the clearinghouse will be able to transfer most of the defaulting member's derivatives book to other clearing members, smoothing the resolution of the defaulting dealer and minimizing the strain on the guaranty fund.

Another major problem with the Lynch amendment is its potential effect on the liquidity of cleared OTC derivatives. As the name implies, "swap dealers" are the market-makers in OTC derivatives. There's already a question as to whether a lot of standardized OTC derivatives are liquid enough to be centrally cleared. I personally think they are, but the Lynch amendment would make it a very close call. You have to think about why clearinghouses only accept liquid derivatives for clearing — in order to collect the right amount of collateral (or "variation margin") from counterparties, cleared derivatives need to be liquid enough to accurately mark-to-market every day. If mark-to-market prices aren't available, a clearinghouse won't be able accurately value the contract, and it won't know how much collateral to demand from counterparties. If a clearinghouse only has 2 or 3 dealers as clearing members — which, again, would be the ultimate effect of the Lynch amendment — then its access to the (real-time) pricing information it needs to accurately set mark-to-market values will be severely constrained. A clearinghouse needs several dealers to be clearing members (at least 7 or 8) in order to accurately mark-to-market standardized OTC derivatives on a daily basis.

Finally, Rep. Lynch is wrong to say that the clearinghouses "are being created to police the big banks in their derivatives trading." Uh, no Congressman, they're not. There's a reason we often say that standardized derivatives should be forced onto "regulated clearinghouses" — it's because the clearinghouses would be "regulated" by the CFTC and SEC! The CFTC and SEC will be the ones policing the OTC derivatives markets, as they'll have nearly unfettered access to clearinghouse data, as well as the authority to impose pretty much whatever standards they want on the clearinghouses. A regulated clearinghouse can only make rules for its members within the confines of CFTC/SEC regulations. Warning that the big banks will be allowed to police themselves without the Lynch amendment is a pure straw man.

Let's hope the Senate takes a second to think through the Lynch amendment before it takes up financial regulatory reform.

A Few Things Worth Considering

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 14 Dec 2009 15:55:00 +0000

From one of the more underrated political philosophers and students of human nature of our time:

Governments, if they endure, always tend increasingly toward aristocratic forms. No government in history has been known to evade this pattern. And as the aristocracy develops, government tends more and more to act exclusively in the interests of the ruling class — whether that class be hereditary royalty, oligarchs of financial empires, or entrenched bureaucracy.

* *
Good government never depends upon laws, but upon the personal qualities of those who govern. The machinery of government is always subordinate to the will of those who administer that machinery. The most important element of government, therefore, is the method of choosing leaders.

* *
What you of the CHOAM directorate seem unable to understand is that you seldom find real loyalties in commerce ... Men must want to do things of their own innermost drives. People, not commercial organisations or chains of command, are what make great civilizations work, every civilization depends upon the quality of the individuals it produces. If you overorganize humans, over-legalize them, suppress their urge to greatness — they cannot work and their civilization collapses.

— Frank Herbert, Children of Dune

All laws and regulations are only as good as the people who create, interpret, and implement them. Given the dominant strains of careerism, materialism, and narcissism among our current socioeconomic elites, this observation falls squarely on the side of those who counsel cynicism and despair.

In the long run, the biggest challenge we face is not writing new laws and regulations, but rather choosing better leaders. We might approach this project first by figuring out how to raise better humans.

Ah, if only it were that easy ...

© 2009 The Epicurean Dealmaker. All rights reserved.

[This post originally appeared at The Epicurean Dealmaker on December 14, 2009. It is reproduced here in its entirety.]

Finreg I: Bank capital and original sin

noreply@blogger.com (Steve Randy Waldman) — Fri, 11 Dec 2009 20:00:00 +0000

[This post originally appeared at interfluidity on December 11, 2009. It is reproduced here in its entirety.]

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I'm having a hard time expressing myself. So I'll ask readers' indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But "liquidity", as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of "liquidity", they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were "illiquid" because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a "too big to fail" option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

The US banking system was recapitalized by precisely three words: "no more Lehmans". All the money we shelled out, the TARP, the Fed's exploding balance sheet, the offered-but-untapped "Capital Assistance Program", mattered only insofar as they made the three magic words credible. At this moment the Fed and the Treasury are crowing about how banks are now able to "raise private capital" and about "how TARP is being repaid" and "losses on TARP investments will be much less than anticipated". That is all subterfuge and sleight-of-hand, flows of urine while the beast lumbers on. The US government has persuaded markets that it stands behind its large banks, that despite no legal right to such protection, all creditors will be made whole and equityholders will live to fluctuate another day. Banks have raised almost no private capital, in an economic sense. They have attracted liquidity on the understanding that the government continues to bear the downside risk.

It's unfair to say that the government now supplies all large bank capital. Stockholders still suffer price volatility and there is some uncertainty that the government will remain politically capable of being so generous. But the vast majority of large-bank economic capital is now supplied by the state, regardless of the private identities and legal forms associated with bank funding arrangements. So long as the political consensus to support them is strong, American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite. But that is not a good thing.

No iron law of economics ensures that those who bear the risk of an enterprise enjoy the fruit of its successes. Governments have the power to absorb the downside of formally private enterprises (and the libertarian so principled as to refuse a bail-out is very rare indeed). But they have no automatic ability to collect profits or capture gains from organizations that they economically capitalize, but do not legally own. Bearing the downside risk of a project with no claim on the upside is the circumstance of the writer of an option. Private parties who write options, either explicitly or implicitly via credit arrangements, demand to be paid handsomely for accepting one-sided risk. Governments do not. Banks pay deposit insurance premia, but only on a fraction of the liabilities the government guarantees and in a manner that does not discriminate between the prudent and reckless (which creates a public subsidy to recklessness). When governments have lent to banks during the crisis, they have lent at well below the rates even untroubled, creditworthy nonfinancial borrowers could obtain on the market, so that the implicit option premia embedded in credit spreads were somewhere between negligible and negative. Governments paid banks for the privilege of insuring their risks, or to put it more accurately, they acknowledged that they had already insured bank risks and found ways of paying out claims via subsidies sufficiently hidden as to be politically palatable.

As we think about how to regulate banks going forward, we must first be clear about what we are doing. We are negotiating the terms of options that the government will offer to bank stakeholders. It is important to understand that, for both practical and philosophical reasons. As long as the state substantially bears the downside risks of the financial system, by virtue of explicit legal arrangements or de facto political realities, philosophical arguments for deregulation are incoherent. Deregulation is equivalent to a blank check from the state. If you are philosophically in favor of free market capitalism, you must be in favor of very radical changes in the structure of banking, towards a system under which the state would have no obligation to intervene, and would in fact not intervene, to support bank stakeholders even when their enterprise threaten to collapse. The "resolution regimes" currently proposed do not restore "free market" incentives, because those proposals codify rather than forbid state assumption of risk and losses in the event of a crisis. A free market resolution regime would allocate losses among private stakeholders only, and prevent any loss-shifting to the government. For the moment, such a regime, and the structural changes to the banking system that would be required to make it credible, are politically beyond the pale.

So, the options written by government to bank stakeholders will remain in place. All that remains, then, is to negotiate the terms of those options. Framing bank regulation in terms of option contracts underlines a reality that is tragic but true: options are zero-sum games. One party's benefit is another party's cost. Very deeply, there is no confluence of interest we can seek between our best and brightest financiers and the public good. Terms that are good for banks are bad for taxpayers. Negotiating the terms of an option with a wealth-seeking counterparty is an inherently adversarial affair. When President Obama is on the phone with Jamie Dimon, do you think he keeps that in mind? A fact of life that our President seems not to enjoy is that while sometimes there are miscommunications that can be resolved via open exchange, sometimes there are genuine conflicts of interest that must simply be fought out. Bank regulation, alas, is much more the latter.

There are indirect as well as direct effects of option contracts, so maybe I've framed things too harshly. After all, we allow and encourage formal derivatives exchanges because, even though the derivative contracts themselves are zero-sum, they permit businesses to insure against risks, and that insurance can enable real wealth creation that might not have otherwise occurred. We claim that derivatives markets make indirect positive contributions to the real economy, despite the fact that their direct effect is simply to shuffle money between participants. Banking also just shuffles money around, but we generally think that it enables important business activity. So one might argue that banks and the public have a common interest after all, and smart regulation to evolve could from a more consensual process. But, one would be wrong. We all have a stake in the existence of a payments system, and banks provide one, but managing that is a largely riskless activity, conceptually separable from the lending and investing function of banks. We would also like our economic capital to be allocated productively. But the effect of writing a more bank-friendly options contract is to reduce the penalties for poor capital allocation while enhancing the payoffs to big, long-shot risks. Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them. If we desire a better banking system, we must limit the degree to which private stakeholders can expect to be made whole by the state. With respect to regulation, what's good for Goldman Sachs is quite opposed to what is good for America. The point of regulating is to align public and private interests by imposing costly limitations on how banks can behave. Indirect considerations of public welfare reinforce rather than reduce the degree to which bank regulation is zero-sum, a fight that pits the health of the real economy against the distributional interests of bank stakeholders.

However, there is some light in the bleakness. Once we understand that we are negotiating option contracts, we can look to some guidance from the private sector. Option-like private contracts are negotiated all the time, and the issues that surround managing them are well understood. A compare-and-contrast of public sector bank regulation and private sector contracts will prove informative. That will be the subject of our next installment.

Acknowledgments: To be acknowledged by me is like being kissed by a putrescent semi-decapitated halitotic zombie creature. Nevertheless, I failed to weave many links into the above, and my thinking on these issues owes a lot to a bunch of people who are smarter and better smelling than me, so I feel duty bound to mention them. In particular, it was Winterspeak and Mencius Moldbug who fully disabused me of the notion that banks are intermediaries between private parties, which pushed me to think more deeply about the meaning of bank capital, and capital in general. Others who have the misfortune of having influenced my thinking on these issues include supercommenter JKH, Economics of Contempt, Wonkess, The Epicurean Dealmaker, James Kwak, Mike Konczal, and John Hempton. (I'm sure there are more I've missed: count yourselves lucky!) But the views expressed above are my own, and all of the people I've mentioned are far too sensible lend them any credence.

For Every Action ...

noreply@blogger.com (The Epicurean Dealmaker) — Fri, 11 Dec 2009 02:16:00 +0000

[This post originally appeared at The Epicurean Dealmaker on December 10, 2009. It is reproduced here in its entirety.]

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

The bankers they don't hire will all get fired by their employers and rehired immediately with guaranteed bonuses—which are exempt from the new tax, for now—or put on retainer as fiendishly well paid independent contractors. The Freelancers' Association of Great Britain should see its membership rolls and dues receipts increase 10,000%, and HM Treasury will no doubt promptly reclassify it as a bank for tax purposes. The stately annual dance of new tax regulation, evasion, and counter-evasion will begin to resemble a cage match at the Ultimate Fighting Championships.

The only parties for whom this will be an unalloyed benefit will be tax lawyers, accountants, and corporate relocation specialists. Their spouses and families won't see much of them over the Christmas holiday, but at least they'll be able to console themselves with frozen rum punch and figgy pudding in £10,000-per-night suites on St. Barts.

* * *

Despite all the frantic squealing by outraged bankers, it is clear the UK government enacted this policy not to "recapture" excess compensation from individual employees through personal taxation, but rather to dissuade banks from paying more than nominal bonuses at all. Instead, it wants them to use the money they save to bolster their weakened balance sheets. Chancellor Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

And, as the following little spreadsheet indicates,¹ he plans to do this by making banks choose between their employees and their shareholders:

Given a hypothetical bank with operating profit before discretionary compensation of one million pounds and one employee which management intends to pay half a million quid, the three rightmost columns show the effect on both employee and net income under the new policy under three different scenarios. Under the first, "equal bonus" scenario, the employee still walks away with his £500,000 pre-tax bonus, but instead of earning £360,000 as before, shareholders take a 66% hit to net income, to £122,500. Under the second, "equal net income" scenario, bank management preserves shareholder income at the pre-policy level of £360,000, but the banker walks away with 39% fewer pre-tax shillings. Finally, in the third, "equal pain" scenario, the bank tries to share the pain of the new policy equally between employees and shareholders, and each take a 24.5% hit to their earnings.

Of course, a stubborn bank could go right ahead and pay full discretionary bonuses to its employees, and under the new policy HM Treasury would drain half the excess straight out of the bank's equity account. This hardly seems conducive toward strengthening capital ratios in the financial sector, however. Presumably the government is relying on bank shareholders to scream bloody murder should management try this, not to mention bank creditors, who will scowl with disapproval as their obligors' creditworthiness looks to sneak out the door to a Ferrari dealership in the pockets of its employees.

Interestingly enough, this scenario is also one in which HM Treasury maximizes its own tax receipts, from the personal income and National Insurance tax paid by individual bankers on larger bonuses plus the direct corporate tax on excess bonuses. The silly thing about such a scenario, however, is that the UK government would be far more likely to have to plow its higher tax revenues right back into the newly weakened banking sector in the form of more direct support. Talk about a "doom loop."

Another complicating factor in this whole discussion is that employees often make up a substantial portion of their employer's shareholder base, especially at investment banks. At the extreme, if a bank had only one employee who also happened to be the sole shareholder, a proper tax minimization strategy would be to forgo a discretionary bonus entirely and book that amount into net income. This is because the standard UK corporate rate of 28% is far less punitive than the new 50% top personal rate for high earners, plus National Insurance deductions. But how would Mr. Eddington-Smythe pay his local grocer? Borrow money from his employer, perhaps? Oops, there goes the leverage ratio again.

* * *

On this side of the pond, the evil genius cephalopods at Goldman Sachs have come up with a different approach. The firm announced today that its 30 top executives will take all their discretionary compensation this year in the form of restricted stock, which they cannot sell for five years.

In principal, this strategy actually makes more sense than the UK tax policy does in terms of bolstering banks' and investment banks' balance sheets. For one thing, it implicitly acknowledges that a bank probably should pay something more than a £25,000 bonus to highly productive employees if it expects to keep them, and it puts no explicit upper limit on that pay. For another, it conserves the gajillions in cash a bank would otherwise pay out in bonuses and replaces it with common stock, and unvested common stock at that. That bolsters both the cash and shareholders equity accounts by the amount of deferred bonuses and strengthens the company's credit position. Furthermore, as I have pointed out before, bankers who receive deferred stock compensation are the best kind of shareholders to have, from a credit standpoint, because they are involuntary, long-term providers of permanent capital. No high frequency traders, these.

However, it's worth noting that as announced this policy only applies to the thirty Executive Committee members at the Squid. So, while it may conserve $300 or so million extra cash which would otherwise have been paid out as the cash portion of these executives' bonuses under prior policy, it says nothing about the up to $10 billion in cash which could presumably get sucked out the window in the pay packets of its non-executive employees. As a public relations stunt, and a sop to Congressmen and other populists on the warpath, it is genius, and Lloyd Blankfein and the other 29 sacrificial lambs probably have enough liquidity to weather the privation. But as a credit bolstering event for Goldman Sachs, it probably nets out close to a wash.

In addition, Goldman's new policy carries a real cost, too: increased dilution for non-employee shareholders. For, as our hypothetical little exercise above should have illustrated, there is a natural struggle over the spoils within a bank between its employees and its outside shareholders. The Goldman announcement makes no disclosures on this topic, but I can assure you top management is having heated discussions with major shareholders right now over just how many basis points of net revenue will go to investors and how many to the hired help.

* * *

This argument may be quite interesting to the parties involved—and their wives, mistresses, and household staff—but it has little practical import for those of us on the outside looking in. In fact, strong arguments can and have been made that an excessively large portion of the filthy lucre Goldman and other US banks' investors and employees are arguing over this year doesn't properly belong to them. A huge portion of the outsize sales and trading profits which have been fattening domestic banks' income statements is due to cheap funding provided both directly and indirectly by the government, direct subsidies from the US taxpayer, and the selective elimination of industry competitors through direct and indirect government action during the height of the financial crisis.

People who object to this situation claim the only sensible thing to do is for the taxpayers to claw back a chunk of these profits in the form of a windfall profits tax. Properly designed, such a tax would be levied against operating profits before compensation expense. Then, taxpayers would get back a portion of the outright subsidy they have been handing to the bankers, and bank employees and outside shareholders would be free to squabble over the remainder. The biggest challenge here, of course—apart from worrying about how to prevent politicians from making a temporary windfall profits tax permanent—would be to determine the proper amount of subsidy, and hence tax, to recover. The answer will always be somewhat arbitrary at the end of the day, but there is no reason a sensible number could not be figured out by a couple of accountants with a calculator and a bottle of scotch.

* * *

In any event, the policy tensions both here and abroad are clear: do we want banks to reduce employee payouts, retain capital, and bolster their weakened balance sheets, or do we want reparations of unearned, "excess" profits in the form of corporate, personal, or windfall profits taxes to the public purse? For conundrums like these, we have few instruments available except tax policy. But tax policy is a blunt instrument, and it acts on the economy a lot like a water balloon: every time we squeeze one end, the other end swells up bigger than before.

Moreover, I am sad to say that all available evidence seems to indicate our water balloon is a whoopee cushion, too.

¹ Please, please, UK types—especially accountants and tax advisers—cool your jets. I know this example is a gross oversimplification, and it simply does not reflect all the relevant details, the intense value added which you and your firm can bring to the discussion with your extensive expertise, blah, blah, blah. It is meant to illustrate a relatively simple point, for which task I believe it is perfectly adequate. As usual, regular readers of this site know not to take my scribblings seriously in any respect, much less in the cloistered thickets of taxation and accounting.

© 2009 The Epicurean Dealmaker. All rights reserved.

Other Voices – December 8, 2009

noreply@blogger.com (The Epicurean Dealmaker) — Wed, 09 Dec 2009 03:52:00 +0000

Where else could Kashkari have gone?, Felix Salmon. Neel Kashkari flees the woods (literally) for PIMCO:

Now it’s entirely possible that Kashkari went to Treasury out of pure selflessness — but he’s blazed a trail now (or at least he would have done had he not been following in the footsteps of many who went before him) and in future anybody moving to Treasury can expect that doing so is liable to do wonders for their employability and their chances of ever making a seven-figure income.

Hmm. Jumping into the welcoming embrace of the private sector so soon after leaving one of the most powerful and undefined governmental roles in financial history does seem a little ... unseemly. Perhaps my suggestion for a merged SEC and CFTC that we should "[d]ouble or triple ... professionals' pay, and impose a minimum five-year ban on joining any financial services provider after leaving the agency" should apply to Treasury, too.

A Windfall Profits Tax for Goldman Sachs?, Steven Davidoff, The Deal Professor. Provocative, to say the least. I worry that I have become excessively attracted to punitive, one-off solutions to intransigent structural problems. Must be my inner Bolshevist asserting itself.

Compromising my values every day, for you., Ultimi Barbarorum. Baruch defends financial markets as excessively complicated and sensitive emergent phenomena unsuitable for clumsy tampering. I think he also argues against a transaction (or Tobin) tax in there somewhere, but I seem to have misplaced my extensive notes.

Build It, and They Will Come

noreply@blogger.com (The Epicurean Dealmaker) — Tue, 08 Dec 2009 14:41:00 +0000

Mike Konczal over at Rortybomb¹ has weighed in this morning on my reformist manifesto. For the most part, he does not seem to have disagreed with me overmuch, which is either a sign that I am on the right track or that Mike is too much of a gentleman to reveal to the world that I am a hopeless idiot. I prefer to believe the former, despite all evidence to the contrary.

Anyway, he specifically comments on a handful of my proposals. While I do not disagree with the substance of his remarks, I thought it would be useful to respond in this forum with a few clarifications and comments of my own. He repeats my proposals in bold and comments below:

2) Narrow and focus the role of the Federal Reserve…3) Render Fed actions and deliberations transparent.

To me this is an either/or. If the Fed wants to be the systematic risk regulator and use its 13 (3) privileges in an expansive manner going forward, there needs to be a change in the way they are monitored. I understand 13 (3) goes back 70 years, but given that the Fed will use these privileges more aggressively in the future then they need to be monitored in an equally aggressive manner. Removing these regulation powers to outside the Fed (as the Dodd Bill currently proposes), means that there isn’t quite the same need for transparency (though the way appointments are made could stand to be reformed either way).

I think we really agree here. My proposal is to narrow the Fed's mandate to its core responsibility for monetary policy and price stability but add "responsibility for monitoring, controlling, and managing systemic financial risk." If we commission the Fed to act as our overall systemic regulator, as I suggest, of course we should increase legislative oversight of it. It is exactly the sort of non-monetary policy decisions like the Fed made in the case of AIG and others recently that must be examined in retrospect under a clear and searching light. Just reassign the Fed's other responsibilities for consumer protection etc., which it has sadly neglected, to other parties. Monetary policy, as far as I am concerned, can remain largely unexamined and protected from political interference in the deep dark hole where it has resided for decades.

4) Consolidate all banking supervision under one unified national regulator.

Yes. Also this is good for business too – the largest, most connected firms have the ability to regulator shop, while the smaller firms have to deal with overlapping, and often contradictory, regulation signals. This point was one of the community banker’s objections to the CFPA – having multiple regulators is a nightmare for small firms, even more so if you aren’t fundraising for their bosses and can compete them against each other.

Okay, but I do believe an independent CFPA or equivalent should exist for consumer financial protection separate from any unified bank regulator. The major reason for this, as I stated before, is that retail financial products and services are different in kind from institutional financial services, and they should be regulated separately. While there is no reason, I suppose, why a CFPA division could not live within the same walls as a federal bank überregulator, I think it would help clarity, efficiency, and oversight if it were separate.

Perhaps I am oversensitive on this point. My prejudice has been formed by watching the SEC make a hash of combined retail and wholesale regulation of securities markets for decades. Also, whichever agency regulates consumer finance, I believe it should do so both for banking products and services and for securities products and services offered to the average Joe. The barrier between these two delivery channels is far more porous than many realize, and I suspect they will continue to converge in the future. (I am not constitutionally averse to financial innovation which accelerates this convergence, as long as it happens under the eye of one coordinated, watchful regulator.) I guess I could be persuaded on this point, but someone will have to convince me a combined retail and wholesale regulator would not just end up looking like an even more bloated, less effective SEC.

* * *

Lastly (or firstly, in his case), Mike addresses my financial contribution ban/free speech proposal which has garnered a significant amount of attention elsewhere:

1) Ban political campaign contributions by the financial industry.

I think it might be ‘bill of attainder’ territory to just go after the financial industry, and banning all contributions is a free speech issue. I think an easier approach would be a simple “No contributions from firms regulated by the committees politicians serve on” rule. No financial industry contributions to those who sit on the Financial Services Committee, no energy contributions to those who sit on the Energy and Commerce Committee. I’m not sure if it would survive a legal challenge, but that seems fair in a way that might convince a lot of people – referees can only be taken out to dinner by teams that they don’t ref for – and it may also provide real incentives for those with some integrity to sit on the most hot-button issue committees while those who just want to cash out their representative position will all rush to the Bird Watching Committee or whatever.

Though that might just be me with diminished expectations – Lawrence Lessig is able to start convincing Richard Epstein on campaign finance, so maybe there’s room for a giant liberaltarian movement here.

I like his refinement of my blunt proposal, and I am sensitive to the free speech issues which such a ban entails. Surely whatever is done in this area will face severe legal challenge, but I truly believe it is worth pursuing. As I have written elsewhere, I believe that our system of financial regulation has been compromised not only by the obvious method of regulatory capture but also by legislative or "complete inside-the-Beltway capture." The nexus and vector for the latter, obviously, is money, and we need to figure out a way to change this.

Related reading:
Rortybomb: ED’s New Site: The New Decembrist (December 8, 2009)
TND: A Reformist Manifesto (December 5, 2009)
TND: Put a Sock in It (December 7, 2009)
TED: A Mighty Wind (June 18, 2009)

¹ Mike, I'm dying to ask: what does "Rortybomb" mean? Tell us, pretty please?

We Didn't Start the Fire

noreply@blogger.com (The Epicurean Dealmaker) — Tue, 08 Dec 2009 03:15:00 +0000

[This post originally appeared at The Epicurean Dealmaker on December 7, 2009. It is reproduced here in its entirety.]

Rob Slolom: "Wow. Eight Oscars, 400 million dollars at the box office, and you saved Tugg Speedman's career."
Les Grossman: "I couldn't have done it without you."
Rob Slolom: "Really?"
Les Grossman: "No, dickhead. Of course I could. A nutless monkey could do your job. Now, go get drunk and take credit at all the parties."
Rob Slolom: "I wouldn't do that."
Les Grossman: "Ah ... joking. "
Rob Slolom: "Ah, there he is! Funny. You're a funny guy."
Les Grossman: "Yeah. But seriously, a nutless monkey could do your job."

— Tropic Thunder

For what it is worth, O Dearly Beloved, you cannot count me among the rabid, spittle-flecked populists who lump private equity plutocrats in with venal investment bankers, clueless commercial bankers, meretricious mortgage brokers, and Nancy Pelosi's manicurist as the principal agents of our current economic desuetude. While it is true that many of these would-be Captains of Industry did purchase companies at preposterously high valuations in 2006 and 2007 at the orgiastic climax of the Sino-Greenspan credit bubble, the most the majority of these hapless boobs can be accused of is getting their wee-wees caught in the woodchipper of mistaken opportunity.

Vast herds of professional morons in the fixed income investor community apparently thought it was a brilliant idea to offer virtually limitless quantities of debt at virtually invisible interest rates with virtually zero credit protection to picayune ex-investment bankers so the latter could snap up the flower of American (and global) industry at 250% of retail. With limited exceptions, said PE types said "What the hell," and signed on the dotted line. After all, their fiduciary and professional duty to their own investors is simply to maximize returns on contributed capital. And, in the unexpected case their investments went belly up, the PE professionals and their limited partners could just hand over the keys to the failed portfolio companies to their embarrassed lenders. What was not to like?

Of course, many of the overlevered companies owned by private equity firms are now struggling or have failed entirely. Hundreds if not thousands of employees who worked at these investments have been laid off, and thousands if not millions of citizens whose pension funds or universities invested in their shitty debt have taken it in the neck. But caveat emptor, eh?

Like many other participants in the Great Financial Clusterfuck of 2008, private equity professionals helped make things worse for everybody through the unholy combination of personal greed, institutional incentives toward excessive debt, and general shortsighted arrogance, but they did not cause the crisis. Furthermore, I do believe the version of the private equity model which focuses on making substantive operational and strategic improvements to portfolio companies—rather than just levering them up the wazoo and hoping for the best—is a valid and effective alternative investment strategy in this economy. Many companies can be materially improved by the tender ministrations of a cigar-chomping five-foot-four inch sadist who would just as soon waterboard a manager as look at him. And they were.

* * *

Paragons of Sweat Equity Capitalism or not, private equity professionals are coming under the legislative microscope along with all the other financiers and hangers on who wear suits that cost more than the average Congressman's car. But in their case, the focus of regulatory reform is taxation, particularly that form of personal taxation peculiar to our hobbyist industrialists and known to all and sundry as carried interest.

I will let Floyd Norris explain:

The “carried interest” tax break lets private equity partners claim that their compensation is really long-term capital gains, since they are allocated percentages of the profits earned by their investments.

The Ways and Means Committee wants to end that, and today a trade group, the Private Equity Council, protested:
“Raising taxes on growth investments by private equity, real estate and many other partnerships just doesn’t make sense — particularly in this time of fragile economic recovery and continuing joblessness. By more than doubling the tax rate, the carried interest proposal will discourage investment; deprive many American businesses of the capital they need to survive and grow; and jeopardize critical job creation opportunities.”

Uh, no. I call bullshit.

We have been down this goat path before (masochists see "Related reading," below), and I remain utterly unconvinced that raising the personal taxes of a couple thousand billionaires, multi-millionaires, and would-be millionaires on the fruits of their labor would have any effect whatsoever on the ability of corporations to find private equity backers for their businesses. After all, the entities which provide approximately 95% of the equity which these Scrooge McDucks play with—pension funds, university endowments, and other large institutional investors—are either tax exempt or completely indifferent to the plight of their PE portfolio managers. And if a couple hundred of these quackers decide to take their (relatively) paltry marbles off the table and stalk off in a huff to endless champagne and chlamydia on the French Riviera, I don't think anyone will miss them.

Then there's the whole "fairness" issue. I will let Mr. Norris expound his view:

Personally, I am not sure that capital gains should get tax breaks anyway. But for private equity partners, who are earning huge sums of money by their skill at investing other people’s money, it seems particularly inappropriate. They earn money from their labor, just like the rest of us.

May I suggest a simple rule to be considered by Congress. “No executive should pay a lower tax rate than the rate paid by the person who cleans the executive’s office.”

There, that should set a few sardonic memoirists' blood boiling.

* * *

On the other hand, I seem to recall reading that the CBO estimated the aggregate proceeds to Treasury from taxing Steve Schwarzman and his fellow übermenschen like normal human beings would only amount to a few billion dollars over several years. So it's not like we're gonna recover the money we've pissed down the drain at Citibank and AIG by picking Henry Kravis's pocket. But then again, every dollar counts, and if I can avoid paying a few more shekels in taxes because we decide to stop treating pencil-necked MBAs like Andrew fucking Carnegie, I will be more than satisfied.

And if the private equity plutocrats don't like it, I would point them to the immortal words of yet another flaming asshole of my acquaintance: "That's baseball."

Related reading:
Tax Breaks for Everyone! (June 14, 2007)
J'accuse (June 15, 2007)
J'accuse, Part Deux (June 27, 2007)
The Taxman Cometh (July 11, 2007)
B(ogus Ta)X (July 13, 2007)

© 2009 The Epicurean Dealmaker. All rights reserved.

Put a Sock in It

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 07 Dec 2009 19:01:00 +0000

Ooh, this is getting fun.

An unnamed bloggist at Salon.com has picked up my anti-Constitutional ball and is running with it. In a post this morning entitled "It's time for Wall Street to just shut up," (s)he gives more background on the reasoning behind the first proposal from the reformist agenda I posted here recently:

Yes, constitutional freedom of speech protections apply even to banks. But the system is clearly broken

The Epicurean Dealmaker has posted a ten-point manifesto for regulatory reform. Everything on it makes sense to me, starting with point one:
1) Ban political campaign contributions by the financial industry.
At The Baseline Scenario James Kwak observes that "there is at least one constitutional problem and possibly two" involved in the recommendation. That's a non-trivial issue.

But the financial industry's influence on legislation is equally non-trivial. There's got to be a better way. Check out the bombshell in Michael Hirsh's new Newsweek piece on Barney Frank and the perils of crafting new regulations for derivatives trading
In the first three quarters of 2009, financial-industry interests have spent $344 million on lobbying efforts, putting them on pace to break all records, according to the Center for Responsive Politics. That's just for lobbyists' and lawyers' salaries, junkets, and dinners, and doesn't include political donations and issue ads. Even more impressive is the lobbying strategy that money is buying. According to insiders and industry e-mails obtained by NEWSWEEK, the banks have sought to stay in the background and put their corporate customers -- a who's who of American business, including Apple, Whirlpool, and John Deere -- out in front of the campaign. "This is an orchestrated, well-funded effort by the banks to manipulate our legislation and leave no fingerprints," says a congressional staffer involved in drafting the legislation.
An industry that would not even be functioning without massive government help is now spending money at a record pace to prevent legislators from fixing the system so as to avoid a repeat. Set aside conflict of interest issues. The sheer gall of banker arrogance and self-interest is inexcusable. As none other than Treasury Secretary Timothy Geithner told Bloomberg News on Friday, even Goldman Sachs' protestations that it would have weathered the financial crisis without government assistance are nonsense.

There is more.

Now, I am no constitutional lawyer (thank God), but it does strike me that one can draw a useful distinction between "freedom of speech" and "freedom to influence policy through direct and indirect bribery," which is what a very large portion of our current lobbying and campaign contribution system seems to encourage. This problem is not limited to the financial services industry, either, but rather permeates the entire political and legislative process in this country.

I think few people would deny that the current system encourages undue influence and bad policy.

Is there a solution? (The lawyers may now speak.)

Sources: It's time for Wall Street to just shut up at Salon.com.

Revolution and Reform

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 07 Dec 2009 16:02:00 +0000

[This post originally appeared at The Baseline Scenario on December 7, 2009. It is reproduced here in its entirety with the kind permission of the author.]

Many of us bloggers are better at criticizing than at proposing anything — especially when the world makes it so easy to be a critic. The Epicurean Dealmaker, who has sent the occasional volley of criticism my way (I’m not linking to examples because my ego is too fragile), recently decided to deal with this head-on and wrote a “reformist manifesto,” complete with an epigraph from The Communist Manifesto, with a list of specific proposals.

Basically these include cleaning up the regulatory structure, expanding the scope of regulation (consumer protection, hedge funds), moving “virtually all” OTC derivatives onto exchanges or clearinghouses (I believe that “virtually all” means the currently-proposed exemption for “end-user” hedges would be drastically reduced), and increasing Fed transparency. There is also this one: “Ban political campaign contributions by the financial industry.” I think that would be great, although there is at least one constitutional problem and possibly two there.

There’s nothing on the list that I disagree with.

However — and there’s always a however — I worry that it won’t be enough. TED consciously leaves the details to what he hopes will be “strong, competent, and well-informed regulators.” Several of his proposals, such as rationalizing Congressional oversight (to eliminate the current situation where the industry can arbitrage between the Senate Agriculture and Banking Committees), should help mitigate the problem of political interference and regulatory capture, but will it be enough? After all, George Stigler’s paper on regulatory capture wasn’t about the financial sector in particular — it was about all regulation, all the time.

In a sense, this comes down to whether you place more faith in Congress or in regulatory agencies. I know defending Congress is a tough sell these days, but for example they did pass something called the Clean Air Act about forty years ago. And when, under the Bush administration, the EPA decided that greenhouse gas emissions didn’t fall under the Clean Air Act, the Supreme Court told the EPA it had to enforce the law. That said, there is also a famous 1984 case in which the Court said that in general regulatory agencies were free to interpret statutes how they choose, so this is not a black-and-white topic.

As far as what I would do instead or in addition, I lean toward Simon and Peter’s earlier post, although Simon and I have had some discussion of the details since then.

You’ll note that TED’s post is not on his personal site, but on The New Decembrists, a new site where he hopes to aggregate discussion regulatory reform in particular. (Bonus points for the historical reference, although that’s nothing new for TED.)

By James Kwak

Cap This!

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 07 Dec 2009 15:24:00 +0000

Lest we forget that the recent financial crisis has imposed real costs on the real economy, Simon Johnson of The Baseline Scenario reminds us, at length.

He claims that bailing out financial institutions considered too big or too connected to fail was the principal vector in the recent contagion, and he asserts we will have fixed nothing if we do not fix this:

9) At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Again, this is the problem in the U.S. looking forward.

And in Europe, too, a point which Mr. Johnson makes as well.

His solution? Explicitly limit the size of financial institutions through the imposition of hard caps:

2) There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits. This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

3) This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

4) Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy. Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

5) What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

6) A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio. On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

This seems to be a sensible goal. Other commentators, including the likes of Felix Salmon, have argued in the past for a hard cap of $500 billion on the largest financial institutions. Certainly the number itself can be argued about, and as usual the devil will hide in the details of exactly how one counts the liabilities of a financial institution in an age of securitization, off balance sheet liabilities, and over the counter derivatives. Nevertheless, it seems like a sensible starting point.

However, Mr. Johnson fails to mention what I consider to be an equally if not more important point: what financial leverage we will allow these institutions to maintain. It will do us no good whatsoever to have a bunch of globally interconnected $500 billion financial intermediaries if they are all levered 15-, 20-, or 30-to-1. At least in the subsector known as investment banking, one can make a strong argument that it was leverage which killed Bear Stearns and Lehman Brothers, not simply their sheer size.

Equity, or permanent capital, is the one shock absorber and resource available to a financial institution which allows it to weather the storm of a financial panic or run on the bank. After that, the only ones left to pick up the pieces are the failed banks' creditors and, as we have been so sadly reminded recently, ourselves.

Sources: Measuring The Fiscal Costs Of Not Fixing The Financial System by Simon Johnson of The Baseline Scenario.

Punish the Monkey (and Let the Organ Grinder Go)

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 07 Dec 2009 02:27:00 +0000

[Submitted by Josh Brown of The Reformed Broker]

The boss has hung you out to dry
And it looks as though
they'll punish the monkey
and let the organ grinder go

— Mark Knopfler, Punish the Monkey

When ex-Dire Straits frontman Mark Knopfler put the song "Punish the Monkey" on his 2007 masterpiece solo album, he probably had no idea how prescient its lyrics would soon become.

When I think about the next wave of regulation headed toward a brokerage firm or a bank near you, my main hope is that the rule-makers are focused on the "organ grinders" themselves rather than on the proverbial monkey. The monkey, who has merely been dancing to the only tune available, has the most to lose in a regulatory overhaul. It is the organ grinders who can usually find a way to keep the largest portion of the profits toward the top of the the organizational structure, even in restrictive environments.

While you cannot legislate every instance of unrestrained greed, avarice, recklessness and fecklessness out of existence on an individual basis, you can certainly make laws to prevent entire corporations and industries from the mass adoption of these non-virtues.

To single out one or two groups of the financial-industrial complex (say, traders or advisors) for extinction-level scrutiny would be to ensure that the next great scandal arises out of the intent of some to subvert the new rules.

Rather, the regulatory arms should attempt to wrap themselves around the root malefactors of our present predicament. I'll save everyone the time of trying to guess whom those malefactors may be: The top five anointed investment banks who've been socially-engineered into their "too big to fail" and "too favored to compete with" status by the regulatory bodies themselves. It was the apocalyptic greed and insatiable appetites of these firms, coupled with a laissez-faire culture overseeing them, that allowed for the growth and malignant rot in all of our post-millennium bubbles.

My suggestion to the reformers is to empower second and third tier competitors so as to create a deeper and wider pool of competence. With a decentralized lending, trading and investing mechanism, we can more easily cordon off the weakened and rogue firms so that no one is above being taught the cautionary lesson of failure and bankruptcy.

To just pass more restriction and make the business of business more onerous for all participants would be the very definition of punishing the monkey. Instead, let competition thrive so that other players can serve as the ultimate safeguard against a Bear Stearnsian vortex of risk.

The next time a Banker-CEO's eyes prove to be too large for his stomach, there will be others to absorb the damage and advantagously clean up the debris before it maims the taxpayer.

Free markets and relentless competition, not the old government-sanctioned Pentarchy of I-Banks.

Joshua Morgan Brown
The Reformed Broker
December 6th 2009

From the Editor

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 06 Dec 2009 22:50:00 +0000

Dear Readers, Collaborators, and Commenters —

As the financial Panic of 2008 recedes in our collective rearview mirror, this author has become increasingly interested in and engaged with the debate surrounding the proper shape and content of financial reform. While I am no expert in the regulation of financial services—nor indeed in almost any of the cognate fields which inform, impinge upon, and affect financial regulation—I am a practitioner in one financial subsector which, for better or worse, has played a central role in the panic and its aftermath; namely, investment banking.

Having practiced M&A and corporate finance within investment banks for approximately two decades, I have an insider's perspective on certain aspects of financial regulation on which many, many people—ranging from exceedingly well-informed and erudite all the way to woefully and stubbornly ignorant—have begun to opine. I myself have many opinions, prejudices, and predilections for what I believe the new regulatory framework for the financial system should look like, and I have shared several of those thoughts on my own blog site on occasion.

However, I am humble enough to realize the extent of my own ignorance, and I am eager to hear from others who have sensible, intelligent, and challenging things to say on this topic. I have been frustrated by how scattered those comments, ideas, and conversations have become, especially in the unregulated and disorganized sphere of the internet. Clever ideas and trenchant conversations take place on widely dispersed and otherwise unconnected blog sites and in the ephemeral and staccato medium of Twitter and email. I believe this weakens both the quality of the conversation and the potential impact these ideas might and should have on the politicians, industry participants, and regulators who have been tasked with fixing the mess we find ourselves in.

Hence, I have started this website to collect in one place the ideas, thoughts, papers, and posts on the topic of our current financial system, its regulatory structure, and the ways in which they should both be reformed which I have stumbled across in my virtual travels. I also hope to entice some of you reading this and engaged in the discussion to contribute your own thoughts here as well, both by means of contributing your own original posts and by adding your voice to the comment streams.

Unlike my other site, this blog site is intended to be a true collaborative forum for open, intelligent discussion. I welcome your ideas, submissions, and thoughts as to how this site should best operate going forward. Please contact me at the following address (not clickable):

Forward, comrades! We have nothing to lose but our chains!

— The Epicurean Dealmaker

The New Decembrist Manifesto

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 06 Dec 2009 22:46:00 +0000

On December 14, 1825 (old style), according to Wikipedia, officers of the Imperial Russian Guard

led about 3,000 soldiers in a protest against Nicholas I's assumption of the throne after his elder brother Constantine removed himself from the line of succession. Because these events occurred in December, the rebels were called the Decembrists (Dekabristy, Russian: Декабристы). This uprising took place in the Senate Square in Saint Petersburg.

The loyal soldiers who became known as the Decembrists held many divergent views, and they cannot be said to have pursued a unified program of change. However, they were united by two fundamental beliefs: they wished to increase social, legal, and economic justice; and they wished to change the existing Russian political system through reform, not revolution.

It is in this spirit that this site appropriates their name. Winston Churchill famously proclaimed:

Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.

We would like to say the same about capitalism as a form of economic organization. We do not seek revolution, or the destruction of what we currently have. We seek only to fix it, to make it better than it was. How we should do that, however, is a proper subject for debate.

Please join the conversation.

A Reformist Manifesto

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 06 Dec 2009 00:15:00 +0000

[This post originally appeared at The Epicurean Dealmaker on December 3, 2009. It is reproduced here in its entirety.]

The Communists disdain to conceal their views and aims. They openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions. Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win.

Working Men of All Countries, Unite!

— Karl Marx and Friedrich Engels, Manifesto of the Communist Party

It has not escaped my notice, O Estimable and Valued Readers, that you have displayed remarkable patience with Your Dedicated Correspondent over the last many moons of the ongoing financial crisis and its aftermath. I have ranted, I have railed, and I have hopped up and down spluttering like a one-legged kangaroo rat on a hotplate over the many failures of our present regulatory system to have avoided or even anticipated the financial tsunami which rolled over us. "Sure," I have seen you mutter to yourself, "TED has fulminated rather spectacularly about what went wrong, and how idiots, nincompoops, and boobs of every stripe screwed the pooch, but what does he suggest? Does he have any ideas, or is he merely content to take potshots at financiers, regulators, and politicians and leave it at that?"

This is a fair question, and I think you deserve an definitive answer. Being none other than who I am, however, you can rightly expect that I will give it to you with both barrels. Subtlety and nuance be damned.

I know full well what I propose is at least a bridge too far, a utopian dream doomed to ignominious death in the fetid swamp of pragmatism, special interests, and meretricious compromise which poses as our vaunted Legislative Branch. A death by a thousand cuts, each made ruefully and reluctantly by unimpeachably reasonable men and women who sport weary smiles and practiced shrugs. Men and women who explain "That's just how it is," or murmur an even simpler answer: "Politics."

But even given this—given that commentators and politicians alike have been writing fulsome obituaries for financial reform since before the first draft sprang aborning from the pen of some Congressional aide—one can still ask why should we not aspire to more? Why should we not try to map out the right answer to our problems first? The simple answer, the clear answer? Then, after we have gotten our bearings, we can debate and argue until the cows come home about the details, the practicalities, and the unintended consequences we want to forestall. Right now, all this debate—if it is taking place at all—is being conducted in the back halls, offices, and lobbies of Capitol Hill, out of public view, by the self-interested financial parties we seek to regulate and the craven legislators who hold themselves in thrall to them.

This is no way to reform our financial system, much less run a representative democracy.

* * *

So let me slap some markers on the table, in the interest of public service. These are concrete ideas which have occurred to me over the course of listening, reading, and participating in the debate over regulatory reform over the last many months. I claim no originality for these ideas, and I cheerfully admit that most if not all have already been put forth by thinkers and writers who are cleverer, better educated, and more eloquent than me. If I can claim credit for anything here, it is in laying out the best of these ideas in the most extreme form. Let us set the perimeter of the debate, and the dimensions of the playing field, before we start arguing over the color of the contending teams' jerseys.

In no particular order, here we go.

1) Ban political campaign contributions by the financial industry. We currently have the best politicians money can buy. I suspect it might be conducive toward better governance should this channel of undue influence be severed. Can you disagree?

2) Narrow and focus the role of the Federal Reserve. The Fed should continue to focus on monetary policy, price stability, and employment. It should add responsibility for monitoring, controlling, and managing systemic financial risk. Of all existing or potential regulatory entities, the Fed is best placed to do the latter. On the other hand, it has failed pathetically to protect consumers, control derivatives, or manage mortgage markets. These and any other non-core duties should be summarily stripped from it. Focus, focus, focus.

3) Render Fed actions and deliberations transparent. Secrecy runs counter to the public weal. Impose a delay of three months, six months, or whatever, but open the minutes of all material Fed actions and decisions to public scrutiny after the fact. This is called accountability, and the Fed must not be immune from it.

4) Consolidate all banking supervision under one unified national regulator. No more "regulator shopping." No more races to the bottom. Should there be real functional and regulatory differences among thrifts, savings and loans, small local and regional banks, and large money center behemoths, I am sure our clever regulators can make the distinction and set up appropriately diverse and differentiated regulatory regimes. Just do it under one roof, I beg you. I have heard no defensible reason whatsoever why this does not make sense.

5) Create a separate, independent consumer financial protection agency charged with regulating all consumer financial products and services. Regulating consumer or retail financial services is different in kind from regulating wholesale or institutional products. Among other things, consumers need protection in a way institutions do not. There is absolutely no reason why consumer protections should not be monitored by a single, dedicated regulator. If it has to do with money, and consumers, this entity should regulate it. In addition to improving the position of ordinary citizens vis á vis their financial service providers, unitary regulation of this field should encourage consumer-friendly innovation across products and services, since there will be only one regulator to deal with. The only long-term question is why this entity should not take over the consumer protection functions of the SEC when it comes to securities and markets. (My answer: it should.)

6) While we're at it, why not create a national insurance regulator? Honestly, the current state-by-state regulation of insurance companies is preposterous, and massively consumer unfriendly. At base, insurance is a very simple business, and consumer choice and value should be improved by national consolidation. Why should this be an issue of states' rights? Anyone? Anyone?

7) Create an integrated regulator of wholesale and institutional financial markets. Merge the SEC and the CFTC. Bolster its combined budget. Make broker dealers and other regulated entities provide operating funds through levies. Upgrade its systems, procedures, and personnel. Double or triple its professionals' pay, and impose a minimum five-year ban on joining any financial services provider after leaving the agency. Increase accountability, esprit de corps, and morale. Hire leaders who are dedicated to turning it into an agency everybody wants to join, instead of a laughingstock. Destroy all evidence that Christopher Cox ever darkened its doors.

8) Register and monitor hedge funds. Honestly, are we going to quibble about collecting information in this space? For what, compliance and reporting fees which will add up to less than Steve Cohen spends on Chunky Monkey ice cream every month?

9) Force virtually all over the counter derivatives onto exchanges and clearinghouses. This will increase visibility, improve netting and credit relationships, bolster systemic stability, and lower costs in most instances. (More information = lower prices.) Exceptions for highly customized OTC derivatives and/or pure end-user hedging instruments should be made on a product-by-product and case-by-case basis. If nothing else, such a regime would have enabled counterparties, regulators, and other market participants to have seen stupid, reckless, unlimited naked-put writers like AIG Financial Products coming from a mile away. How, exactly, will greater transparency and easier margin and credit control increase costs in these markets? They won't. Disagree? Prove it.

10) Simplify and rationalize Congressional oversight of financial regulators. No more oversight of financial derivatives by the Agriculture Committees, I beg you. Pretty please?

* * *

Please note that I say nothing about the particular policies which these new entities should create or enforce. Nothing about the critical issues of maximum leverage, separation of commercial, retail, and investment banking, compensation, or explicit limits on firm size or connectivity. This is intentional.

While I have some firm opinions on the right answers to many of these questions, I think it is far more important to set up strong, competent, and well-informed regulators for the financial sector than to worry about policy particulars right now. For one thing, our current regulators simply do not have enough information or understanding about the current financial system to start making those kinds of decisions. And I think most reasonable observers would agree the financial system is dynamic enough to render static regulation by explicit legislation impractical, if not downright dangerous. Set up strong regulators with clear mandates and well-defined duties, and they will come up with the right policies. What we need to do now is sever some of the improper and counterproductive patterns of influence that have hobbled regulators in the past and let the overseers of the system do their job.

Simplify, simplify, simplify. The global financial system is complicated enough as it stands. We should not render its overseers' jobs more difficult by forcing their activities into outdated, counterproductive patterns designed three quarters of a century ago for a far simpler time. Sure, many of the very same professionals and regulators who fucked up so comprehensively last time will be hired into the same roles at the same or different institutions. These brand new spanking institutions themselves will be vulnerable to the same bureaucratic sclerosis, political and ideological pressures, and civil service mentality which afflicted their predecessors. But it's time to shake things up, to clear away the underbrush, and to make a clean break with the past.

And if our elected representatives in Washington are incapable of doing this, then perhaps it is time we took to the barricades ourselves.

If I had my way
If I had my way
If I had my way
I would tear this old building down

— The Grateful Dead, Samson and Delilah

Comment Policy

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 05 Dec 2009 17:00:00 +0000

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