naked capitalism

You have to love it. If the allegations prove true, it provides further evidence that the banksters cannot contain themselves. Here they get their bacon saved by the TARP (which was way too cheaply priced relative to the risk involved) and a host of hidden subsidies and supports. Yet the employees cannot stand to let an opportunity for personal enrichment go to waste, legal or not.

The Financial Times appears to have broken the story that the Office of the Special Inspector General is investigating reports of insider trading in connection with the TARP. And what makes this probe potentially serious (aside from the brazenness of it) is that the suspects include executives as well as foot soldiers:

Eight of the largest banks in the US received between $2bn and $25bn in October 2008 under a programme to prop up the financial system led by Hank Paulson, then Treasury secretary.

Dozens more institutions followed and Mr Barofsky, who examines the troubled asset relief programme, is looking into whether information improperly made its way to trading rooms during a feverish period in which the government and banks were frequently exchanging information.

“We have pending investigations looking into that – typically into insider trading,” he said. “Once upon a time getting Tarp funds actually meant your stock price would go up and we are looking at specific trading around Tarp announcements by insiders or looking at potential tips from insiders.”

Yves here. With the notable exception of the network surrounding , Raj Rajaratnam, nearly all insider trading scandals have involved junior employees as the ones leaking confidential information, usually on corporate mergers. While most M&A deals involve lots of junior level support, knowledge of pending TARP financings at a particular firm would presumably be limited to comparatively few people, and then largely the very top officers.

SIGTARP is also looking into possible gaming of the Public Private Investment Partnerships, a potential pitfall that had worried many commentators. Note he indicates here the trades he is questioning may have been permissible, reflecting weak controls and program design:

Mr Barofsky….said there remained substantial problems with the structure of the public-private investment programme, which is designed to encourage investors to buy troubled assets from banks to clean their balance sheets and stimulate lending.

He said there should be walls between fund managers taking part in PPIP, which co-invests government funds with those of the private sector, and managers at the same firm buying and selling similar securities.

An example of suspicious activity at an unnamed firm showed a manager selling a security from a non-PPIP fund and then buying it back at a slightly higher price with a taxpayer-supported PPIP fund minutes later.

“The rules are insufficient,” said Mr Barofsky. He said even if the behaviour, which Sig-Tarp is investigating, was found to be within the rules “it still creates this credibility issue, this reputational damage, this appearance of fund managers gaming the system”.

The Treasury said it had identified the suspicious behaviour and brought it to the attention of Sig-Tarp, showing that the system was transparent.

Yves here. Ahem, “bringing it to the attention” of SIGTARP falls well short of a remedy. And as we discussed at length, the PPIP made no sense unless it acquired securities at above current market prices (the whole point was to avoid having banks mark soured positions down to current market levels; had they been willing to do that, there would be no impediment to selling them). It will be interesting to see whether SIGTARP examines the contradictory claims made for the PPIP (that it was a good deal for the banks and taxpayers) and exposes what the structure was designed to hide, namely, the amount of the subsidies.

Apologies, no Links, I need to be up early to catch a flight and have not even started to pack.

Paul Volcker has an op-ed in the New York Times that made my stomach sink. I had considerable hopes for Volcker’s involvement in financial reform; he’s one of the few regulators with the stature (literally and figuratively) who can say things to bankers, the media, and government officials that are unpalatable yet need to be addressed.

For instance, I’ve been delighted with Volcker’s frontal challenge to the financial services industry continued insistence that it needs to be unfettered so it can continue to “innovate”. This looks like yet another bit of Orwellianism; innovation in the financial services is tantamount to “creation of complex products that let us extract fees and shed our risks in ways the customer won’t understand.” One thing to keep in mind: even a otherwise sound investment is no good if it is overpriced, and loading in hidden charges will to just that. The most recent innovation that Volcker approves of is the ATM. He gave made some disapproving remarks to a gobsmacked audience in Sussex late last year:

Echoing FSA chairman Lord Turner’s comments that banks are “socially useless”, Mr Volcker told delegates who had been discussing how to rebuild the financial system to “wake up”. He said credit default swaps and collateralised debt obligations had taken the economy “right to the brink of disaster” and added that the economy had grown at “greater rates of speed” during the 1960s without such products.

When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed “nothing at all”, he replied: “You can innovate as much as you like, but do it within a structure that doesn’t put the whole economy at risk.”

Yves here. So how can you not be a fan? Well, as much as Volcker’s is suitably skeptical of the 21st century version of financial services, his remedies would work for the industry circa 1990, but look anachronistic for the world we live in now.

Now admittedly, I am basing my views on Volcker’s recent remarks and his New York Times op-ed. Now that Tall Paul has been brought in from the wilderness and is the new face of Team Obama banking industry “reform”, his freedom to state his own views may be more circumscribed than before.

But regardless, in all his comments before, there is a scary failure to mention some critical aspects the modern world of finance. The big reason banks are too big to fail is that they control infrastructure which has become critical to commerce. Most important, they control the credit markets. And credit is essential to any economy beyond the barter stage.

One reason it is hard to make this notion as explicit as it ought to be is that “banks” covers a very wide range of firms, ranging from ones that look like traditional commercial banks (they take deposits and make commercial and residential loans), to ones with substantial asset management businesses (State Street) to ones heavily involved in transaction clearing (Chris Whalen contends that JP Morgan is a $76 trillion derivatives clearing operation with a $1.3 billion bank attached) to global capital markets players like Goldman, UBS, and Deutsche Bank.

The part that Volcker keeps skipping over in his various statements is the thorniest problem from a policy standpoint: what to do with global capital markets firms. We have had an over twenty-year shift in practice. By most measures, the amount of lending that winds up being held by banks has fallen by more than 50%. Geithner, in a 2007 speech on financial innovation, noted that US banks were responsible for a mere 15% of non-farm, non-financial debt outstandings. The rest takes place via what Geithner calls “market based credit” or what others call the “originate and distribute” model (although Geithner also clearly includes credit default swaps in his use of “market based credit”).

Now even assuming we wanted a partial reversal (more on balance sheet lending), this is not an quick process. It is costly (as in banks on average would have to have much bigger balance sheets, hence vastly more equity than they possess now. Think of what it would take to reduce the use of plastic by 50% because we now know plastic has nasty environmental consequences. Going back to considerably more on-balance sheet lending would be a similarly large undertaking).

The consequence of this system of “market based credit” is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial. The Bank of England in its April 2007 Financial Stability report noted the importance of certain firms it called “large complex financial institutions” and deemed them to be important not simply due to their size, but also their crucial position in certain markets. Its list then was:

ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS

Of course, that list is somewhat shorter now, but a bigger issue remains: if you tried breaking the capital markets operations of these dominant firms up, those businesses would tend to evolve back into a concentrated format. And it is these origination and trading operations that make them too indispensable to fail.

In reading Volcker’s op-ed, he completely ignores the 800 pound gorilla in the room, that this crisis extended a safety net under these global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people’s money. Now they play with other people’s money and a guarantee. Having the officialdom say it ain’t so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.

If you read the Volcker piece, “How to Reform Our Financial System,” you see an utter failure to acknowledge the problem posed by OTC credit markets (and before you say, “Put them on exchanges,” instruments with low liquidity don’t work well on exchanges. I can give you the longer form argument, but this post is already getting long. A lot of financial products simply do not trade often enough for them to be suitable to exchange trading).

Volcker first talks about traditional banks:

…we need to recognize that the basic operations of commercial banks are integral to a well-functioning private financial system. It is those institutions, after all, that manage and protect the basic payments systems upon which we all depend. More broadly, they provide the essential intermediating function of matching the need for safe and readily available depositories for liquid funds with the need for reliable sources of credit for businesses, individuals and governments.

Yves here. No where in the article does he acknowledge that, as a result of policy, much of this activity has shifted to trading markets. We still get a traditional bank-centric view:

Instead, governments have long provided commercial banks with the public “safety net.” The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform.

Volcker then proceeds to act as if we have traditional banking versus proprietary trading of various sorts. He discusses the flawed distinction in his proposal, of customer trading versus proprietary trading, not to suggest that market making has become (like it or not) an integral component of our credit system:

The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally.

Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships….the three activities at issue — which in themselves are legitimate and useful parts of our capital markets — are in no way dependent on commercial banks’ ownership. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a “level playing field” without clear value added.

Yves here. Notice the gap and the slippery use of “capital markets’? Volcker talks about commercial banks, then talks about “independent funds…independent capital markets institutions.” Where are the trading desks that serve these funds and other investors? He at best alludes to it (“heavily dependent upon commercial bank services….including prime brokerage”). Then we get this:

Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be “too big” or “too interconnected” to fail….What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption.

Yves here. Huh? What does he mean here? In context, is it not clear whether by “investment banks” he is referring to firms that engage only principal investing type activities, or referring players like Goldman and Morgan Stanley who are market-makers (as are Citi, Barclays, SocGen, etc.). And even if he does mean to include market-making (and it does appear he has switched gears) this bit does not inspire confidence:

The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.

To help facilitate that process, the concept of a “living will” has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts.

Yves here. This idea is not politically viable, and it may not be operationally viable. AIG illustrates the difficulty of knowing how big these black holes will be when they open up, and further illustrates that they tend not to happen in isolation (as in a downdraft that can take out one systemically important player has probably imperiled others). It is not acceptable in a democracy to give the Treasury the near-unlimited check-writing authority to deal with systemic failures of highly-connected firms. While he mentions in passing the problems of connectedness, there is not enough focus on it here (and as we have discussed in earlier posts, the initial derivatives reform proposal did not do enough to address the real problem, credit default swaps, and its watered-down version looks certain to leave this product as hazardous as it was before).

And while Volcker does speak of the need for structural reform, which is absolutely necessary, his outline does not go anywhere near far enough to start defusing the bomb that financial services deregulation managed to create.

I believe this problem is solvable, but it requires even more intrusive measures than Volcker contemplates. The lesson of the Great Depression was that firms that benefitted from government guarantees had to be kept on a very short leash, and regulated in such a way that if they stayed within the rules and were competent, they would earn decent, but far from spectacular, profits.

The world has evolved so that many market making activities are now as essential to commerce as deposit gathering and lending. Those activities are de facto backstopped; there is simply no ready way back here (trust me, even if there were, it would take twenty years, and we’d still need an interim solution). We need to regulate those activities aggressively, including requiring much more capital to support them, and strict limits as to how much and what type of credit these firms can extend to hedge fund and other speculative investors.

The unintended message of Volcker’s op ed may be that even someone as tough-minded as he is may not recognize the magnitude of structural change needed to limit the extent of government guarantees to the financial sector and contain officially-backstopped risk-taking. It would be better if I were wrong, but we may need yet another crisis to produce the needed political will.

Reader John D sent a link to an Atlantic Monthly story that appeared in its December issue, “Did Christianity Cause the Crash?”. Although this piece is arguably dated, I though it was worthy of consideration. It makes an argument I haven’t seen made elsewhere; a quick search of the blogs to which I subscribe confirms it received far less attention that it deserved. One reason might be the headline; it overstates the article’s thesis. But as likely is that the article complicated the tidy narratives that many people seem to have constructed about subprime borrowers.

Whenever this blog has brought up the idea of mortgage mods or bankruptcy cramdowns, the response has tended to be wildly polarized. Some readers are pro some form of resolution regarding severely stressed borrowers, whether for reasons of efficiency (as banks used to do mods before the age of securitization; it can be a better economic outcome to restructure a debt than foreclose, not just for the borrower, but also for his neighbors) or the belief that a fair number of borrowers had bad luck (medical bankruptcy, job loss, etc.). Another set of readers is vociferously opposed, generally for reasons of fairness and morality (these readers themselves often consider themselves to be prudent; the arguments are sometimes personalized: “I saved to make a sizable downpayment, I’ve never missed a loan or credit card payment. Why should these people who lived beyond their means get a break?”).

But underlying these debates is generally (not always, but generally) the long-standing “deserving poor versus undeserving poor” thread, that the unfortunate should get help only under certain circumstances. But drawing that line may not always be so easy.

What happens when people seek out advice from people they trust or think are experts and are led astray? What if those people benefitted from their at best misguided, and often self-serving advice? And worse, what if some of those people were religious leaders?

This line of reasoning may seem like a stretch, but Hannah Rosin shows it operated in “prosperity churches” that came out of the Oral Roberts lineage:

In June, the Supreme Court ruled that state attorneys general had the authority to sue national banks for predatory lending. Even before that ruling, at least 17 lawsuits accusing various banks of treating racial minorities unfairly were already under way. (Bank of America’s Countrywide division—one of the companies Garay worked for—had earlier agreed to pay $8.4 billion in a multistate settlement.) One theme emerging in these suits is how banks teamed up with pastors to win over new customers for subprime loans.

Beth Jacobson is a star witness for the City of Baltimore’s recent suit against Wells Fargo. Jacobson was a top loan officer in the bank’s subprime division for nine years, closing as much as $55 million worth of loans a year. Like many subprime-loan officers, Jacobson had no bank experience before working for Wells Fargo. The subprime officers were drawn from “an utterly different background” than the professional bankers, she told me. She had been running a small paralegal business; her co-workers had been car salespeople, or had worked in telemarketing. They were prized for their ability to hustle on the ground and “look you in the eye when they shook your hand,” she surmised. As a reward for good performance, the bank would sometimes send a Hummer limo to pick up Jacobson for a celebration, she said. She’d arrive at a bar and find all her co-workers drunk and her boss “doing body shots off a waitress.”

The idea of reaching out to churches took off quickly, Jacobson recalls. The branch managers figured pastors had a lot of influence with their parishioners and could give the loan officers credibility and new customers. Jacobson remembers a conference call where sales managers discussed the new strategy. The plan was to send officers to guest-speak at church-sponsored “wealth-building seminars” like the ones Bowler attended, and dazzle the participants with the possibility of a new house. They would tell pastors that for every person who took out a mortgage, $350 would be donated to the church, or to a charity of the parishioner’s choice. “They wouldn’t say, ‘Hey, Mr. Minister. We want to give your people a bunch of subprime loans,” Jacobson told me. “They would say, ‘Your congregants will be homeowners! They will be able to live the American dream!’”

Rosin spends most of the article discussing one church in Charlottesville, VA, and some of its parishoners:

It can be hard to get used to how much [pastor] Garay talks about money ….Garay was preaching a variation on his usual theme, about how prosperity and abundance unerringly find true believers. “It doesn’t matter what country you’re from, what degree you have, or what money you have in the bank,” Garay said. “You don’t have to say, ‘God, bless my business. Bless my bank account.’ The blessings will come! The blessings are looking for you! God will take care of you. God will not let you be without a house!”…On the altar sat some anointing oils, alongside the keys to the Mercedes Benz.

Later, D’andry Then, a trim, pretty real-estate agent and one of the church founders, stood up to give her testimony. Business had not been good of late, and “you know, Monday I have to pay this, and Tuesday I have to pay that.” Then, just that morning, “Jesus gave me $1,000.” She didn’t explain whether the gift came in the form of a real-estate commission or a tax refund or a stuffed envelope left at her door. The story hung somewhere between metaphor and a literal image of barefoot Jesus handing her a pile of cash. No one in the church seemed the least bit surprised by the story, and certainly no one expressed doubt. “If you have financial pressure on you, and you don’t know where the next payment is coming from, don’t pay any attention to that!” she continued. “Don’t get discouraged! Jesus is the answer.”

And the areas worst hit by the subprime crisis were also ones where the prosperity churches were well represented:

Demographically, the growth of the prosperity gospel tracks fairly closely to the pattern of foreclosure hot spots. Both spread in two particular kinds of communities—the exurban middle class and the urban poor. Many newer prosperity churches popped up around fringe suburban developments built in the 1990s and 2000s, says Walton. These are precisely the kinds of neighborhoods that have been decimated by foreclosures, according to Eric Halperin, of the Center for Responsible Lending.

Now this does NOT mean that the prosperity churches were the main cause of the subprime crisis. But simple black and white narratives that overlook ugly nexuses of gullibility and greed can impede coming up with the best (or more likely, least bad) remedies.

You can find the entire article here.

Update: Independent Accountant e-mailed some supporting links:

3 Hebrew Boys’ Guilty In $82 Million Ponzi/Affinity Fraud Scheme

California Man Guilty In $62 Million Ponzi Scheme

Fraud trial begins for ex-execs of Baptist Foundation

He adds: “Yes, people do not want to brand religious leaders as fools or corrupt. About four or five times a year one of my clients will ask me about one of these programs. Invariably when I tell him it looks like a scam, he gets angry with me! What’s wrong with you that you are so unenlightened you can’t see the promoter has “God’s favor”?

“So far none of my clients has lost more than a few thousand dollars in any of these scams.”

Masculinity in a Spray Can New York Times

AIG exec’s big loan from Blankfein New York Post (hat tip Michael T)

Shoes may have changed how we run BBC

FCC’s Net Neutrality Plan Would Permit Blocking of BitTorrent Electronic Frontier Foundation (hat tip reader John D)

Australian Greens go Black p2pNet (hat tip reader John D)

Aliens can’t hear us, says astronomer Guardian

Most Parents Don’t Realize Their 4 Or 5-Year-Olds Are Overweight or Obese Science Daily (hat tip reader Michael T)

NY pols stunned to learn Obama administration opposes funding for 9/11 health bill Daily News (hat tip DoctoRx)

Bloomberg’s Reilly Wrecks the Lex on Fed/AIG Columbia Journalism Review

It’s All About Leverage Michael Schussele

A Growing Share of Americans’ Income Comes from the Government Michael Panzner

The Audacity of Populism Wall Street Journal

A Colossal Failure Of Governance: The Reappointment of Ben Bernanke Simon Johnson, Baseline Scenario. Today’s must read.

And a little note from Marshall Auerback re the 5.7% GDP growth release yesterday:

Even if you use the government’s own massaged data, it suggests that we’ve had barely any growth at all and curiously, a massive rally in the stock market. I was chatting to Frank Veneroso about this yesterday. He pointed out that the giant gains in the stock market (after an 86% fall from 1929-1932) were accompanied by the most explosive fundamentals ever. The years after 1932 saw the most rapid advance in industrial production in the entire history of the U.S. economy. The market rose starting mid-1932 with a 14% rise in industrial production in a mere four months. It soon deeply corrected as a result of a fall in industrial production into early 1933 that wiped out all those very sizeable but brief production gains. The stock market’s biggest surge came off that early 1933 low. It was coincident with a 62% rise in industrial production in a mere four months. That outsized gain in the stock market and the one that followed it were obviously driven by extraordinary fundamentals.

By contrast, the almost 70% rise in the S&P since last March has occurred amidst a modest five percentage point rise in manufacturing production off its cycle low. And, in fact, there has been only a 2.6% increase in industrial production so far relative to March when the stock market rally began.

So viewed relative to the fundamentals, there has never, ever, ever been a stock market rally as outsized as the one since March of last year.

Antidote du jour:

We have a President who, in his displays of pique against banksters, can work himself up to calling them “fat cats”. But immediately after that, um, display, he met with bank CEOs (well, the ones that didn’t stand him up) and was conciliatory, when the right move would be to show some steel. And when, after chewing out lobbyists in the State of the Union, which department in the Executive branch was the first out of the box to call lobbyists to set up private briefings? The Treasury.

It sure isn’t hard to discern the yawning chasm between word and deed and decide which to take seriously.

By contrast, the authorities in the UK are more united in their stance and are taking steps that show far more determination as far as reining in the financial services industry is concerned. Even if the bonus tax did not work as planned, it was a bold move, and at least showed seriousness of intent. And the UK regulators are pushing measures sure to elicit howls of pain from the banksters. The latest is that the head of the FSA, Lord Turner, has suggested a crackdown on currency carry trades. And more important, look at the basis of his argument: carry trades serve no useful social purpose. Lordie, if banks are restricted to doing things that are productive, just think of what it will do to profits and bonuses!

Similarly, can you imagine anyone of any stature in the US (well, save maybe Paul Volcker, who is currently in favor, but who knows how long that will last) having the kind of talk with bank top brass that Alistair Downing had. From the Guardian:

Alistair Darling told the City’s top bankers today to stop feeling sorry for themselves and instead work with the government to create a stronger financial system.

The chancellor held clear-the-air talks with eight UK and foreign-owned banks at the meeting of the World Economic Forum in Davos at which he urged faster international action to strengthen banking regulation.

“My message to the banks is that it is in their interests to get off the front pages,” Darling said at a press briefing ahead of the meeting.

“The banks should do what they are supposed to do, provide credit to the economy. They must know that changes are necessary. They can all see that the regulatory regime needs to be more robust and more intrusive.

“Don’t feel sorry for yourselves. Work with the government to see how you can improve the situation.”

Today’s meeting involved executives from Standard Chartered, HSBC, Barclays, Goldman Sachs, UBS, Morgan Stanley, JP Morgan and Citigroup.

The chancellor said he was frustrated that changes to bank regulations proposed by the G20 group of developed and developing nations were taking so long to be agreed by the Basle committee of central bank governors and international regulators.

“The Basle process can be quite tortuous,” Darling said. “We don’t have years to sort it out.”

He added that he was disturbed by reports that proposed reforms to the global financial system – originally expected this autumn – now looked as if they would be delayed until 2011.

“I would like to see the Basle regulations published this autumn,” Darling said. “I have heard it may slip into next year. That would be very, very bad.”

Is the modern version of “Beware of Greeks bearing gifts” “Beware of ‘reform’ proposals that bankers favor”?

The fact that banksters seem to be bowing to the inevitable, that they will have to submit to some changes in how they do business, should be a step in the right direction. But their inability to accept their central role in creating the worst economic disaster in modern times is stunning. The implosion almost certainly would have brought about a depression absent massively liquidity injections, and still appears like to leave us with years, if not a decade, of halting growth and dislocations for those whose savings were given a nasty haircut. And the lack of real reform means the odds of creating bigger bubbles with an even worse aftermath remains high.

And why should we be a little wary of this new found religion among our financial overlords? Consider this report from the Financial Times:

Support has been growing among regulators and politicians for an insurance levy as the best way to ensure that the burden of big bank collapses would not fall on taxpayers. But until now bankers have resisted the idea. They say the impetus for considering a global levy came from President Barack Obama’s $90bn balance sheet levy, which will tax banks in the US to recover the cost of an earlier bail-out programme.

Yves here. So why are the bankers rallying behind an Obama-type fee? Because the charge is too low, natch! The banks no doubt noticed what James Kwak figured out when the fee was announced (to howls, remember, even mutterings of Constitutional challenges?):

The best thing about the tax is that it helps level the playing field between large and small banks. From Q4 2008 through Q2 2009, large banks had a funding cost that was 78 basis points lower than that of small banks, up 49 basis points from 2000-2007. Closing that gap could lead some of those customers, faced with lower interest payments on deposits or higher fees, to take their money elsewhere. (Of course, they are already getting lower interest and paying higher fees, so there may not be much of an effect.)

But the tax isn’t nearly big enough! It’s being calculated as 15 basis points of uninsured liabilities, calculated as assets minus Tier 1 capital minus insured deposits. 15 basis points is a lot less than 78 basis points. And if the FDIC cost of funds data are based on all liabilities (not just uninsured liabilities),* then charging 15 basis points on uninsured liabilities only increases the overall cost of funds by about 7 basis points (at least in the administration’s example). This doesn’t come close to compensating for the TBTF subsidy.

Yves here. It gets even better:

Josef Ackermann, chief executive of Deutsche Bank, told the Financial Times on Friday : “To help solve the too-big-to-fail problem I’m advocating a European rescue and resolution fund for banks. Of course, the capital for this fund would have to come from banks to a large degree.”

Yves again. Ahem, to a large degree? How about in toto? Oh, because it might mess up precious bank economics. FDIC insurance is too cheap too; the FDIC did not have sufficient resources to handle the savings and loan crisis. Congress had to allot additional funds to create the Resolution Trust Corporation, which acquired the assets of dud thrifts.

And Team Obama is now considering exempting repos, one of the Street’s favored sources of cheap funding, so this won’t do much to solve the leverage problem either (yes, you can make a case for excluding Treasuries, but don’t expect any carve-outs to stop there).

So all this change of posture means is that some bank leaders have ascertained that some gestures that have modest costs attached to them would make for good PR. So expect theatrics and public declarations to make these measures sound more effective than they really are.

Update: The Wall Street Journal reports that top bankers got such a cold shoulder at Davos that it might finally be dawning on them that they not only screwed up big time, but also overplayed their hand in the year after the crisis. But I would not expect a wee bit of reality penetrating their well-developed defenses to lead to a change of heart, merely a change of tactics. And some organizations still appear to be beyond redemption:

….a senior London-based investment banker offered this wager: Lloyd Blankfein, CEO of Goldman Sachs, would be out within two years, he said, and he was prepared to back up his bet with millions of pounds…

Asked about the wager over Mr. Blankfein, Goldman spokesman Lucas van Praag said: “It is preposterous that The Wall Street Journal would even consider publishing such effluent.”

The vote on Bernanke’s confirmation produced 30 “no” votes, more than any previous vote on a Fed chairman, even exceeding those against Paul Volcker after he had driven the economy into the most severe post-recession downturn in his effort to wring inflation out of the economy.

But that was still a comfortable win, right, even if the finally tally showed considerable unhappiness with Bernanke? Not at all. This observation came from an informed Hill observer:

Despite the wide margin, they were genuinely shitting bricks last Thursday. He was on the brink of going down, but they rallied and won. It was definitely closer than it appeared…. It’s just that once he got the votes, the undecideds broke hard in his direction.

And one of the factors in Bernanke and the Administration prevailing is that progressives believe in fighting fair, which puts them at a considerable disadvantage. As we pointed out, the real vote on the Fed confirmation was the cloture vote (the vote to force an end to debate and move on to a vote), particularly with several senators having put a “hold” on the Bernanke vote (a threat to filibuster). Conservatives (many of whom had joined with progressives to oppose to Bernanke) will close ranks and use the filibuster (hence the importance of the loss of the Democrat’s 60 votes in the Senate with the election of Scott Brown in Mass. The 60 votes would matter less if the Republicans had some compuntions about using filibusters and other procedural measures to prevail).

As Ryan Grim explained at Huffington Post:

The seven senators who voted for cloture but against Bernanke included six Democrats and Florida Republican Sen. George Lemieux, who is retiring in 2010. Sen. Ted Kaufman (D-Del.) is also retiring. Senators on their way out often promise leadership they will “be there on cloture,” but are then freed to vote against final passage. Sen. Byron Dorgan (D-N.D.) is also retiring and voted yes on cloture but no on final passage.

Democratic Sens. Barbara Boxer (Calif.), Al Franken (Minn.), Tom Harkin (Iowa) and Sheldon Whitehouse (R.I.) also flipped their votes.

Whitehouse told HuffPost after the vote that it would have been hypocritical of him to filibuster the nominee, because he’d been critical of his colleagues who abused the filibuster in the past. “I’m for moving through cloture on this stuff. I’ve been annoyed by the Republican cloture blockades and I’ve been critical of members of my caucus who’ve denied the leader cloture. It would be highly inconsistent to vote against cloture,” he said. “I hope that my vote against him will help send a message to economic leadership that they need to pivot and they need to back off the record of, ‘Banks win every dispute with consumers and the public.’”

Franken expressed a similar sentiment. “While I voted for cloture because I believed this nomination deserved an up or down vote, I couldn’t in good conscience support it,” Franken said in a statement after the vote, after declining to talk to a HuffPost reporter in the hallway.

Franken said he opposed the nomination because he didn’t get the assurances he wanted about consumer protection. “A strong Consumer Financial Protection Agency and other consumer protections are essential to securing our economy for Main Street and the middle class,” Franken said. “I needed to know that a robust CFPA would be a part of financial regulatory reform in order to support Chairman Bernanke’s confirmation to a second term. As governor of the Federal Reserve and then Chairman of the Federal Reserve, Bernanke did almost nothing to protect consumers and when he did, it was too late. I needed the assurance that would improve. And I didn’t get that.”

“I wasn’t somebody who wanted to prevent a vote on it,” Dorgan said after the vote.

The lesson here: Centrist and conservative senators are willing to deny an up-or-down vote on policy they oppose, but progressive senators often are not. That dynamic tilts political power toward leadership and conservative priorities.

Bernanke’s opponents pointed to the relative success of their push against his confirmation, which was considered a virtual certainty two weeks ago but became an open question following the election of a Republican, Scott Brown, in the Massachusetts Senate election. “I think it’s important for him to note that he did have 30 votes-plus [sic] against him. I think the message is, take a look at Main Street, not just Wall Street,” Sen. Barbara Boxer (D-Calif.) said.

As the Israelis say, “Love your enemy, for you will become him.” Progressives seem not to have made that leap.

This via e-mail from reader Scott:

But as someone else on the thread remarked, “He thinks he needs a ‘decoder ring’ for that?”

Emotional signals cross cultures BBC

Neuron breakthrough offers hope on Alzheimer’s and Parkinson’s Times Online

EU signals last-resort backing for Greece Financial Times (hat tip Swedish Lex)

Bank Sues Victim To Avoid Replacing $200k In Stolen Funds Consumerist

Soros: ‘bleak outlook for UK’ Robert Peston (hat tip reader Tim C)

Bailout time Eurointelligence

A limited speech by a constrained president James Pethokoukis

Swiss halt deal with U.S. that IDs Americans with secret UBS bank accounts Washington Post (hat tip reader John D)

Radical Inequality Is Literally Killing Us Alternet (hat tip reader John D). It’s actually income inequality, and we posted about it in 2007, the FT was talking about this in 2002.

UK banks downgraded by credit rating agency Guardian

State of the (Cardboard) Box Outside the (Cardboard) Box

U.S. may exempt Treasuries from new bank tax -sources Reuters

March of the Peacocks Paul Krugman, New York Times

In the Packaging of Loans, a Bust With Precedent Floyd Norris, New York Times. This is intriguing.

Antidote du jour (FYI, I lived in the Upper Peninsula for three years when I was growing up). John Bougearel writes:

Look at this Moose!

By the length of his beard and the grey legs, I figure he must be over 10 years old. He looks to be well over 8 feet at the top of the shoulder hump, and with his head up the height to the top of his antler must be about 12 feet. This guy is king of the forest, no bear or pack of wolves would dare come after him when he has this rack……Considering that a dirt road can fit 1 1/2 cars across … this fellow is HUGE …THIS IS ONE BIG BOY!

The picture was taken in Elliot Lake, which is near Sault Ste. Marie in Michigan ‘s Upper Peninsula.

Yes it is a regular size dirt road.

If anyone had any doubts that Obama rhetoric does not comport with his conduct, consider Exhibit A, courtesy reader DoctoRx.

This is what Obama said in the State of the Union address:

We face a deficit of trust – deep and corrosive doubts about how Washington works that have been growing for years. To close that credibility gap we must take action on both ends of Pennsylvania Avenue to end the outsized influence of lobbyists; to do our work openly; and to give our people the government they deserve.

Yves here. The funny bit is Obama’s use of the phrase “credibility gap”. That was coined by the media to describe the whoopers that Lyndon Baines Johnson told with abandon while President. Does Obama recognize that he is channeling another legislator turned Chief Executive?

He is certainly exhibiting the same sort of behavior. After criticizing lobbyists in his State of the Union address, what does Team Obama (in this case, the Treasury Department) do but invite lobbyists in for a private chat…about the State of the Union address? And no doubt to tell them the tough talk on banks meant less than it appeared to.

The really appalling part is the lobbyists are so deeply embedded in the the operations of government, that the get upset when they are called bad names. Not only are they predictably blind to how corrupting their influence is, but they think their role is legimate, and have lost sight of the fact that the legislators and Executive Branch members that they influence need to have plausible deniabilty, hence need to issue the occasional stern statement about how awful lobbyists are before going back to business as usual. The fact that lobbyists are chafing at this necessary ritual says how disproportionate their role has become.

From The Hill:

A day after bashing lobbyists, President Barack Obama’s administration has invited K Street insiders to join private briefings on a range of topics addressed in Wednesday’s State of the Union.

The Treasury Department on Thursday morning invited selected individuals to “a series of conference calls with senior Obama administration officials to discuss key aspects of the State of the Union address.”…

The invitation stated, “The White House is encouraging you to participate in these calls and will have a question and answer session at the end of each call. As a reminder, these calls are not intended for press purposes.”…

A handful of lobbyists told The Hill on Thursday morning that they received the invitations and were planning to call in.

Some lobbyists say they are extremely frustrated with the White House for criticizing them and then seeking their feedback. Others note that Democrats on Capitol Hill constantly urge them to make political donations.

One lobbyist said, “Bash lobbyists, then reach out to us. Bash lobbyists [while] I have received four Democratic invitations for fundraisers.”…

Lobbyists say the Obama White House has held many off-the-record teleconferences over the past year…Another lobbyist said these types of teleconferences occur “all the time.”

And that is why many on K Street are exasperated with Obama’s use of lobbyists as a punching bag. Some have said they understood why he used strong rhetoric on the campaign trail but are irritated the White House solicits their opinions while Obama’s friends in Congress badger them for political donations.

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.

If nothing else, it’s clear (as one wag wrote this morning) that the state of Obama’s rhetoric is strong.

The President almost always gives a good speech, but it’s the follow-through that is generally problematic. And the speech itself sends mixed messages about what Mr. Obama views as his “achievements” and his priorities moving forward. For all of the talk about more jobs and tax cuts, the speech also made it clear there has been a shift to ‘fiscal responsibility’ with plans to pay back the 2 trillion in new debt, all well down the road (3 year spending freeze starting in 2011). The job initiatives announced were minor and there appears to be no additional fiscal relaxation of consequence apart from promises of a new jobs’ bill, the effect of which could be blunted if the President aims for “fiscal neutrality”.

A State of the Union address is always a good place for an incumbent President to set out his priorities, and in that regard, Obama’s speech is most revealing. He rightly argues that everything “begins with our economy” and then curiously emphasizes that “our most urgent task upon taking office was to shore up the same banks that helped cause this crisis.”

No, Mr. President. Your most urgent task upon taking office was to shore up employment. Over the past year it has become obvious that the policy to shore up the banks has been a dismal failure in this regard. It has done nothing to pull the economy out of its deepest slump since the late 1970s. The single most important thing Washington can do to help the vast majority of American citizens who do not work on Wall Street is to create jobs — tens of millions of them.
The President was right about one thing: “If there’s one thing that has unified Democrats and Republicans, it’s that we all hated the bank bailout. I hated it. You hated it. It was about as popular as a root canal.”

But at least a properly executed root canal solves the problem once and for all. The President and Congress have administered the economic equivalent of pain killers, without addressing the underlying problems in our financial sector. If we’re going to undergo root canal, then let’s fix the damaged nerve and prevent a recurrence of the problem. Tens of trillions of dollars have been committed to deeply insolvent institutions (the extent of which we still do not understand due to persistent stonewalling from the Treasury and Federal Reserve). These institutions continue to pay out massive bonuses to their staff on the basis of fraudulent accounting. And many of these institutions are still engaging in activities which continue to worsen household balances in order to maximize their own profitability. Households and non-financial institutions have hitherto received very limited assistance. If this is how the President measures success, God help us when we have failure.

Obama observed that “if we had allowed the meltdown of the financial system, unemployment might be double what it is today. More businesses would certainly have closed. More homes would have surely been lost.” All true, but there was little value to be gained by preserving what are fundamentally insolvent institutions. The President could have done something politically popular which would have resonated with the public by shutting down zombie banks, and used fiscal policy to promote employment via a Job Guarantee program. That would be both smart economics and politically popular. The two are not always mutually exclusive, but this administration curiously appears to conflate unpopularity with “responsibility”. This is what happens when you take your advice from a bunch of failed Rubinite retreads.

Again, the references to the banks reflect profound conceptual confusion at the heart of the President’s financial reforms: “A strong, healthy financial market makes it possible for businesses to access credit and create new jobs. It channels the savings of families into investments that raise incomes.” To repeat, credit is not a “flow” which one can access. Credit is a two-way contract between lender and borrower. The only thing that constrains the bank loan desks from expanding credit is a lack of creditworthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to take out additional loans. The President would be more accurate in suggesting that a strong economy makes it possible for businesses to create new jobs, thereby creating a healthy financial market which facilitates access to credit.

Yes, President is correct to argue that the markets may well have stabilized…for now…but personal balance sheets have not. How long can the former be sustained in the absence of the latter not improving?

And reiterating his proposed fee on the biggest banks might play to the peanut gallery, but the real purpose is not to recover the money spent on TARP, but to change the structure of finance, particularly in the capital markets, once and for all. The President still displays an incoherent approach to financial reform and implicit beliefs in government budget constraints.

For all of the talk about tax cuts (”Let me repeat: we cut taxes. We cut taxes for 95% of working families.”), what really stands out is the President’s fiscal timidity. This represents the cut for 95% of working families that he promised on the campaign. It equated to about $8 per week, on average, for workers. This despite the fact that the President himself seems to recognize at one level that fiscal policy really does work:

Because of the steps we took, there are about two million Americans working right now who would otherwise be unemployed. 200,000 work in construction and clean energy. 300,000 are teachers and other education workers. Tens of thousands are cops, firefighters, correctional officers, and first responders. And we are on track to add another one and a half million jobs to this total by the end of the year.

Surprise, surprise! Fiscal policy works! And if the President had implemented a national payroll tax holiday and introduced revenue sharing for the states, he could have trumpeted even greater economic achievements. Why muddle the message with talks of spending freezes and support for misconceived “bipartisan commissions” to discuss ways of reducing “runaway government spending” when unemployment has shown little sign of stabilizing, let alone coming down? The true engine of job creation in this country will always be America’s businesses, as the President recognizes, but he also notes that “government can create the conditions necessary for businesses to expand and hire more workers.” We have a mixed economy, which is why the President should not capitulate to the conservative lobbies now engaged in a renewed push for fiscal austerity even though the labor markets are disaster zones. History has a habit of repeating itself. The US government did exactly this in 1937 and the unemployment worsened. Japan did it in 1997 with the same outcome.

I could go on. It would have been interesting to hear the President explain how we would succeed in Afghanistan when both the British and Russians had comprehensively failed, but Obama clearly could only achieve so much in the space of an hour. Bowing to the conservative calls for “fiscal consolidation” at a time when unemployment is still very high and will continue to exert a massive deflationary force on the overall economy is the best way to ensure a double-dip recession occurs. Trumpeting the perpetuation of a failed banking system hardly strikes us as an achievement.

There were moments when the President really did appear to understand what it takes to make the state of the union stronger. Unfortunately, those moments were few and far between. Let’s hope for once the muddled message does not reflect the reality.

Lucky rescue for dog stranded on ice floe BBC (hat tip reader John M)

Veterans for Rethinking Afghanistan Jake Diliberto, YouTube (hat tip reader Cynthia)

As Freezing Persons Recollect the Snow–First Chill–Then Stupor–Then the Letting Go Outside (hat tip reader MIchael T).

Opinion: Europe hopes PIIGS will fly Global Post

Geithner’s faulty apologia Rolfe Winkler

The Poor and Their Money (hat tip reader Tim C)

Political Risk: The Bernanke Nomination and the Return of American Populism Institutional Risk Analyst

The bankruptcy routine The Deal (hat tip DoctoRx)

What Housing Recovery? Nationwide, Defaults Are on the Rise Bruce Krasting

What Happens When the World Defaults? FT Alphaville (hat tip reader Don B)

Dissent Tim Duy

A Proposal for Genuine Financial Reform Marshall Auerback, New American Contract

Volcker’s axe is not enough to cut banks to size Martin Wolf, Financial Times. Apologies for missing this yesterday….

Antidote du jour:

By Tom Adams, an attorney and former monoline executive, and Yves Smith

For those of you who followed the House Oversight Committee hearings on the Fed’s conduct in the AIG bailout, one focus of discussion was the Fed’s efforts to keep the details of the CDOs that the Fed effectively bought via an entity it created, Maiden Lane III, secret.

As we demonstrated, these details were hardly secret. The identity of most of the transactions were already public, and from that, considerably more information could be added with not much difficulty from other public sources. We published this detail last week (apologies for the itty bitty print, it’s easier to enlarge from here), with a discussion of findings and gaps.

Yesterday, Darrell Issa, who was the moving force behind the subpoena by the House Oversight Committee which forced the release of 250,000 pages of documents related to the AIG bailout from the Fed, released the notorious Schedule A, the transaction-level detail the Fed was so keen to keep secret, to Huffington Post, which published it.

From that, we have been able to update our work and are publishing the full output of our latest model run. We had already added CUSIPs (which the Fed stressed in testimony yesterday that was something it needed to keep confidential) on 85% of the deals prior to the Issa release,. Getting Schedule A allowed for refinements and corrections.

We indicated in our earlier post that while we did not have all the Maiden Lane III transactions, we had most of them, and this was confirmed by the publication of Schedule A. Of the $62.1 billion in par value, our earlier spreadsheet had all but $11 billion, or 82%, which is consistent with our estimates of our success re capture.

Here is a link to the updated version (which contains more information than Schedule A). Please note that there may be some minor errors; we will go over it again today to double check and correct. In some cases, the print was hard to read, and we hope to resolve anomalies today. For $11 billion of deals added, we also need to add collateral type, year and deal manager; that should also be incorporate today. Some sample output below:

We will be writing up our observations regarding counterparty relationships later today, but one point leaps out of this cut, namely, that for a fair number of deals, the posted collateral is very close to the notional amount of the bonds. In layperson-speak, that means some deals were basically dead already – and they were distributed across vintages and collateral type (excluding the commercial real estate CDOs, which are a small portion of the total). This implies that the other deals were going to catch up at some point. Put another way – if a 2005 high grade deal from one issuer had 80% collateral posting (meaning the counterparty and AIG agreed it was worth only 20% of its original value), odds are high that the other 2005 high grade deals and the 2006 high grade deals are going to get there soon enough (there was enough similarity in structures and underlying assets that the dispersion among eventual outcomes, in most cases, would not be that great).

The fact that some transactions were acknowledged both by AIG and the dealers to be zeros as of the bailout is yet another reason to doubt that these deals would have future upside. That is contrary to both the Fed’s logic in buying the CDOs (see our related post) and its current claim that the deals have traded up despite a massive decay in credit quality. Per a BlackRock memo prepared just prior to the November 2009 decision to buy the CDOs, only 19% were rated junk. Now, according to Moody’s, the more conservative of the two ratings agencies, 93% are rated junk.

Note that the Fed is already engaging in shifting rationales as to why this information needed to be kept in confidence. Its first argument was that the revelation of this information would damage AIG. That was obviously bunk; AIG has limited upside in the vehicle that owns the CDOs (and that charitably assumes there will be any upside). But that was the only line of argument that would fly with the SEC.

The new claim, from the New York Fed’s general counsel Thomas Baxter, is that BlackRock said secrecy was necessary to keep traders from taking advantage of the Fed if and when it decided to sell down the road. But even setting aside how much information was already known and could be developed, the argument is simply implausible. These are unique, illiquid deals; there is no obvious way to manipulate the market in advance of a Fed sale (yes, in theory one could game the ABX, but a sale of this sort is a protracted process, and any party trying to push the ABX around is not assured at all of benefitting by being the winning bid).

Consider: let’s say a bank wound up owning a bunch of apartments because a real estate developer went bust. You know they are scattered across three buildings (some apartments were sold before the developer failed), you know what the developer’s aggregate asking price was, you know the mix of one, two, and three bedrooms; you know the floor plans for one, two, and three bedrooms in each building. You don’t know how many of each type, and where they are situated (ie, which floor, which exposure, which will affect light, views, noise levels).

The bank is going to sell them individually. Thus, the “identity” of each apartment has to be made public for a sale to occur.

Maiden Lane III and the Fed are in a position very much like the bank in question. Even ex the transaction level detail, prospective buyers know the ratings across the portfolio. The names of the biggest deals were disclosed in Maiden Lane III financials. AIG in previous presentations to shareholders provided a good deal of information on vintages and collateral in the residential real estate CDO portion of the Maiden Lane III portfolio. And when Maiden Lane III goes to sell any particular CDO, any market professional has access to the databases that will allow it to look at the underlying collateral (analogous to an apartment viewing).

So how can keeping the identity of the “apartments” secret be of any benefit as far as producing more value in the event of sale? All of the evidence points to the fact that there are other reasons for keeping this under wraps. We’ll continue this line of thought in a post later today once we have tidied up the data a bit more.

Richard Smith contributed to this article

No matter which way you look at it, the picture that is emerging of the Federal Reserve, as revealed by the ongoing probes into its AIG bailout, is singularly unflattering.

The explanations for its actions can only support one of two interpretations: that the Fed was a chump, taken by the financiers, or a crony, and was fully aware that it was not just rescuing AIG, but doing so in an overly generous way so as to assist financial firms in a way it hoped would not be widely noticed or understood. The problem with this sort of back-door subsidy, aside from its dubious propriety, is that at best, it’s sorta random (who benefits isn’t necessarily who is in most need or more deserving of help, just who happens to be lucky enough to be associated with AIG train wreck), and at worst, it rewards stupidity and duplicity.

For the Fed, if it was mainly engaged in “Fed as crony” behavior, that bodes ill for the central bank’s future, since it means it has been lying to the public as to why it did what it did. As investigators keep digging, for they will be certain to find evidence that the various explanations that the Fed has given for its actions will be at odds with its internal debates. If you think the Fed’s reputation is bad now, just wait to see what happens if it emerges that it was engaged in deception.

Although the focus of press and public attention has been the decision to pay out “100%”, this issue has not been framed as crisply as it should be. Remember, the underlying transactions were crap CDOs that the banks (or bank customers, a subject we will turn to later) owned, and on which the banks had gotten credit default swaps from AIG. The Fed in fact paid out WELL MORE than 100% on the value of the AIG credit default swaps by virtue of also buying the CDOs.

Recall the sequence:

1. Fed authorized $85 billion credit facility in September 2008

2. In early October, AIG pays out an additional $18.7 billion to its CDO counterparties, bringing their total collateral to $35 billion (against CDOs with a par value of $62.1 billion) So the dealers had already received 56% of par value at this point (remember, possession is 9/10 of the law).

3. In early November, it looks as if AIG will have to pony up more to its counterparties if it is downgraded, as it presumably will be once it releases crappy earnings. Resulting collateral calls might exceed the remaining amount of the $85 billion loan facility. Fed goes into panicked overdrive, decides of all its options for dealing with the AIG black hole, the best is to buy the CDOs, thus eliminating the need to worry about those pesky CDS.

What we need to stress here, before going into the chump vs. crony theories, is that buying the CDOs in order to terminate credit default swaps is not normal protocol. The Fed could have negotiated a cash settlement (which probably would have amounted to letting the counterparties keep the collateral, with some further adjustments based on the usual arm wrestling. This by the way, could have constituted a 100% payout on the credit default swaps (ie. the decision to pay out in full on the CDS was separate from the decisions to acquire the CDOs), but it would have left the banks with the CDOs. That would have been well short of $62.1 billion; all the dealers felt then that the CDOs had some value (while their marks also said that, dealers have been known to mark paper at unduly high prices to avoid reporting losses; with AIG’s credit-worthiness in doubt, the bankers’ accountants presumably required markdowns on the credit default swap hedges, which might give some banks an incentive to be less aggressive in reducing the value of their CDOs). That implies the credit defaults swaps themselves were worth considerably less than 100 cents on the dollar.

Buying the CDOs was an unnecessary step and increased the amount paid by the Fed, through AIG, to the counterparties. Moreover, the Fed has gone to unusual, even bizarre, lengths to keep matters regarding the CDOs themselves secret (a good bit of the discussion at the House Oversight Committee hearings on Wednesday today revolved around this issue; we’ve discussed previously why the Fed’s arguments for secrecy do not add up; we will return to this subject at later today at Naked Capitalism).

So let’s see how these theories stack up. Each has supporting evidence.

Fed as Chump

This viewpoint boils down to the old saw about poker: if you sit down at a poker table and you don’t know who the mark is, by definition, it is you.

The Fed has long believed that the financial crisis was a liquidity event, that investors panicked, but the prices of securities of all sorts fell below “rational” levels. From Bernanke on down, the Fed has made various pronouncements taking up the theme that securities prices, particularly in the October 2008 through March 2009 time frame, reflected irrational despondence. Funny how once Greenspan dared admit in 1996 there might be such a thing as irrational exuberance, not only that turn of phrase, but the very concept, seems to have been expunged from permitted reasoning at the central bank. Not only does the Fed seem constitutionally unable to admit that it was asleep at the switch during the rise of a global credit bubble, but that cheap credit leads to overvalued assets. So asset prices will fall as cheap credit is withdrawn. The Fed has fought this process tooth and nail, believing it can validate asset prices by pulling the right levers (see here for a long-form version of this logic and my objections to it).

So why did they buy the CDOs? Get this: one argument is that they wanted the upside. Huh? That means:

1. They seem to have forgotten that where there is upside, there is also downside. They took a speculative position. This went well beyond what was necessary to deal with the AIG mess

2. They thought they had a better perspective on value than the banks themselves. This is staggering. They have NO idea how these deals are structured, no day-to-day involvement in the subprime, Alt-A, or commercial real estate markets. They are at a massive information disadvantage. The idea that the Fed could make a better trading bet than the banks themselves is a remarkable combination of hubris and stupidity.

While there might be reason to think that prices of liquid assets had overshot on the downside, assets like CDOs that don’t trade and are (in this case) priced on cash flows which reflect, among other things, expected defaults and loss severities, are quite another matter. And here, the Fed (its valuation claims to the contrary) looks to have gotten it badly wrong. Per Tom Adam’s analysis, at the time Maiden Lane III (the vehicle that bought the CDOs) was created, 19% of the portfolio had been downgraded to junk. Currently, it’s 93% below Baa3 according to Moody’s, the more conservative of the two major ratings agencies.

More confirmation of the “Fed as chump” theory comes via its reliance solely on BlackRock for advice on the CDOs, particularly once it had set up Maiden Lane III (and recall BlackRock is also managing Maiden Lane I, the Bear bailout entity, and Maiden Lane II, which was created to deal with AIG’s securities lending mess). I’d be curious to hear additional reader input, but I am told that private managers of portfolios of this size would have at least two portfolio mangers to give them different views and to compete. But the government would set its criteria for these assignments in such a way that Pimco and BlackRock were the only viable candidates. By contrast, there are asset managers and consultants that are not as large but are very skilled in the CDO space.

The Fed was also played by the French regulators, and perhaps their banks. One of the arguments for the Fed not pushing for a haircut on the credit default swaps, as other banks had accepted in dealing with a distressed insurer, was that French law prohibited it. But this was false, since Societe Generale and BNP Paribas took very large haircuts to close out credit default swaps with Ambac, another bond insurer.

Other examples of Fed naivete comes from e-mails recently made public as a result of the House Oversight Committee investigation: its surprise that AIG might have to make disclosures regarding the bailouts, its clumsy and aggressive efforts to keep matters under wraps, and its reluctant recognition that too many people were party to what went down to maintain secrecy.

Fed as Crony

Although we’ll set forth the fact pattern that gives credence to this notion, the most powerful support comes from the Fed’s seeming desperation to maintain secrecy, particularly around Maiden Lane III. The Fed’s arguments here do not hold up. In Congressional testimony today, the Fed, particularly the general counsel of the New York Fed, Thomas Baxter, argued that keeping transaction-level detail secret, was necessary to maximize value of Maiden Lane. As we have discussed earlier, and continue in more detail in a related post, that is bunk. And that begs the question of why the Fed is so insistent on holding the line here. While it may be imperial overreach and fear of starting down a slippery slope of disclosure, the Fed’s bobbing and weaving under the hot lights FEELS like a cover-up.

Moreover, the Fed has withheld information requested via subpoena from both SIGTARP and the House Oversight Panel. That says they are awfully keen to hide…something. That sort of intransigence is a red flag before a bull. The fact they hoped they could get away with it is troubling, and strongly suggests something is amiss.

Now mind you, the Fed’s cronyism does NOT have to come about via corruption or other nefarious reasons (the stonewalling could be to protect Geithner and Bernanke; for instance, they could have given testimony that is contradicted by internal evidence). The Fed appears to be captured by the industry, so badly that it is unable to recognize how distorted its perspective has become. This means it will vociferously defend the industry and individual firms.

So what is sus about the Fed’s conduct? Consider:

1. The Fed’s unusual step of buying the CDOs provided nearly $30 billion more in liquidity to a small number of banks. To put that in context, the first of the Fed’s emergency rescue programs, the Term Auction Facility, was at its outset a $40 billion program open to a much larger universe of firms and provided 28 day loans, not a permanent transfer.

2. The insistence that the Fed was up against a hard deadline of November 10. In response to questions today, Baxter insisted that the Fed had to have a new program in place by November 10, because that was when AIG would announce earnings and a rating agency downgrade seemed inevitable, which would lead to more collateral calls.

But that is misleading. First, even if the rating agencies issued their downgrades that very day, the collateral payment was not due that day. There would be some sort of time delay, not long, but I would guess 3-5 days (I assume expert readers will advise me and I will revise the post accordingly). Perhaps more important, it is typical when parties are negotiating to agree on waivers. How hard would it be for the Fed to obtain a waiver if it were negotiating an exit from the AIG CDS? Answer: not very if good faith negotiations were under way. At worst, the Fed could have had AIG make a partial collateral payment out of the remain credit line while discussions continued.

3. The Fed had done nothing to understand the CDS market or prepare for a crisis. Many observers believe the reason that Bear was not allowed to fail was that it was a significant counterparty in the credit default swaps market, that letting any big CDS player go could produce a domino effect, creating a wave of counterparty failures that would lead to systemic collapse. Aside from the backlash against the Bear rescue, Lehman was presumably dispensable despite its larger size because it was not as big a participant in the CDS game.

Since the CDS market was obviously a major source of risk and firms that were big CDS players (Merrill, Morgan Stanley, UBS) were seen as vulnerable, it would seem to be Job Number One of the Fed/Treasury to do some meaningful investigating to see how big the risks were and do some contingency planning (don’t even try telling me the Neel Kashkari “break glass” memo mentioned in Sorkin’s Too Big To Fail amounted to “planning”. You can’t plan if you don’t understand the terrain. And the “plan” was clearly too high concept to be useful when the dominoes did start to fall).

Now of course, preparation for an investment bank bankruptcy, which would lead (among other things) to a hard look at the credit default swaps market; failure to do so could fit the “Fed as chump” theory, that the authorities dropped the ball, big time. But the powers that be have shown a remarkable lack of interest in real diagnostics throughout. By contrast, the Bank of England, twice a year, puts out a Financial Stability Report than runs rings around anything I have seen the Fed prepare. When UBS got itself in so much hot water that it needed a rescue, the Swiss Banking Federation made it conduct an internal investigation (conducted by outside parties) and make two reports: one to the public, in the form of a report to shareholders that was very detailed, and an even more extensive one to the authorities.

The lack of interest in either post-mortems or planning suggests that the Fed does not want to know. And who would that lack of curiosity benefit? The Fed itself (as in not exposing past policy failures) and of course, the industry (not exposing incompetence and misconduct).

If that is not a misguided set of (implicit) priorities, I don’t know what is.

4. As we discuss separately (the new post on this will be up later today), the Fed keeps trying to keep transaction-level detail on Maiden Lane III under wraps, even though its arguments defending this action make no sense. That suggests there must be other reasons. One is that ML III is really not doing so well, despite valuation reports that say otherwise; the second is that digging into the transactions would be embarrassing to the Fed or the counterparties themselves.

4. A look at transaction detail (that is, the stuff the Fed has been desperate to hide), and counterparty exposures (which we have put together, not just CDS counterparty, but lead bank on the CDO, which in a surprisingly large number of cases is different than the CDS counterparty), suggests at a minimum pervasive patterns of really abysmal counterparty risk maangement amongst the AIG counterparties; notably, massive Goldman exposure, along with apparent efforts to conceal it. Thus the reluctance of NY Fed to disclose information about the counterparties begins to look like a possible case of regulatory capture. Or maybe, yet another case of credulity of experts.

As much as the Fed seems awfully eager to close this chapter, enough parties with subpoena are taking interest that l’affaire AIG is going to be scrutinized in exhaustive detail. The dirt will come out. Given the Fed’s past record on disaster planning, if there is something serious they are hiding, they are likely to be inadequately prepared for the blowback.