naked capitalism

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As everyone from Paul Krugman to Simon Johnson has noted, the banks are so big and politically powerful that they have bought the politicians and captured the regulators.

But the giant banks are not only dangerous because they skew the political system. There are five economic arguments against the mega-banks as well.

Impaired Competition

Fortune pointed out last February that the only reason that smaller banks haven’t been able to expand and thrive is that the too-big-to-fails have decreased competition:

Growth for the nation’s smaller banks represents a reversal of trends from the last twenty years, when the biggest banks got much bigger and many of the smallest players were gobbled up or driven under…

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand.

So the very size of the giants squashes competition.

Less Loans, More Bonuses

Small banks have been lending much more than the big boys.

The giant banks which received taxpayer bailouts actually slashed lending more, gave higher bonuses, and reduced costs less than banks which didn’t get bailed out.

Lack of Transparency in Derivatives

JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

Experts say that derivatives will never be reined in until the mega-banks are broken up.

Increased Debt Problems

As I pointed out in December 2008:

The Bank for International Settlements (BIS) is often called the “central banks’ central bank”, as it coordinates transactions between central banks.

BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:

The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.

In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default.

Now, Greece, Portugal, Spain and many other European countries – as well as the U.S. and Japan – are facing serious debt crises. See this, this and this.

By failing to break up the giant banks, the government is guaranteeing that they will take crazily risky bets again and again and again.

We are no longer wealthy enough to keep bailing out the bloated banks. We have serious debt problems. See this, this and this.

(Anyone who claims that Chris Dodd’s proposed “reform” legislation will prevent banks from getting bailed out again is wrong. If the giant banks aren’t broken up now – when they are threatening to take down the world economy – they won’t be broken up next time they become insolvent, either. And see this.)

Unfair Competition and Manipulation of Markets

Moreover, Richard Alford – former New York Fed economist, trading floor economist and strategist – recently showed that banks that get too big benefit from “information asymmetry” which disrupts the free market.

Nobel prize winning economist Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market:

“The main problem that Goldman raises is a question of size: ‘too big to fail.’ In some markets, they have a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information.”

Further, he says, “That raises the potential of conflicts of interest, problems of front-running, using that inside information for your proprietary desk. And that’s why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you’re going to trade on behalf of others, if you’re going to be a commercial bank, you can’t engage in certain kinds of risk-taking behavior.”

The giants (especially Goldman Sachs) have also used high-frequency program trading which not only distorted the markets – making up more than 70% of stock trades – but which also let the program trading giants take a sneak peak at what the real (aka “human”) traders are buying and selling, and then trade on the insider information. See this, this, this and this. (This is frontrunning, which is illegal; but it is a lot bigger than garden variety frontrunning, because the program traders are not only trading based on inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing).

Goldman also admitted that its proprietary trading program can “manipulate the markets in unfair ways”. The giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government’s blessings.

Again, size matters. If a bunch of small banks did this, manipulation by numerous small players would tend to cancel each other out. But with a handful of giants doing it, it can manipulate the entire economy in ways which are not good for the American citizen.

No wonder virtually every independent economist and financial expert is calling for the big banks to be broken up.

Some argue that it is logistically impossible to break up the behemoths. But if we broke up Standard Oil, we can break up the giant banks as well.

NASA mulls 28 potential ‘search for life’ missions Raw Story

The Ultimate Connection Machine h+ (hat tip reader Sugar Hush)

FDA wants your advice on food labeling MarketWatch

The Feds vs. Goldman Matt Taibbi, Rolling Stone

Legislating a Conscience on Wall Street Michael Hirsh, Newsweek

When You Lie Down With Them Dept: Morgan Stanley Has 69% Tier 1 Capital Exposure to the PIIGS Jesse

The crisis will spread without a Plan B Nouriel Roubini and Arnab Das, Financial Times

Fuld Understated Pay More Than $200 Million, Lehman’s Budde Says Bloomberg

Fraudonomics New York Press

Geithner Threatens Crack-Down on HAMP Servicers Housing Wire. I’ll believe it when I see it.

We Can’t All Be (Net) Exporters Tim Duy

One of the things that has been striking as revelation of bad behavior in the collateralized debt market has gotten more press is that a number of commentators who had taken the “nothing to see here, move on” stance have gotten religion.

Even more dramatic has been the change in perception of Goldman. The firm has had its vocal critics (including yours truly) but they seemed an ineffective minority. Goldman’s arrogance seemed only to confirm its “Government Sachs” connections, that it could do as it pleased and thumb its nose at the rest of us to boot. It compounded the public outrage over its record 2009 bonuses through its hamhanded, narcissistic rationalizations. Lloyd Blankfein’s “We’re doing God’s work” has come to epitomize what is wrong with the financial services industry post-crisis the same way Chuck Prince’s “We’re still dancing” did for the bubble era.

So the has been more that a little bit of schadenfreude at work. The press and public sentiment against Goldman has become widespread and heightened with the SEC lawsuit over Abacus AC1 2007. Even the supposedly bipartisan Senators were on the same page in Tuesday’s marathon hearings.

Now some point out, correctly, that Goldman is being singled out. On the one hand, there was a lot of bad behavior in the industry that has yet to be scrutinized closely. On the other, collateralized debt obligations were the ground zero of the crisis, and the banks like Goldman that were particularly “innovative” are now looking to have been too clever by half. As I discuss in some detail in ECONNED, these vehicles were spectacularly leveraged. Comparatively small amounts of capital produced greatly disproportionate systemic effects. Both our own contact with structured industry experts, and other accounts of subprime short strategies make clear that DeutscheBank was at least as aggressive as Goldman as far as real-estate-related CDOs were concerned. For instance, Deutsche was also creating synthetic CDOs on behalf of subprime short John Paulson; it had its own version of Goldman’s Abacus program (Deutsche’s was called Start).

A striking point of the hearings was that Goldman kept claiming that it was a mere market-maker, while the Senators kept asserting that the firm had a duty to customers. While Goldman arguably did not have a fiduciary duty, it most certainly is required to make accurate disclosures as an underwriter, and that is the basis of the SEC’s suit. Moreover, even if Goldman’s actions were narrowly legal, markets operate on trust. What happens to capital formation if investors increasingly regard markets as a shark pool?

What is stunning is that the Wall Street Journal defends Goldman (its headline labels the hearing an “inquisition”), and chooses to ignore the applicable regulations to do so. The piece disingenuously and inaccurately asserts that the Senate was trying to apply an incorrect standard to Goldman’s conduct, a “consumer narrative”. A representative section:

On one side was a Senate committee preaching a populist narrative that’s only been boosted by the Securities and Exchange Commission’s lawsuit against Goldman. Goldman bet against its clients. It sold mortgage securities to sometimes unwitting buyers, without disclosing that the broker or important clients were betting the other way. That fueled the mortgage crisis by dumping more junk into the system. It was also disingenuous.

Senators tried to make the case that this wasn’t the fair dealing customers expect in our consumer society. In this narrative, a customer or client buys a television from Best Buy and both the seller and the manufacturer carry some responsibility that the product will do what it’s supposed to do. The consumer can return it. There are warranties.

Wall Street doesn’t work that way. That was the point made by Goldman officials including Mr. Sparks, Josh Birnbaum, Michael Swenson, Fabrice Tourre—the trader named in the SEC case against Goldman—and at the end of the day, Lloyd Blankfein, Goldman’s chief executive.

The consumer narrative isn’t the one at work at Goldman or anywhere on Wall Street. It’s a pure caveat emptor market. Buyers carry the responsibility of knowing that products carry risk. They may not work as advertised. They know that Goldman, or any broker/dealer will work to line up investors to short the deal, or take that position itself. There are no guarantees.

Yves here. This is patent rubbish. It is a sign of the lousy state of the press in America that a politically-oriented blog, FireDogLake, does a better job of describing the applicable rules than the self-styled preeminent business newspaper in America. Oh, but we forget. That paper is opposed to the idea that commerce should be subject to rules.

As FireDogLake explained:

The staff of the Permanent Subcommittee on Investigations put together a memo explaining the basics of the transactions. After defining the terms related to securitized debt instruments, the memo explains that Wall Street firms can act as “underwriter” for the issuance of new securities.

If an investment bank agrees to act as an “underwriter” for the issuance of a new security to the public, it typically bears the risk of those securities on its books until the securities are sold. By law, securities sold to the public must be registered with the Securities and Exchange Commission (SEC). Registration statements explain the purpose of a proposed public offering, an issuer’s operations and management, key financial data, and other important facts to potential investors. Any offering document, or prospectus, given to the investing public must also be filed with the SEC. If a security is not offered to the general public, it can still be offered to investors through a “private placement.” Investment banks often act as the “placement agent,” performing intermediary services between those seeking to raise money and investors. Solicitation documents in connection with private placements are not filed with the SEC. Under the federal securities laws, investment banks that act as an underwriter or placement agent are liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of the securities to investors.

Firms can also act as market-makers:

Investment banks sometimes take on the role of “market makers” for securities and other assets that they sell to their clients, meaning that, in order to facilitate client orders to buy or sell, an investment bank may acquire an inventory of assets and make them available for client transactions. In addition, investment banks may buy and sell assets for their own account, which is called “proprietary trading.” The largest U.S. investment banks engage in a significant amount of proprietary trading that generates substantial revenues. Investment banks generally use the same inventory of assets to carry out both their market-making and proprietary trading activities. Investment banks also typically have an inventory or portfolio of assets that they intend to keep as long term investments.

GS wants everyone to interpret the ABACUS 07-ACI transaction and similar deals as if GS were a market-maker. The fact is GS acted as an underwriter. Underwriting is the creation and sale of new securities.

Yves here. Before readers try arguing “these were not securities,” CDOs are legal entities, mini-banks with asset and liability sides. Some tranches of the Abacus deal (the liability structure) was placed in the form of notes, which most assuredly are securities.

Legal issues aside, it isn’t merely the great unwashed public that is taking an increasingly dim view of Goldman. What is striking is the change in sentiment among professionals.

Recall Goldman’s reputation: that of being the best managed firm on the Street, and its boasting about its risk management as key to its superior profits (cynics will note that Goldman nevertheless needed to be rescued along with every other major financial player). Thus Goldman cannot readily shift blame for its mortgage market misdeeds onto staff; its obsessiveness about communication makes it well nigh impossible that any of its staffers were acting without authorization. And its once-vaunted risk management, which led observers to believe that Goldman was doing a better job of managing exposures, now increasingly looks like the firm was simply more systematic and aggressive than its peers in not just shifting risks onto customers but engaging in further profit-maximizing strategies that look downright predatory.

For instance, Bruce Krasting, who has often taken issue with me over credit default swaps and is generally of the view that like love and war, all is fair in markets, took a very dim view of a revelation by Josh Birnbaum. Per a post by Tom Adams:

Senator Coburn turns to short positions that Goldman took in companies that were sensitive to mortgages, including Merrill and Bear Stearns. Senator Coburn notes that after Goldman sold Timberwolf to Bear Stearns, they took a short position in the stock of Bear Stearns. This seems pretty devastating,

Yves here. Note that these positions were NOT taken on a equity desk (based on, say, a house view that all mortgage-related credits were a short, including, say, homebuilders). They appear to have been taken within (or at least credited to) Birnbaum’s group, the Structured Products Group. Krasting elaborates:

In 2007 the SPG had gains from hedges of ~$3b and losses of ~$2b on write down of inventory. It was described that the hedges included (1) shorts on the ABX index (2) shorts on single name ABS (3) long CDS against a variety of single names and (4) they shorted common stock of companies that had a high beta to a downfall of the Sub-Prime/Alt.A market.

We know from the testimony Bear Stearns was on that “short” list. That entire list is public. I have not seen it so I will just guess that in the fall of 2007 GS was shorting the likes of New Century, WaMu, the mono lines, Countrywide, Bear Stearns, and Lehman. That list could have been broader; it might have included Fannie Mae and Freddie Mac, Citi, and BoA, even the likes of a Northern Rock or RBS.

One aspect of the collapse of 2008 was how destructive capital markets had become. The shorts pushed equities down so fast that managements and regulators lost control. The shorts were clearly predators. For me it was the shorts that destroyed the equity values. It was a near daily event.

My questions on this is (A) How much of this did Goldman do? (B) How much did the rest of the market do? (C) Did this exceptional demand for short interest in financial stocks accelerate the collapse of Bear, Lehman and all the others?

Yves here. Krasting focuses on the equity short, but the CDS single name longs were if anything even more destructive (even the Wall Street Journal described CDS as a great vehicle for bear raids). Buying CDS protection in volume pushes up yields on bonds. The rating agencies respond to market signals (this is a dirty secret). If the market yield on a bond is too far out of line with their rating, they feel pressured to downgrade. The downgrade confirms the suspicions of those who have doubts, leading to either sales of the bonds themselves or purchases of CDS by new parties, further pushing up yields. And for highly leveraged companies, rising interest rates translate pretty quickly into diminished profits, again putting pressure on ratings.

Now admittedly Lehman was beyond redemption, but had it decayed in a more gradual fashion, it might at least have filed for a long-form bankruptcy, or possibly even gone through a good bank-bad bank restructuring (the sort of deal the Fed was trying to broker that failed at the 11th hour). And had Lehman not collapsed, September and October 2008 would have looked very different.

Moreover, industry participants believe DeutscheBank was engaged in similar activity. One industry participant who had the vast misfortune to be long some of the CDOs that Deutsche pedaled recalls in 2007, when Deutsche came to his firm proposing a hedge against some of those deals, recalls his board asking point blank, “Are you short our company?” and not getting a straight answer.

Goldman is increasingly beleagured. Its lobbyists are now pariahs. More private lawsuits are coming to the fore. There are rumors it is in settlement talks with the SEC. But the once-storied firm apparently turned its well oiled machine to ruthless profit-seeking. It is an open question how much damage the firm will sustain from the well-deserved backlash, and whether it can change its conduct.

Bloomberg provides a summary of a report by Morgan Stanley that has tried to quantify the level of strategic defaults. The analysis seeks to identify borrowers who walk away from mortgages that they can arguably afford, and defines that group as those who go from paying on time to missing three mortgage payments in a row, while still paying on time on other consumer debts that are greater than $10,000.

This definition highlights some interesting issues. First, it’s a reminder of how pervasive consumer indebtedness is in America. In the 1980s, it would be almost unheard of to get a car loan or run a credit card balance. Second, it also suggests that some of these strategic defaulters are simply “pre defaulting”, as in recognizing their ability to service the mortgage is tenuous (as in they may be straining to stay current, and recognize that one shock will put them in arrears) and they’ve decided, with the home under water, that it’s better to face the inevitable early. Third, and perhaps most important, the defaults again illustrate the perverse side effects of securitization. In the old world of a mere 20 years ago, most banks would work with a borrower that was facing financial stress and needed a mortgage mod. The lender would recognize that as long as a mod left it with appreciably lower losses than getting the house back, principal reduction was a sound move. And as we’ve argued repeatedly, deep principal mods have been shown to produce lower redefault rates than payment modification programs.

The report contained other findings:

A fifth of U.S. homes carrying mortgages were worth less than their loans in the fourth quarter, according to Seattle- based Zillow.com, which runs a real estate data Web site. Home prices in 20 metropolitan areas tumbled 33 percent from July 2006 through April 2009, then rose for five months before falling for the next five, leaving them up 2.8 percent from lows, according to an S&P/Case-Shiller index….

For mortgage-bond investors, the data signals a problem with prime-jumbo debt and strengthens the case for investing in subprime, the analysts wrote. That’s in part because strategic defaults are less prevalent among borrowers with subprime characteristics and they may benefit from government-aid programs that don’t target large loans, the analysts wrote.

Yves again. This indirectly raises an issue that Tanta wrote about, that many subprime borrowers did not initially borrow as subprime, but as their financial condition deteriorated, refied into subprime.

And this problem is not going away…..

Housing won’t recover for three to five years as mounting foreclosures hold down prices, mortgage-bond pioneer Lewis Ranieri said yesterday in a panel discussion at the Milken Institute Global Conference in Beverly Hills, California.

“There’s another big leg down,” he said. “You can’t have much of a rally when you’ve got this big overhang.”

This is a post I wrote earlier today at Credit Writedowns.

As I said yesterday,  investment banks are institutions which do fulfil a useful role in society. I would define their role as companies where large institutions and governments receive financial advice and raise capital. Goldman Sachs is an investment bank. As such, Goldman must offer financial advisory services, capital markets origination, and secondary market support to maintain an orderly market in the markets in which it originates deals. That is what a full-service investment bank does and has always done.

In my view, the advisory business and the sales and trading functions are black and white issues.

Advisory Business

When Goldman gives financial advice to a client and executes a transaction or deal on the back of this advice, it must do so only in the best interests of the client. There are no ifs ands or buts here.  The client comes first. I went into the moral and ethical obligations in my post "Inside the mind of an investment banker: Greece, Goldman and derivatives," so I will let you read that post to get a full picture there. I will just reiterate that this is a black and white issue.  You simply cannot execute transactions or do deals that you know are not in your client’s interests. Full stop.

Sales & Trading

On the sales and trading side, Goldman Sachs is a market maker. That means their traditional role is to buy and sell securities principally to facilitate liquidity in the market. They are not a principal actor in this regard. As such, caveat emptor applies to their counterparties. Goldman is under no obligation to reveal its positions to counterparties in the market it makes. In fact, doing so compromises a firm’s ability to make a market. If you want to do a trade, Goldman’s only obligation is to show you a price because that’s what broker/dealers do. Lloyd Blankfein said as much in his Senate testimony. I see this as a black and white issue. They have no obligation to reveal their positions. Full stop.

Capital Markets

Then there is origination, an area where I have worked. Origination is what many firms call their ‘Capital Markets’ group. Here is where the problems begin because the origination groups are at once advisors and market-makers in their function. Your role as Capital Markets professional is to originate equity, debt, or structured product (derivative) deals for institutional clients, sell those deals to ‘buy-side’ clients, and to make a market in those instruments in the after market.

So, the capital markets guys must do deals that are in the best interests of the institutions, originating those deals. But, do they have an obligation to inform ‘buy-side’ clients of the pitfalls of those deals?  Yes. 100%.  This is where the problems lie in the Abacus AC1 deal that is the subject of alleged fraud. This was not a deal without a client. Paulson was the client. The synthetic CDO never would have been created had Paulson & Co. not asked for its creation. Goldman originated this Abacus deal at the behest of its institutional client, Paulson & Co. Therefore, Goldman’s obligation in the deal was to structure a deal which was in Paulson’s best interest.

The problem, therefore, is that in originating this transaction, Goldman was obligated to disclose to its initial buy-side clients what Paulson’s role in the deal was. Goldman was not selling a structured product without a client nor was it making a market in a security already originated. It was originating a deal purposely put together for a specific institution, Paulson & Co.. If Goldman did not fully disclose Paulson’s exact role – and all indications are it did not – then, at a minimum, it was not fulfilling its public purpose. The SEC has indicated this goes further – to fraud i.e. making ‘material’ misrepresentations to its buy-side clients and the company structuring the deal.

Proprietary Positions

Moving to a different track, let’s talk about ‘proprietary trading’ and the Volcker Rule for a second. What is novel in financial services is what is known in the business as "risking one’s own capital as a principal." Every major bank now is not just in the business of servicing clients in the ways I described above but also in making money as a principal actor.

This began during the 1980s when firms would risk their own capital in making bridge financing to corporate raiders like Carl Icahn during the Predator’s Ball days. One reason investment banks became so leveraged is that commercial banks had a natural advantage in this business due to their enormous balance sheet.  So you saw firms like UBS, Deutsche Bank and JPMorgan muscling their way into mergers and acquisition and origination via this channel.

At some point, the banks realized that deregulation meant they didn’t have to risk their capital just for other people. They didn’t have to do deals where the profit accrued only to their clients. They could become principals, taking what they deemed to be prudent risks for their own benefit. In essence, the banks all became hedge funds and private equity groups, often competing with their clients for business.

Now, the capital markets business already presents an ethical dilemma because of the opportunity for duplicity i.e. flogging off garbage as AAA to sell-side clients just to make a buck. This goes as far as getting bad assets off the bank’s balance sheet and sticking it with buy-side clients.

But, proprietary activity raises the potential conflicts to a new level by pitting a potential client against the bank for the very same business. The bank goes from market-maker or advisor to rival who cannot be trusted.  This is why the Volcker Rule has been posited. The goal of the Volcker Rule is to fashion a way to separate these proprietary activities which are replete with conflicts of interest from the more public purpose role of banks.  I don’t think the legislation based on the rule drafted makes a lot of sense given how difficult it is to define what a proprietary trade is. But the concept is grounded in the knowledge that these conflicts of interest pose a risk to the financial system.

My own view is that none of this will be resolved because banks make too much money in proprietary activities. They will lobby Congress until they get legislation more palatable to their interests. Only when the financial system does collapse will Congress be forced to turn away from the banking special interests. And at that point, with populist fervour against banks much greater than it is today, much more draconian remedies will be in store.

Of course, between now and then, there will still be a lot of money to be made by individual bankers.

Update: one of the comments mentioned asset management. This is another area into which the legacy investment banks have expanded, but that isn’t a part of their traditional role.

Have Goldman Sachs charges opened floodgates? BBC

Obama the Centrist Brad DeLong, Project Syndicate. Mirabile dictu, DeLong says bad things about Obama!

Election 2010: Can Gordon Brown survive this hurricane? Jonathan Freedland. A rather amazing turn of events….

Random Thoughts on the irony of Minarchism One Salient Oversight

Roubini Says Rising Sovereign Debt Leads to Inflation, Defaults Bloomberg. For more detail, see Milken: Nouriel Roubini and Mike Milken on What’s Next Paul Kedrosky, which has the video.

Who’s exposed to Greece (with Parts II and III) FT Alphaville

Now We Are Talking! Joe Costello

CDO fees flow to ratings agencies Financial Times

European debt crisis: the possible domino effect Guardian (hat tip reader Crocodile Chuck)

Household debt and macroeconomic fluctuations Atif Mian and Amir Sufi, VoxEU

Austerity Tony Judt New York Review of Books

Antidote du jour:

→ Washington’s Blog

You might assume that the reason for the implosion in the Eurozone is a mystery.

But it’s not.

There Wouldn’t Be a Crisis Among Nations If Banks’ Toxic Gambling Debts Hadn’t Been Assumed by the World’s Central Banks

There wouldn’t be a crisis among nations if banks’ toxic gambling debts hadn’t been assumed by the world’s central banks.

As I pointed out in December 2008:

The Bank for International Settlements (BIS) is often called the “central banks’ central bank”, as it coordinates transactions between central banks.

BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:

The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.

In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default.

No wonder Greece, Portugal, Spain and many other European countries – as well as the U.S. and Japan – are facing serious debt crises.

But They Had No Choice … Did They?

But nations had no choice but to bail out their banks, did they?

Well, actually, they did.

The leading monetary economist told the Wall Street Journal that this was not a liquidity crisis, but an insolvency crisis. She said that Bernanke is fighting the last war, and is taking the wrong approach (as are other central bankers).

Nobel economist Paul Krugman and leading economist James Galbraith agree. They say that the government’s attempts to prop up the price of toxic assets no one wants is not helpful.

BIS slammed the easy credit policy of the Fed and other central banks, the failure to regulate the shadow banking system, “the use of gimmicks and palliatives”, and said that anything other than (1) letting asset prices fall to their true market value, (2) increasing savings rates, and (3) forcing companies to write off bad debts “will only make things worse”.

Remember, America wasn’t the only country with a housing bubble. The world’s central bankers let a global housing bubble development. As I noted in December 2008:

The price of Southern California homes is already down 41%, Southern California hasn’t fallen as fast as some other areas, and we’re nowhere near the bottom of the market.Moreover, the bubble was not confined to the U.S. There was a worldwide bubble in real estate.

Indeed, the Economist magazine wrote in 2005 that the worldwide boom in residential real estate prices in this decade was “the biggest bubble in history“. The Economist noted that – at that time – the total value of residential property in developed countries rose by more than $30 trillion, to $70 trillion, over the past five years – an increase equal to the combined GDPs of those nations.

Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.

And the bubble in commercial real estate is also bursting world-wide. See this.

***

Moreover, the real estate bubble formed the base upon which a series of bubbles in derivatives were built. Specifically, mortgages were packaged in “collateralized debt obligations” (CDOs), which were sold in enormous volumes all over the world. Credit default swaps were then bet against the companies which bought and sold the CDOs.

Now, with housing prices crashing, the CDO bubble is crashing, as is the CDS bubble.

A series of other derivatives bubbles are also crashing. For example, the “collateralized fund obligations” – sort of like CDOs, but where the assets of a hedge fund are the asset being bet on – are getting creamed as hedge funds are forced to sell off many hundreds of billions in assets to cover margin calls.

As everyone knows, the size of the global derivatives bubble was almost 10 times the size of the world economy. And many areas of derivatives are still hidden and murky.

So the bust of the derivatives bubble could even be bigger than the bust of the housing bubble.

BIS also cautioned that bailouts could harm the economy (as did the former head of the Fed’s open market operations). Indeed, the bailouts create a climate of moral hazard which encourages more risky behavior. Nobel prize winning economist George Akerlof predicted in 1993 that credit default swaps would lead to a major crash, and that future crashes were guaranteed unless the government stopped letting big financial players loot by placing bets they could never pay off when things started to go wrong, and by continuing to bail out the gamblers.

These truths are as applicable in Europe as in America. The central bankers have done the wrong things. They haven’t fixed anything, but simply transferred the cancerous toxic derivatives and other financial bombs from the giant banks to the nations themselves.

Are Debt-Based Economies Sustainable?

Of course, Eurozone countries like Greece and Italy have been living beyond their means and masking their real debt levels for years (with a little help from Goldman Sachs, JP Morgan and the boys) – just like the U.S.

And of course, Eurozone central banks – like America’s Federal Reserve – create fiat money out of thin air. As I argued in March, one or the primary problems is that Europe and America have debt-based economies, and the debt-based ponzi scheme has reached it’s maximum limit:

Private banks don’t make loans because they have extra deposits lying around. The process is the exact opposite:

(1) Each private bank “creates” loans out of thin air by entering into binding loan commitments with borrowers (of course, corresponding liabilities are created on their books at the same time. But see below); then

(2) If the bank doesn’t have the required level of reserves, it simply borrows them after the fact from the central bank (or from another bank);

(3) The central bank, in turn, creates the money which it lends to the private banks out of thin air.

It’s not just Bernanke … the central banks and their owners – the private commercial banks – have been running the printing presses for hundreds of years.

Of course, as I pointed out Tuesday, Bernanke is pushing to eliminate all reserve requirements in the U.S. If Bernanke has his way, American banks won’t even have to borrow from the Fed or other banks after the fact to have reserves. Instead, they can just enter into as many loans as they want and create endless money out of thin air (within Basel I and Basel II’s capital requirements – but since governments are backstopping their giant banks by overtly and covertly throwing bailout money, guarantees and various insider opportunities at them, capital requirements are somewhat meaningless).

The system is no longer based on assets (and remember that the giant banks have repeatedly become insolvent) It is based on creating new debts, and then backfilling from there.
It is – in fact – a monopoly system. Specifically, only private banks and their wholly-owned central banks can run printing presses. Governments and people do not have access to the printing presses (with some limited exceptions, like North Dakota), and thus have to pay the monopolists to run them (in the form of interest on the loans).

See this and this.

At the very least, the system must be changed so that it is not – by definition – perched atop a mountain of debt, and the monetary base must be maintained by an authority that is accountable to the people.

A Bloomberg story today on Neil Barofsky, the head of the Office of the Special Inspector General for the Troubled Asset Relief Program, or SIGTARP, contained this explosive little item (hat tip Tom F):

The TARP watchdog has also criticized Treasury Secretary Timothy F. Geithner in reports and in congressional testimony for his handling of the process by which insurance giant American International Group Inc. was saved from insolvency in 2008, when Geithner was head of the Federal Reserve Bank of New York.

The secrecy that enveloped the deal was unwarranted, Barofsky says, adding that his probe of an alleged New York Fed coverup in the AIG case could result in criminal or civil charges.

In Senate Finance Committee testimony on April 20, Barofsky said SIGTARP would investigate seven AIG-linked mortgage-related securities similar to Abacus 2007-AC1, the instrument underwritten by Goldman Sachs Group Inc. that is at the center of a U.S. Securities and Exchange Commission lawsuit filed against the investment bank on April 16.

Yves here. We’ve been told that Barofsky is political, despite his “take no prisoners” image, and indeed, his report that criticized the New York Fed for paying out 100% of the notional value to holders of AIG credit default swaps bore that out when it bizarrely exonerated the Fed for its repeated retrades of the AIG funding, which is of greater economic consequence than the failure to negotiate a haircut on the CDS).

In fact, this investigation was first discussed publicly in late January, when SIGTARP made it abundantly clear that is was not prepared to tolerate New York Fed intransigence. As we noted then:

Oh, this is starting to get VERY interesting. L’affaire Fed/AIG is beginning to smell a little like Watergate, where an imperial organization that thinks it writes its own rules (then the Nixon administration, here the Fed) fights tooth and nail to keep certain activities hidden well away (recall, for instance, the Saturday night massacre).

Now of course, the Fed lacks the Nixonian appetite for dirty tricks and open confrontation. And unlike Watergate, where a crime had been committed, here instead we have a mystery: why is the Fed so desperately to hide the details of the AIG bailout, particularly since the bulk of what they say they are trying to sequester is already in the public domain? (And my own little pet peeve is that the focus has been strictly on how much Geithner knew and when. Ahem, what about Bernanke? He and Paulson were virtually joined at the hip during the crisis, and Paulson was heavily involved in all the bailouts. Was the NY Fed a rogue organization of some sort? How can you not say the board of governors is not ultimately responsible for a matter as significant as the AIG rescue?)

As this little scandal brews, the Fed has engaged in the classic error of withholding documents, so that the cover-up may well prove to be a more serious matter than the underlying chicanery (although we rather doubt that; more on that in due course). And remember, the Fed is a regulator! Here we have a body that has as one of its significant duties enforcing rules, both legislation as well as its own regulations, bending them in its dealing with the SEC and refusing to comply with subpoenas. Why should the public trust an organization that puts itself above the rule of law?

So the real significance of the Bloomberg update today is Barofsky would be unlikely to mention the idea that his investigation could result in charges unless he thought it probably would result in charges.

Another factor favoring this outcome is that Barofsky has the wind in his sails in taking on Fed secrecy. While the audit the Fed movement isn’t getting as much press as Goldman, Greece, and the financial reform bill slugfest, it continues to gain momentum. From a story at Huffington Post by Ryan Grim:

As unusual a coalition as can be crafted in the Senate plans to fight for an amendment to the Wall Street reform bill that would open the Federal Reserve to a serious audit by the Government Accountability Office. Sponsored by Sen. Bernie Sanders (I-Vt.), the language is modeled after an amendment that passed the House, sponsored by Reps. Alan Grayson (D-Fla.) and Ron Paul (R-Texas).

Sanders is joined by four Republicans of varying politics: John McCain (Ariz.), Jim DeMint (S.C.), David Vitter (La.) and Sam Brownback (Kan.). If Democrats in the Senate back the measure, it would have at least 63 votes, but Banking Committee Chairman Chris Dodd (D-Conn.) is opposed and has argued against a broad audit.

Yves here. While there is a large and growing constituency for reining in the Fed, I am not convinced that anyone in the circles of power is willing to take on a Cabinet secretary who most see as sincere but badly captured.

Sometimes I can miss the blindingly obvious.

Like other observers of the widening sovereign debt crisis in Europe, we’ve commented on the fact that the big reason for Germany to work towards a rescue (more likely, the end game is a restructuring) of Greece and other Club Med members at risk is that its own banks, like those of France, are exposed if Greece defaults. Given that Eurobanks were thinly capitalized in the runup to the crisis and have recognized even fewer losses than their US counterparts, they are still fragile and vulnerable to systemic shocks. So the axis of contagion seemed to be through bank holdings of Greece sovereign debt (as well as having written CDS on Greek debt).

But we neglected to consider a more direct source of trouble, namely, that of bank runs in the countries at risk. John Mauldin’s latest newsletter tells us that is already underway in Greece:

Money is flying from Greek banks, which makes sense, as how can a bankrupt Greek government guarantee Greek bank deposits? I know that Greek bankers may have a different view, but Greek depositors are voting with their feet. And …it is not just Greece. It is fast becoming Portugal. And Spain is not far behind in my opinion.

Yves here. Despite all the noise about government debt defaults, the pattern in the Great Depression was selective default (war debt being the big favorite). However, this was also an era before bank deposit insurance was the norm for advanced economies. Moreover, Europeans may be even more quick trigger to pull funds out of banks, given that they have more direct experience of the fragility of governments (World War II memories, the implosion of Yugoslavia on its borders, the impact of general strikes). Recall that in the financial crisis, many US depositors were nervous about bank safety (witness how bank analysis service Institutional Risk Analyst offered a retail bank soundness product to cater to inquiries).

So we have a second potential axis of contagion, via impairment of banks in the Club Med countries themselves. That has the potential to affect:

1. Bondholders of banks in Club Med countries (witness the virtual shutdown of bond issuance in Europe)

2. Companies, whether domestic or foreign, who do business in Club Med countries (transactions are normally settled in local banks; finding banks both sides to a commercial deal will find acceptable may loom as a issue)

3. Most important, interbank markets

So far, the reaction to the Greece/Club Med crisis seems to be a generalized widening of risk premia (ex the US, where investors seem to believe the eurozone can implode without having any adverse impact here). We may start to see more differentiation, in particular, further widening in exposures that are arguably on the front lines, as the crisis grinds on.

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The Fed believes that it has succeeded in making monetary policy significantly more transparent. Furthermore, the Fed believes that by being transparent it can influence market expectations and the behavior of the real economy. This is the basis for the emphasis on “talk as policy”.

However, one can ask: has rhetorical guidance regarding the Fed funds target made policy significantly more transparent than in the past? Assume for the moment that, in an effort to make its next statement less repetitive, the Committee decided to replace the word “extended” with a synonym – “prolonged” Is there any doubt that the markets would react to the changing of the word “extended”, even if it was only to replace with one of its synonyms?

In this context, it seems to me that one might reasonably ask:

1) If policy is so transparent, why should the market care one iota if the FOMC were to substitute “prolonged” for “extended” or to replace any other word in any of its communications with a synonym?

2) Has the use of “code” words in FOMC statements increased policy transparency, or simply reduced the uncertainty about the near-term course of short-term interest rates?

The detailed parsing of FOMC statements and minutes by Fed watchers reminds me of the analyses produced by Kremlinologists and Sinologist during the height of the Cold War. Limited in their ability to do any real analysis of developments in Russia and China, Kremlinologists and Sinologists carried out careful textual analysis of the public pronouncements of the relevant political leaders. Great importance was attached to the most miniscule changes in statements, e.g., an out-of-favor former official who had previously been described as a revisionist dog suddenly being described as a running revisionist dog. This form of usually meaningless “analysis” waned after the Cold war ended and analysts had access to real information.

The Fed cares about policy transparency, but the markets care about and want certainty regarding the future course of interest rates. The Fed has made it clear that it is targeting inflation using a Taylor Rule construct. Does micro managing volatility in the Fed funds market via code words make policy formulation more transparent? Is using “talk” to dampen uncertainty in the Fed funds market necessary to achieve policy transparency? Providing transparency about the policy formation process does not eliminate uncertainty about the future course of interest rates. The Fed, however, has come to view reduced uncertainty about the near term course for the Fed funds target as a necessary component and measure of policy transparency.

The market seems to enjoy the reduced uncertainty. However, if there are benefits to the Fed providing verbal guidance about the near term course of policy, there are also costs. Reduced uncertainty about the future course of the Fed funds rate potentially makes economic agents more willing to employ leverage and run maturity mismatches. In point of fact, increasing the use of maturity mismatches may currently be a goal of policy. However, the slow and overly telegraphed tightening cycle post 2003 almost certainly contributed to the excessive use of leverage and the maturity mismatches which supported the housing bubble. It is entirely possible that someday the FOMC will be forced to delay or alter the targeted path for the Fed funds rate because the desired adjustment of policy would be too big a shock for the markets. Surprises do happen.

If the Fed gets policy right, then any increased uncertainty about the near term course of the Fed funds rate would be a non-issue. If the Fed sets policy incorrectly, no one will care about the increased volatility in the Fed funds rates either. The economy, the markets and the Fed would be better off if the Fed stopped its editorial hand holding and encouraged economists inside and outside the Fed to spend their time and energy focusing on the economy and the financial markets instead of the thesaurus.

S&P cut Spain’s long term rating to AA today with a negative outlook. From Bloomberg:

S&P said in a statement today that the outlook on Spain is negative, reflecting the chance of a possible further downgrade if the “budgetary position underperforms to a greater extent than we currently anticipate.” Spain was last cut by S&P in January 2009.

The risk premium investors demand to hold Spanish bonds surged to the highest in more than a year today and the price of insuring Spanish bonds against default reached a record as doubts about Greece’s ability to pay its debt spilled over into Spanish and Portuguese markets…

“We now project that real GDP growth will average 0.7 percent annually in 2010-2016,” S&P said.

From the Wall Street Journal:

The ratings agency said that the Spain is likely to have an extended period of subdued economic growth, which weakens its budgetary position. The move sent equities in Spain the U.S. broadly lower, while the euro fell back to a one-year low against the dollar of $1.3131….

In addition, S&P took into account the possibility that Spanish public and private sector borrowing costs could remain elevated this year and next and further slow Spain’s recovery from the current recession.

S&P warned that “additional measures are likely to be needed to underpin the government’s fiscal consolidation strategy and planned program of structural reforms.”

Main factors dampening Spain’s medium-term growth prospects include private sector indebtedness, which S&P estimates is higher than that of many of Spain’s peers, as well as high unemployment, a fairly low export capacity, and an unwinding of the government’s fiscal stimulus as part of its current efforts to reduce general government deficit to 3% of GDP by 2013.

→ Washington’s Blog

It’s not just Greece and Portugal.

As Simon Johnson reports:

This is not now about Greece (with 2 year yields reported around 20 percent today) or Portugal (up 7 basis points) or even Spain (2 year yields up 27 basis points; wake up please) or even Italy (up 6 basis points). This is no longer about an IMF package for Greece or even ring fencing other weaker eurozone economies.

This is about the fundamental structure of the eurozone, about the ability and willingness of the international community to restructure government debt in an orderly manner, about the need for currency depreciation within (or across) the eurozone. It is presumably also about shared fiscal authority within the eurozone – i.e., who will support whom and on what basis?

(In related news, Eurozone sovereign credit default swaps widened somewhat Tuesday, but tightened again after the German finance minister said that Germany will rush through a disbursement of funds to Greece.)

Standard & Poor’s downgraded Spain’s sovereign credit rating today from AA+ to AA, after recently slashing Greece’s rating to junk and lowering Portugal’s rating two notches from A+ to A-.

Ambrose Evans-Pritchard writes that there are “ominous signs of investor flight from Spain and Italy.”

As this Reuters chart shows – based on information from BIS – France, Switzerland and Germany are the largest holders of Greek debt:

David Rosenberg notes:

Portugal’s stock market has traded down to a 12-month low and it’s so bad in Greece that the government has banned short selling for two months. (Hey, it worked in the once-capitalistic U.S.A. didn’t it?) We see in the NYT that Barclay’s analysts believe that Greece needs €90 billion to see them through, €40 billion for Portugal and €350 billion for Spain!That is €480 billion of refinancing help, which dwarfs the latest €45 billion EU-IMF joint aid announcement by a factor of TEN (according to Ken Rogoff, the IMF is maxed out after €200 billion)! Do euros grow on trees as fast as Bernanke-bucks? Would the ECB, modeled after the Bundesbank, ever resort to the printing press for a fiscal bailout? Where exactly is this money going to come from?

***

Yesterday was really as much, if not more, about Portugal than it was about Greece. Contagion risks are spreading as they were amidst the turmoil around Bear Stearns in early 2008 …

[Spain's] combined fiscal and current deficits are the highest in the industrialized world, save for Iceland (and we know what shape it is in). The amount of debt it has to refinance in the coming year is as large as the entire Greek economy …

***

If the other two major rating agencies follow S&P’s lead and cuts Greece to “junk”, then the ECB would be in a real bind for it cannot hold below-investment-grade bonds on its balance sheet. If the ECB does accept junk-rated Greek debt as collateral, then the sanctity of its balance sheet will be seriously undermined; though this ostensibly didn’t matter too much to the Fed in the name of saving the system.

Nouriel Roubini says “in a few days there might not be a eurozone for us to discuss.”

It is tempting to assume that this is just a European problem. But that might be a very erroneous assumption. See this, this and this.

And as Megan McCardle writes:

The most terrifying words I’ve seen written so far about the growing crisis in Greece were penned by Yves Smith yesterday: “So the whole idea that the financial crisis was over is being called into doubt. Recall that the Great Depression nadir was the sovereign debt default phase. And the EU’s erratic responses (obvious hesitancy followed by finesses rather than decisive responses) is going to prove even more detrimental as the Club Med crisis grinds on.”

The Great Depression was composed of two separate panics. As you can see from contemporary accounts–and I highly recommend that anyone who is interested in the Great Depression read the archives of that blog along with Benjamin Roth’s diary of the Great Depression–in 1930 people thought they’d seen the worst of things.

Unfortunately, the economic conditions created by the first panic were now eating away at the foundations of financial institutions and governments, notably the failure of Creditanstalt in Austria. The Austrian government, mired in its own problems, couldn’t forestall bankruptcy; though the bank was ultimately bought by a Norwegian bank, the contagion had already spread. To Germany…. It’s also, ultimately, one of the reasons that we had our second banking crisis, which pushed America to the bottom of the Great Depression, and brought FDR to power here.

A version of this post appeared yesterday at Credit Writedowns.

I am running a poll on whether Greece will default. Please click here to vote. And feel free to comment on why you voted as you did.

German Chancellor Angela Merkel is feeling pressure to force German banks to take a haircut on Greek debt by both her own party and opposition leaders (like Frank-Walter Steinmeier, the former Vice Chancellor and now head of the opposition in the Bundestag).  This is the first public indication that German politicians recognize that a Greek default would negatively impact the capital base of German domestic institutions which hold large amounts of Greek sovereign debt.

So, now the rhetoric is shifting away from one purely of austerity for Greece in return for (the now larger) aid to one in which Greece undergoes a voluntary restructuring. Yves’ most recent post on this topic tells you that. On Friday, in a post based on Marshall’s BNN interview, I mentioned three scenarios for Greece at this juncture.

• In scenario one, you eject Greece from the Eurozone, they devalue their currency and, after a turbulent period, they are on the road to recovery.
• Outcome number two is to depreciate the Euro, of course. The Euro is dropping as we speak.  But, I am talking about a more serious decline. As I recall, the Euro dipped to as low as 83 cents during Robert Rubin’s strong dollar policy days.  If the EU structures the bailout in the right way (fully backstops the period of increasing debt to to GDP) and floods each country with liquidity (aka prints money), you are sure to get this kind of outcome. Everyone gets a massive boost to competitiveness. Problem solved.
• Neither of these scenarios is particularly palatable as they are likely to increase already mounting trade friction.  The other Edward mentions the only other viable alternative: a restructuring or default.

So, where there has been a lot of political posturing around scenario number one (or its analogue in Germany and a few core Europe countries leaving the euro), there has been little public discussion from policy makers about scenarios two and three. In the link in the last bullet above, Edward Hugh puts it in plain English.

At the same time, some sort of Greek default is now no longer simply a theoretical possibility among many others, indeed talk of the inevitability of some form of debt restructuring (albeit voluntary) grows with every passing day. Erik Nielsen European Economist with Goldman Sachs said this week he is expecting Greece to offer some sort of “voluntary debt-restructuring” to creditors over coming months, while JP Morgan issued a research note saying that while such restructuring may not be imminent, the move would make sense given that Greece could be seen as “the sovereign analogue of a ‘bad’ company with a bad capital structure”.

Restructuring is simply a polite word for default, with the difference that it is normally carried out by agreement. The most likely form of restructuring in the present context would be debt rescheduling, whereby short and medium-term debt is converted into a long-term version, as happened with the so-called “Brady bonds” devised by the US Treasury to resolve the debt difficulties of a number of Latin American countries in the late 1980s.

Two weeks ago, we were considering the options including True Fiscal Austerity (see Greece And The Potential Upside In An IMF Rescue). Yet, while Marc Chandler mentions raising the pension age to 67 without exception as part of a True Fiscal Austerity solution, few are talking about True Fiscal Austerity as a solution anymore. It’s now either a default or restructuring within the euro-zone or a break-up of the euro-zone (and default or currency devaluation). This is a signal that things have deteriorated significantly. The worry now must be contagion inside the euro-zone and within the banking sector.

Man rescued off Isle of Sheppey after sailing blunder BBC. Reader John M deems this to be a Darwin award honorable mention.

India to stop tiger tourism in attempt to prevent species extinction Times Online

Gamble Sours for Many Kentucky Horse Breeders New York Times. Another “this is a recovery?” datapoint.

Cornell Study: Juries Convict Attractive People Less Often Cornell Daily Sun (hat tip reader John D)

Robots In Space h+ (hat tip reader Sugar Hush)

The Senate Goldman Hearing: Fiduciary duties for broker-dealers? Conglomerate

A Middle East Peace That Could Happen (But Won’t) Tomgram

Did Josh Birnbaum Make a Slip? Did the Senators Catch It? Bruce Krasting

Volcano crisis cost airlines more than £2bn Independent

Citigroup’s Vikram Pandit pens letter to White House Politico

US Equity Markets Feel an Unfamiliar Twinge of Fear Jesse

SEC Probes ‘Side Pocket’ Arrangements Wall Street Journal

Why cautious reform is the risky option Martin Wolf, Financial Times

Antidote du jour:

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Economists have joined the debate about the merits of requiring the downsizing of too big to fail (“TBTF”) financial firms. However, these debates have almost been devoid of theoretically based economic arguments.

Some economic analysts have argued that the TBTF institutions have captured and will manipulate the relevant regulatory and political structures to their advantage. This a political argument and economists as economists do not have any greater insight into the political dimension of issues than Joe and Mary Sixpack. Other economists have decried the TBTF institutions and their contribution to a further skewing of the distributions of income and wealth. Again, economists as economists have no greater insight in to issues of economic fairness than the next person.

With the exception of citing moral hazard incentives to greater risk taking, economists speaking as economists have been virtually silent about the fact that TBTF (and wanted-to-be-TBTF) firms were the center of a process of designing, underwriting, and issuing a variety of structured capital market products that contributed not only to redistributions of wealth in their favor, but (and more importantly to economists as economists) also contributed to the misallocation of resources on a massive scale. And the efficient allocation of resources is the sine qua non of economics.

This post outlines one line of economic reasoning that leads to the conclusion that TBTF financial firms should be dismantled on the grounds that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.
It is not a general theory of the recent crisis, but an argument suggesting that in financial markets dominated by a few large firms, those firms will be in a position to exploit informational asymmetries and enrich themselves even as their excess profits are dwarfed by the costs to society of the misallocated resources.

Informational Asymmetries

Economics indicates that markets and trading lead to an efficient allocation of resources. This result is predicated on a number of assumptions including the assumption that all parties to transactions make equally well-informed decisions. Implicit is an assumption that all the relevant information is free and is reflected in the decision-making processes of all parties. However, information is not free; the markets are unlikely to generate optimal levels of information given the “public good” dimension of information, and the information that is available is not uniformly distributed.

Economists have recognized that problems can arise when one party is intentionally misinformed or does not have access to some of the relevant information that other counterparties possess. If one of the less well-informed parties to the transaction would not have agreed to the trade or exchange had it had access to all the information, than the transaction was presumably inefficient and welfare reducing. To date, economists’ focus has been exclusively on information about the item (good or service or financial asset) being exchanged. The classic case in the economics literature is Akerlof’s, The Market for Lemons—i.e., the used car market where sellers have more information than buyers about the true condition of the cars.

Society has an interest in preventing inefficiency-producing, welfare-reducing transactions. Efficiency-enhancing disclosure standards should include all relevant information (but not all analyses). In addition to issuer and issuer-specific information, all non-issue non-issuer specific information (baring proprietary client information) should be disclosed to all of the counterparties. In the context of financial markets, relevant information is all information that bears on the expected return or the riskiness of the instrument. Currently, counterparties are implicitly assumed to have equal access to non-specific, relevant information, e.g., macroeconomic conditions and information regarding the relevant sector of the economy.

Informational asymmetries are particularly troublesome in markets for fixed income securities. For fixed income instruments, the expected return for a buy-and-hold investor is the current yield to maturity (re-investment risk of coupons aside). Significant informational asymmetries with regard to expected rate of return for such investors are limited. However, the risk dimension of the risk/return analysis is another story. The upside risk in fixed income securities is more limited than the downside risk as the coupon is fixed. On the other hand, credit events can degrade performance, but not enhance it. Tail risk is also often the most opaque.

When informational asymmetries contribute to mispricings in credit markets and resource misallocations in the economy, it will most likely be the result of buyers having less information then sellers about downside risks. Furthermore, firms involved in structuring products or underwriting issues that have more or better information about downside risks being higher than generally perceived will keep it private.

Financial product specific informational asymmetries can exist when the product is complex. For example, in 1994, a headline dominating financial scandal involved Banker’s Trust. If my memory is correct, BT had sold a non-vanilla interest rate swap product with embedded bells and whistles to P&G. Evidently unknown or unappreciated by P&G (when the deal was struck) was a provision by which P&G financed part of the deal (reduced the cost to themselves) by selling a currency option (on DEM/FrF). The ERM experienced a crisis and P&G found itself on the wrong side. It suffered losses and called foul. During the ensuing investigation, the regulators gained access to internal BT emails regarding the deal. One of the emails read something like: “They think that they know what they are doing, but they don’t. They are the perfect customer for us.”

Large financial firms may also possess non issue specific information of a kind unavailable to other market participants by virtue of the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination. For example, Goldman Sachs, by virtue of the scale of its activities relative to the CDS market may have had non-public knowledge about the vulnerability of AIGFP, AIG itself. It may have had insight to the stability of the CDO market and the balance sheets of firms which had purchased CDS protection from AIGFP as well the market for RMBS in general.

Attention has recently focused on GS’s role in creating CDOs that enable GS and one client to short the sub-prime market while GS sold the long side to other clients. GS has argued that it did nothing illegal and that it was acting on its own analysis and entirely properly. It may be that GS acted legally, but it was acting on the basis of an informational asymmetry as the clients that went long did not have access to all the information necessary to perform all the analyses that lead GS to take steps to short the market. The question of legality aside, it seems that GS knowingly exploited an informational asymmetry and encouraged the misallocation of capital.

GS has argued that it has outperformed its competitors because it was more knowledgeable, i.e., performed better analysis. However, GS may have been more knowledgeable, because it positioned itself to glean more information (from it counterparties and its numerous business lines), process it and act on that information before it was widely available to other market participants.

Chris Whalen recently stated publicly what many in the markets have believed for years: “In our experience, Buy Side investors today don’t do business with GS or the other major Sell Side firms because they trust them. They do business with firms like GS because they believe that the firm has better access to information than do the other dealers in the marketplace.”

GS uses information gained in the markets and from client contact to structure products and take proprietary positions To the extent that the trades and positions are based on informational asymmetries they represent a transfer from the “dumb” money to the “smart: money GS, and its high value clients.

With the number of large financial firms now three less than before the crisis, it is likrly that the remaining firms will reach a size relative to the markets that they will have access to information unavailable to other players, and hence be in a position to exploit informational asymmetries.
There are a number of questions which should concern economists and regulators.

1. Did the buyers of CDOs under invest in information and analyses because of the expense and the perception that disclosure and the rating agencies leveled the playing field?
2. What can and should be done to prevent firms from operating on non-instrument specific informational asymmetries gleaned through market activities?
3. What if anything can be done to insure that “sophisticated” investors are sophisticated enough to understand all the risks in new complex and unseasoned instruments and products.

Given the difficulties of determining whether one of the financial firms has or had relevant market non instrument specific information that the other counterparty(s) did not, regulators would have an impossible time enforcing compliance with a disclosure standard consistent with the efficient allocation of capital.

However, regulators could prevent firms from gaining informational asymmetries by preventing them from establishing large market shares in underwriting, issuance or trading of the relevant instruments. If each of the financial firms were constrained to be a small fraction of every market and activity they were engaged in, then it is less likely that any firm would be in possession of significantly more information about the market, counterparties, etc than any other participant in the market.

Furthermore, increasing the number of players with access to non-public information increases the likelihood that the information would become public.

Would limiting the size of a firms activities in a market/instrument be too costly to society, i.e., would downsizing the large financial firms be rightsizing them, or would it be inefficient? Defenders of the large firms argue that their size enables them to achieve economies of scale and that they are efficiency promoting.

While there are undoubtedly economies of scale in some financial market activities and while some subset of customers may find it advantageous to deal with a dominant provider of financial services, these considerations do not necessarily imply that large firms are more efficient or contribute to more efficient allocation of capital than small firms.

If the larger firms are larger because they are more efficient than smaller firms, it should be reflected in higher accurately measured returns on equity and risk-adjusted rates of return on capital. I believe that the readily available numbers (at least for commercial banks) would be inconsistent with the idea that the larger firms are more efficient. It seems much more likely that the existing large financial firms owe their size and success to the TBTF doctrine, their oligopolistic positions and their ability to profit from the informational advantage that they hold rather than to efficiencies arising from the scale of their operations

It is likely that TBTF firms have exploited informational asymmetries which contributed to the mis-pricing of risk and the misallocation of resources. The most straightforward way to prevent a repeat of the crisis in the future would be to limit the size of financial firms so what their activities are small relative to the markets in which they operate.