naked capitalism

Readers may recall that I solicited their comments on an FDIC Advanced Notice of Proposed Rulemaking on its proposal to link deposit premiums to executive compensation programs (the high concept is to charge higher premiums to banks that reward executives for undue risk-taking. Now admittedly, a program like this would take some thought to make sure it was not easily circumvented (as in measures need to be in place to make sure that banks don’t simply skirt the rule, say by putting risky exposures in off balance sheet entities).

I was going to pen a simple cover note expressing general support and attach reader comments, but I wound up writing up something more substantive. The letter raised a couple of issues that have not gotten the attention they warrant, namely, the need for bank executives and key operating staff to bear greater liability, and the way that the bank merger wave seems to have been driven to a considerable way by the fact that it leads to higher CEO pay post-merger.

Sheila Bair

Chairman

Federal Deposit Insurance Corporation

550 Seventeenth Street, NW, Room 6076

Washington, DC 20429

Dear Chairman Bair,

America can no longer afford to have a banking system that serves the ends of its executives rather than those of taxpayers and communities who have been saddled with cost of reckless profit-seeking. The FDIC proposal to tie deposit insurance premiums to the incentives in executive compensation programs would be an important step forward towards making sure that bank managers operate in a way that reflects the value of the extensive government support and safety nets they enjoy. Bank officers should not be encouraged, as they are now, to take “heads I win, tails you lose” bets with deposits.

There is no question that the annual accounting/bonus cycle is badly out of line with the time horizon of many of the wagers that financial institutions take. Unfortunately, the belief that using stock options or restricted shares as an important part of compensation would lead to responsible behavior has proven wildly false. Both Bear Stearns and Lehman had substantial equity ownership at both the executive level and among the rank and file. By contrast, when Wall Street was dominated by private partnerships, so the management group was jointly and severally liable for losses, the sort of profligate risk-taking that took place in the run-up to the global financial crisis was virtually unheard of.

Unfortunately, all compensation arrangements at public companies are inherently, “heads I win, tails you lose.” No matter how badly a corporate team performs, its pay is immune from clawback, except in the case of fraudulent conveyance in bankruptcy, and even then, the “lookback” period is usually shortly before the failure of the firm. By contrast, it often takes years to reap the bitter harvest of bonus-flattering decisions.

It may be that the only way to cope with the agency problems inherent to risk-taking in a public firms is to make pay arrangements more symmetrical, as in to find ways to recover compensation from executives and senior business unit managers who managed and led programs and products that were ultimately destructive to their companies. The better the arrangements of the old private partnerships can be approximated (admittedly a tall order) the better.

In addition, I would encourage you to think hard about the perverse incentives posed by acquisitions. One of the striking developments in the US banking industry over the last 20 years is an increase in concentration, particularly among the largest players, which has played directly into our current “too big to fail” policy problem. The usual rationale given in greater efficiency, that is, that bigger banking is cheaper. Yet every academic study I am aware of has found the reverse: that once a minimum threshold is reached (there is some disagreement as to where that lies), banks in the US exhibit a slightly negative cost curve, which means the bigger the bank (measured in assets) the higher its cost ratios. Thus the dramatic expense cutting that occurs in the wake of acquisitions could have been done by each of the merged institutions, separately.

Another reason to be skeptical of bank acquisitions is the poor track record of mergers generally. Virtually every academic study ever done has found most mergers “fail” as in they deliver negative outcomes to stockholders.

So why do deals continue? First, there is a large constituency that promotes them because they are particularly lucrative, in particular, investments bankers (who collect M&A and financing fees) and management consultants. A host of other “helpers” such as lawyers and accountants also reaps fat fees from deals.

But the biggest incentive is again flawed executive compensation. Bank CEO pay is highly correlated with the size of the institution, measured by total assets. And the senior team of the acquired bank is effectively bought off via golden parachutes.

I strongly encourage the FDIC to remove the incentive for executives to bulk up their banks solely to pay themselves more. One way might be to require that executive bonuses be set in relationship to the pre-acquisition peer group for a substantial initial period (at least three years, better yet five) and be benchmarked against the new peer group of bigger banks only if the merged entity had met certain operational performance targets.

I also asked readers of my blog, Naked Capitalism, to offer their comments on the proposal that you, Vice Chairman Martin Gruenberg, and Thomas Curry are supporting. They are glad that the FDIC is serous about bank reform and are keen to see meaningful measures implemented to curb executive-serving, public-endangering compensation structures. I am attaching their remarks.

Sincerely,

Yves Smith

The folks at Goldman, and Blankfein in particular, really do not get it. From Times Online:

Goldman Sachs, the world’s richest investment bank, could be about to pay its chief executive a bumper bonus of up to $100 million in defiance of moves by President Obama to take action against such payouts.

Bankers in Davos for the World Economic Forum (WEF) told The Times yesterday they understood that Lloyd Blankfein and other top Goldman bankers outside Britain were set to receive some of the bank’s biggest-ever payouts. “This is Lloyd thumbing his nose at Obama,” said a banker at one of Goldman’s rivals.

Bill Gates thought he could treat the government with impunity, and the only reason he escaped the likely outcome of having Microsoft brought to heel was an amazing gaffe by judge Thomas Penfield Jackson (speaking to a reporter while it was still in progress) that led to his removal. Jackson had formed a very dim view of Microsoft’s business practices (no doubt worsened by its conduct in court; the dissembling by Bill Gates was painfully obvious). He was prepared to mete out a harsh sentence, but was replaced by the comparatively clueless Kathleen Kollar-Kotelly.

Too bad no one (save maybe SIGTARP) has the inclination and the nerve to take this crowd on.

We’ve said that a Tobin tax, meaning a tax on transactions, could help both as a financial reform measure and as a tax generator. The logic is that trading, particularly OTC trading, involves costs (periodic taxpayer-funded bailouts) that are not borne by the buyers and seller (ie, they should be paying for rescue insurance as part of their cost of being engaged in a type of business that periodically blows up and forces uninvolved parties to pony up; the transaction tax would be a way to go about doing that). Any such tax would need to be though through carefully (as in plain vanilla, socially productive transactions like foreign exchange would not be taxed heavily, while high margin products with little to no redeeming value like credit default swaps would be taxed heavily.

But of course, who is opposed to such a sensible idea? The US, natch, with its pols bought and paid for by the financiers.

From the Independent:

Proposals for a global transaction tax on banks are “gaining traction”, Gordon Brown claimed yesterday, as Britain sought to push its reform agenda with other G7 economies ahead of rival American plans for regulatory overhaul.

The US is the main obstacle to a so-called “Tobin tax”, which remains popular across Europe as a way of building up a fund to ensure that banks no longer have to call on taxpayers’ cash if they run into problems.

Treasury officials believe President Barack Obama’s suggestion of a “risk-based” levy on US banks to recoup federal aid already spent means that the Americans could be persuaded of the merits of a transaction levy to deal with future crises.

Yves here. The proposed US “TARP fee” is paltry, yet the banks are already clamoring for it to be cut back, so it appears to be yet another Potemkin reform that will be diluted down to nothing. So I don’t think observers can make overmuch of it. Back to the story:

One Treasury official said: “[Mr Obama's plans] address specific problems in the US, where there are large investment banks. They would not be appropriate here. And you have to remember that it was narrow banks such as Lehman Brothers or Dunfirmline Building Society that failed.” This point has been pushed by “universal” banks such as Barclays, which has a substantial investment banking division but did not need to ask the state for financial support. The British Bankers’ Association has also been lobbying on this point. As Lord Myners opened the talks at 11 Downing Street, he said the costs of failures should be “distributed more fairly”, with financial institutions and investors shouldering more of the burden. “There is clearly a strong rationale to charge for the externality caused by the financial sector and financial institutions should shoulder the responsibilities for losses they may face,” he added.

I don’t know if any readers know Jay Leonhart, but his “Sometimes I Think” from Salamander Pie is my theme song. I cannot relate to a lot of behavior considered normal. So I hate to personalize this discussion, but the subject of this post involves one of those areas of human activity I find to be a complete mystery.

Start with shopping, or more accurately, the idea of shopping as an enjoyable leisure activity. I detest shopping, it’s an utter waste of time. Any effort expended on shopping would be better spent on something worthwhile, say a nap, a good book or a movie. But faced with purchases beyond the trivial, I will take the trouble to make sure I am getting something that has the functionality I want/need and I am not overpaying. One side effect of my distaste for shopping is that I use computers longer than anyone I know (I soup up the memory until ever-escalating demands render them so hopelessly underpowered as to be untenable. I was very happy with my NeXT, which was my workhorse for 10 and a half years, and the laptop I am using now is over seven years old and sadly is probably due to be retired soon).

Now that isn’t to say that I don’t like buying nice things, but the effort required to locate said “thing” is generally an annoyance. John Kenneth Galbraith was right when he said consumption takes effort.

So today’s object lesson on behaviors I find incomprehensible is Swapoo, described by Richard Thaler in today’s New York Times as a clever example of a website that preys on cognitive biases. Thaler first gives the background:

If a business school professor is running short on cash, there is a sure-fire solution: run a dollar auction game in class.

To start, the professor offers to sell the class a $20 bill. Bidding starts at $1 and goes up in $1 increments. The winner pays the professor whatever the high bid was, and gets the $20. Here’s the catch: the second-highest bidder also has to pay, but gets nothing in return.

Typically, a few brave or stupid students — nearly always male — open the bidding but fairly quickly only two bidders remain and they discover they are in a war of attrition. The bidding slows when someone bids $20, but then resumes with neither wanting to “lose.” If the two students are particularly stubborn, prices can go over $50. (The professor typically gives the money to charity, or claims to.)

The dollar auction game was invented by a pioneer of game theory, Martin Shubik of Yale, and it illustrates the concept of “escalation of commitment.” Once people are trapped into playing, they have a hard time stopping. (Consider Vietnam.) The higher the bidding goes, and the more each bidder has invested, the harder it is to say “uncle.” The best advice you can give anyone invited to play this particular game is to decline.

Yves here. I’ve never been a fan of auctions, or more accurately, live auctions. Perhaps some readers are more cold blooded, but I notice how my pulse rises when an item I am interested in goes under the hammer, and am annoyed that the process is triggering that response. I have found that more than once I violated my pre-planned limit as to how high I would go. As I result, when I do bid at auction (not often, mind you, this is hardly a routine activity), I only submit bids in advance (or on eBay, at the very close if the price has not exceeded my limit. But the fact that I have to monitor an eBay auction to see if I want to lob an last-minute bid is another “shopping” time sink).

But some people clearly enjoy this sort of thing a great deal. Back to Thaler:

Swoopo sells new merchandise using unusual auction formats. Let’s concentrate on one of them, the so-called penny auction.

Typically an item — say, a laptop that retails for $1,500, is offered for sale. The bidding starts at a penny, and goes up in one-cent increments, but it costs bidders 60 cents to make a bid. Each auction has a scheduled closing time, but as the deadline nears, that time is extended by 20 seconds whenever someone bids.

The site’s home page displays several attractive objects for sale with closing times fast approaching. It is mesmerizing.

One winning strategy might seem to be this: Bid at the last second, just before an auction is about to end. To “help” you do so, the site offers an automatic bidding program called a Bid Butler that allows you to make bids in the last 10 seconds. Alas, others can also use this automatic program, and you soon discover that just as the clock is ticking down and you’re about to make your big score, a bunch of other Bid Butlers get busy, the price jumps by a few cents, and the clock adds more time. Items can remain “in their final seconds” for days.

Yves here. Do any of you find this procedure acceptable? Yes, it’s disclosed, but this is no different than the “gotcha” fine print in credit card agreements; in fact, it’s core to the economics of this service. This reminds me of one description of lotteries: “a tax on people that are bad at math.” Back to Thaler:

What makes this procedure so devilish is that while bidders are looking at what seem to be amazing bargains, the Web site is raking in the money. Because Swoopo collects 60 cents for each penny bid, its revenue is the selling price multiplied by 60. This means that if a computer you covet sells for $100, seemingly a bargain, Swoopo collects $6,000 in revenue, a very juicy profit.

Swoopo has even sold cash using this format — specifically, checks for $1,000. My colleague Emir Kamenica and I looked at 26 such auctions we found in a data set posted on the Swoopo Web site. For each of these, the average revenue to Swoopo was $2,452. Winning bidders also did well: Of the winners, all but two made money even after accounting for the cost of their bids, with an average profit of $658. Still, the important point to remember is that, collectively, bidders are losing money. Only the lucky last bidder is a winner….

AND some lucky bidders do get bargains. The site’s list of completed auctions includes a laptop that sold for $23.27, a video game for $5.88 and a microwave oven for $60.96, prices that don’t include bidding fees.

How much danger does Swoopo pose to consumers? Your view of that may depend partly on whether you think people are playing for fun or merchandise. If they are looking for the thrill of chance, it’s hard to argue that Swoopo.com doesn’t have as much right to life as slot machines or state lotteries.

But if people are looking for a good deal, the right comparison isn’t to gambling, but to a discount retailer. The difference between Swoopo and Best Buy is that at Swoopo you end up paying for stuff in the other guy’s shopping cart.

Now I imagine that a few hardy souls will contend that they have highly optimized strategies, or have just been lucky, and they think Swoopo is just dandy. But this looks like the sort of business P.T. Barnum would love.

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

Oh dear, there he goes again.

After sensibly calling for a jobs summit to deal with the problem of rising unemployment, President Obama’s Herbert Hoover-like alter ego has re-emerged again to warn us again about the evils of government deficit spending. According to Politico.com, the President “plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 — and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.”

The President and his economic advisors are now being driven by the polls, which, in turn, are being driven by the deficit myths of their own creation. It is a case of the blind leading the blind down the rabbit hole. They impose political constraints on their own actions in a manner which is highly destructive in terms of securing their prized legislative goals (like the health care debate, where all decent policy proposals have foundered on the question of “how are we going to make this ‘deficit neutral’”?).

The Administration fails to understand that the “solution” of cutting back government spending is not a solution at all. It won’t actually achieve the “desired” result because the destruction of tax revenue through a declining economy — caused by the cutbacks in spending — will run counter to the President’s stated (and misguided) goal. There are two ways to obtain large budget deficits: the “ugly” way and the “virtuous” way. Like Japan during it’s “lost decade,” we have mostly gotten the deficits the bad way–by destruction of tax revenue caused by a collapsing private sector. Early fiscal measures have done enough to stabilize aggregate demand, but done little to generate sustained recovery. So they get discredited and public debt trap questions keep getting raised, which in turn inhibits a fiscal response properly sized and held. The economy waffles through stagnation.

Now, I realize that some of the economic moralists amongst us think that cutting back government spending is a wonderful thing because we will “purge” the system of its “socialistic” tendencies (see Governor Rick Perry of Texas) and end “malinvestment.” But that’s an interesting social experiment I hope the President is not prepared to undertake.

At the core, we have a problem of insufficient aggregate demand. The government is the only entity in a position to remedy that problem, because only the government can create new net financial assets via spending. There are any number of measures which would have an almost instantaneous impact in terms of improving aggregate incomes and demand. A national payroll tax holiday, revenue sharing with the states (so as to preclude additional cuts in state spending which offset the Federal fiscal stimulus) and a government as employer of last resort (an idea we plan to expand on further in a subsequent New Deal 2.0 posting) would all do the trick.

In the 1930s, we had a president who was unafraid to embrace bold experimentation. He wasn’t always right, but by the end of 1934, more than 20 million Americans (one out of six) were receiving jobs or public assistance of one form or another from the “Welfare State”. The system remained viable thanks to FDR. As I’ve written elsewhere, the government hired unemployed Americans to work on projects that advanced our society during the Great Depression:

The government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

On housing (a huge contributor to the current crisis), both L. Randall Wray and Eric Tymoigne have argued,

A more effective way to restart the economic process on the solid ground is to deal with the underlying cause of the problem: borrowers cannot meet the required payments. This implies sustaining their income and employment and, if necessary, drastically modifying their debt service burden. The whole boom of the 2000s (and more broadly the growth process that emerged at the in the early 1980s) was based on household borrowing and the continuation of negative saving trends (that is, household deficit spending).

One good place to start would be loan modifications, which would have a much more beneficial impact than what we’re doing now. Today, when the homeowner stops making payments, the mortgage company that services the loan makes the payments that are then distributed to the securities holders, so the economic incentives actually discourage active loan modification and worsen the home owner’s personal balance sheet. It is in the interest of the mortgage companies that service mortgages to maximize the number of delinquencies as well as the amount of time each household is delinquent.

A vastly superior alternative would be a Home Owners’ Loan Corporation (HOLC) type of entity, advocated as early as January 2008 by Paul Davidson:

In 1933, the Home Owners Refinancing Act created the Home Owners’ Loan Corporation (HOLC) to refinance homes to prevent foreclosures, and also to bail out mortgage holding banks. The HOLC was a tremendous success, making one million low-interest loans which often extended the pay-off period of the original loan, thereby significantly reducing the monthly payments to amounts that homeowners could afford. In its years of operation, the HOLC not only paid all its bills, but it also made a small profit.

To be sure, any program designed to increase incomes and aggregate demand will certainly require a major increase in government spending, precisely the opposite of what Obama is calling for right now. Even a focus on the “jobs deficit” is misguided because the President fails to understand that it is the overall growth in government spending which will facilitate private sector deleveraging, not the selective application of government. But if the President is genuinely concerned about spending too much money, he can simply redeploy part of the $23.7 trillion committed to help the banks to finance the programs above.

In any event, the President’s single-minded focus on the budget deficit is profoundly misguided. Why? Because a sovereign government can always afford to buy anything that is for sale in its own currency –whether that is unemployed labor, real estate, or bad financial assets.

This focus on “affordability” and “fiscal sustainability” is ridiculous: these are empty phrases which mean nothing when divorced from the economic backdrop.

The size of the deficit is irrelevant in itself. There is no meaning in the terms a large deficit or a small deficit. You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 17.5 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message – the deficit is not large enough.

In a year Obama has gone from “we cannot afford not to do this” to “we’ve run out of money”.
If we continue down this path, such that robust recovery does not begin for many years, we will have large budget deficits for many years to come. Of course, it could always get worse –if Obama is serious about his singular focus on the deficit, which I fear he is.

Paul Krugman has a good op-ed tonight on how Germany has fared versus the US in the global financial crisis. Recall that there was much hectoring of Germany early on, for its failure to enact stimulus programs. German readers were puzzled, since Germany has a lot of social safety nets that serve as automatic counter-cyclical programs. As an aside I visited a few cities in Germany on the Rhine and Danube in June (unfortunately in heavy book writing mode, and so did not get to see as much as I would have liked) and it was remarkable how there were no evident signs of the downturn: no shuttered retail stores, no signs of deterioration in public services, stores and restaurants looked reasonably busy (although I had no idea of what norms there might be).

Krugman holds Germany up as an example of the merits of employment oriented policies (which had been the norm in America prior to the shift to “markets know best” posture (and more aggressive anti-union policies) inaugurated by Reagan:

Consider, for a moment, a tale of two countries. Both have suffered a severe recession and lost jobs as a result — but not on the same scale. In Country A, employment has fallen more than 5 percent, and the unemployment rate has more than doubled. In Country B, employment has fallen only half a percent, and unemployment is only slightly higher than it was before the crisis.

Don’t you think Country A might have something to learn from Country B?

This story isn’t hypothetical. Country A is the United States, where stocks are up, G.D.P. is rising, but the terrible employment situation just keeps getting worse. Country B is Germany, which took a hit to its G.D.P. when world trade collapsed, but has been remarkably successful at avoiding mass job losses. Germany’s jobs miracle hasn’t received much attention in this country — but it’s real, it’s striking, and it raises serious questions about whether the U.S. government is doing the right things to fight unemployment….

Germany came into the Great Recession with strong employment protection legislation. This has been supplemented with a “short-time work scheme,” which provides subsidies to employers who reduce workers’ hours rather than laying them off. These measures didn’t prevent a nasty recession, but Germany got through the recession with remarkably few job losses.

Should America be trying anything along these lines? In a recent interview, Lawrence Summers, the Obama administration’s highest-ranking economist, was dismissive: “It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as expanding the total amount of work.” True. But we are not, in fact, expanding the total amount of work — and Congress doesn’t seem willing to spend enough on stimulus to change that unfortunate fact. So shouldn’t we be considering other measures, if only as a stopgap?

Now, the usual objection to European-style employment policies is that they’re bad for long-run growth — that protecting jobs and encouraging work-sharing makes companies in expanding sectors less likely to hire and reduces the incentives for workers to move to more productive occupations. And in normal times there’s something to be said for American-style “free to lose” labor markets, in which employers can fire workers at will but also face few barriers to new hiring.

Yves here. Krugman does Germany an injustice by failing to contest US prejudices about European (particularly German) labor practices. If German labor practices are so terrible, then how was Germany an export powerhouse, able to punch above its weight versus Japan and China, while the US, with our supposedly great advantage of more flexible (and therefore cheaper) labor, has run chronic and large current account deficits? And why is Germany a hotbed of successful entrepreneurial companies, its famed Mittelstand? If Germany was such a terrible place to do business, wouldn’t they have hollowed out manufacturing just as the US has done? Might it be that there are unrecognized pluses of not being able to fire workers at will, that the company and the employees recognize that they are in the same boat, and the company has more reason to invest in its employees (ignore the US nonsense “employees are our asset,” another line from the corporate Ministry of Truth).

A different example. A US colleague was sent to Paris to turn around a medical database business (spanning 11 timezones). She succeeded. Now American managers don’t know how to turn around businesses without firing people, which was not an option for her. I submit that no one is willing to consider that the vaunted US labor market flexibility has produced lower skilled managers, one who resort to the simple expedient of expanding or contracting the workforce (which is actually pretty disruptive and results in the loss of skills and know-how) rather than learning how to manage a business with more foresight and in a more organic fashion because the business is defined to a large degree around its employees.

By George Washington of Washington’s Blog.

When a liberal labor leader and a conservative financial policy analyst unite against something, you know that something is really bad (actually, I don’t believe in the whole false left-right dichotomy; I think its Americans versus those trying to steal our wallets and our rights, but that’s another story).

Today, AFL-CIO president Richard Trumka has slammed the Fed and the proposed “Tarp on steroids” legislation in his testimony to Congress today. Here are the must-read parts of Trumka’s prepared remarks to the House Financial Services Committee:

We are deeply concerned that the Committee’s work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. We urge the Committee to work with the leadership to strengthen these bills before they come to the House floor.

However, these powers must be given to a fully public body, and one that is able to
benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency, with a board made up of a mixture of the heads of the routine regulators and direct Presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative.

But we cannot support the discussion draft made public earlier this week because it gives dramatic new powers to the Federal Reserve without reforming its governance so that the banks themselves are removed from the governance of the Federal Reserve System. Even more alarmingly, the discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital markets—power which could be used to gut investor and consumer protections. If this Committee wishes to give more power to the Federal Reserve, it must make clear this power is only to strengthen safety and soundness regulation and it must simultaneously reform the Federal Reserve’s governance. Reform cannot be put off until another day.

The Federal Reserve currently is the regulator for bank holding companies. In that
capacity, it was responsible throughout the period of the bubble for regulating the parent companies of the nation’s largest banks. While regulatory authority rests in the Board of Governors of the Federal Reserve in Washington, routine responsibility for regulatory oversight has been delegated by the Board of Governors to the regional Federal Reserve Banks. The Federal Reserve System’s regulatory expertise resides in these regional banks.

The problem is that these regional Federal Reserve Banks are actually controlled by their member banks—the very banks whose holding companies the Fed regulates. The member banks control the selection of the majority of the regional bank boards, and the boards pick the regional bank presidents, who are effectively the CEO’s of the regulatory staff.

These arrangements may explain why the Federal Reserve has never given any account of how it allowed bank holding companies like Citigroup and Bank of America to arrive at a point where they required tens of billions of dollars of direct equity infusions from the public purse to avoid bankruptcy.

Giving the Federal Reserve with its current governance control over which financial
institutions are bailed out in a crisis is effectively giving the banks the ability to raid the Treasury for their own benefit.

We are also deeply troubled by provisions in the discussion draft that would allow the Federal Reserve to use taxpayer funds to rescue failing banks, and then bill other nonfailing banks for the costs. The incentive structure created by this system seems likely to increase systemic risk.

We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments, and stricter capital requirements, as they get larger. This would be a way of actually discouraging “too big to fail.”

In addition, language in the draft that appears to limit taxpayer bailouts of bank
stockholders actually does no such thing, rather it simply ensures that when stockholders are rescued with public funds, bondholders and other creditors are rescued with them…

Finally, and not least, the discussion draft appears to envision a process for identifying and regulating systemically significant institutions, and for resolving failing institutions, that is secretive and optional—in other words, the Federal Reserve could choose to take no steps to strengthen the safety and soundness regulation of systemically significant institutions. In these respects, the discussion draft appears to take the most problematic and unpopular aspects of the TARP and makes them the model for permanent legislation.

Instead of repeating and deepening the mistakes associated with the bank bailout,
Congress should be looking to create transparent, fully publicly accountable mechanisms for regulating systemic risk and for acting to protect our economy in any future financial crises.

Conservative Peter Wallison – financial policy study analyst at the American Enterprise Institute – largely agrees. In his prepared remarks to Congress, Wallison says:

The Discussion Draft of October 27 contains an extremely troubling set of proposals which, if adopted, will bring economic growth in this country to a standstill, essentially turn over the control of the financial system to the government, and seriously impair competition in all areas of finance.

Rather than ending too big to fail, the Draft makes it national policy. By designating certain companies for special prudential regulation, the Draft would signal to the markets that these companies are too big to fail, creating Fannies and Freddies in every sector of the economy where they are designated. This will impair competition by giving large companies funding and other advantages over small ones.

The idea that the designation of these companies will be kept secret is, with all due respect, absurd; securities laws alone will require them to disclose their special status; simple truthfulness will do the rest…

If this legislation is passed, every industry will be in Washington, asking for special treatment or exemption. Competition in the market will become competition before this committee or in the halls of the Fed, lobbyist-to-lobbyist and lawyer-to-lawyer…

This will not only create uncertainty and moral hazard, but it will give the large and powerful companies special advantages over small ones. Those that seem likely to be taken over by the government will have easier access to credit, at lower rates, than those likely to be sent to bankruptcy.

In other words, the Draft proposes nothing more or less than a permanent TARP, using government money to bail out the large or politically favored companies, and then taxes the remaining healthy companies to reimburse the government for its costs of competing with them…

The [proposed bill] would take control of the financial industry in the United States, stifle risk-taking and initiative, and change competitive conditions in every sector of the economy so that they favor large, government-backed, too big to fail enterprises…

The Draft … would now give the Fed authority to regulate any financial company that the Council determines should be subject to “heightened prudential standards,” even if there is no insured bank in the group…

The result is that the question becomes one of political clout, with industries fighting in Congress for the competitive result they want. Some industries want to invade others’ turf; the invaded industry uses the law to fend off the competition; consumers are the losers. Congress becomes the battleground. It’s not just unseemly; it’s a frightening example of what happens when the government starts picking winners…

Congress will be injecting itself into competitive fights between firms and industries, further politicizing what should be economic or financial decisions…

The Designated Companies are under the complete control of the Fed. They will not be able to initiate new activities without the Fed’s approval, or enter new competitive fields, or perhaps even open new offices in new places. This is a degree of political control of business that has never been attempted before. Not only will it place the dead hand of government on the activities of financial companies, but it will almost certainly drive many financial companies out of the United States before they submit to these restrictions.

The effect of these restrictions for the U.S. economy will be dire. First, Designated Companies will clearly have been labeled as too big to fail. In effect, the government has notified the capital markets that these firms will not be allowed to go into bankruptcy—they will be rescued in the ways I will describe below. This means they will be less risky borrowers than smaller companies that are not going to be controlled in the same way. As less risky borrowers, the Designated Companies will have lower costs of funding and will be able to drive smaller competitors from the markets they enter. Sound familiar? Yes, it’s Fannie Mae and Freddie Mac all over again. The existence of these Designated Companies will impair competition in every market they are allowed to enter, and will force the consolidation of competitors so that markets become dominated by government-backed giants like themselves….

[The bill assumes that] our entire financial system must be subjected, today, to far-reaching control by the Federal Reserve Board. With all due respect, this is absurd, and certainly disastrous for economic growth in the future.

The Draft also contains language that suggest some of the problems of identifying Designated Companies in advance—and thus creating the Fannie/Freddie too big to fail problem—can be avoided if the designation of these companies is not disclosed to the public. This, too, with all due respect, is absurd…

In addition, there is very little incentive for the government not to rescue failing Designated Companies, because the Draft provides that the surviving members of the financial industry larger than $10 billion in assets—whether Designated Companies or not—will be taxed to reimburse the government for its costs in the bailout…

As in the GM and Chrysler bailouts, preferences are going to go to favored groups, and disfavored groups will suffer disproportionate losses. It will be a political free for all, with important legislators pressing the FDIC to treat their constituents better than someone else’s constituents.

What we know is that no losses will be taken immediately by creditors. This is because the objective of the resolution authority is to prevent a “disorderly” failure, which actually means a failure in which creditors suffer immediate losses…

The proposals in the Draft reflect very bad policy—far more likely to be destructive of the financial system and damaging to the economy than an improvement on what exists today.

By George Washington of Washington’s Blog.

I have repeatedly pointed out that big banks are not more efficient than smaller banks.

For example, I previously noted that an article in Fortune concluded:

The largest banks often don’t show the greatest efficiency. This now seems unsurprising given the deep problems that the biggest institutions have faced over the past year.

“They actually experience diseconomies of scale,” [Celent analyst Bart] Narter wrote of the biggest banks. “There are so many large autonomous divisions of the bank that the complexity of connecting them overwhelms the advantage of size.”

Now, James Kwak has done some sleuthing and discovered that even Fed economists don’t buy the bigger-is-more-efficient argument. Kwak points out that New York Fed economist Kevin J. Stiroh found that most of the increase in efficiency during part of the time in which banks were consolidating was due to the increased use of information technologies:

His main explanation for the productivity growth is not consolidation, but information technology: “The finding of steady productivity growth, in particular, is important since it is consistent with the idea that the massive investment in new technology is working to improve the performance of the banking industry.” This is not proven in this paper, but Stiroh went on to write a bunch of other papers on the link between information technology and productivity. For example, this paper (on the entire economy, not just banking) concludes:

“IT-producing and IT-using industries account for virtually all of the productivity revival that is attributable to the direct contributions from specific industries, while industries that are relatively isolated from the IT revolution essentially made no contribution to the U.S. productivity revival. Thus, the U.S. productivity revival seems to be fundamentally linked to IT.”

Stiroh also wrote a paper on banks in Switzerland, concluding:

“We find evidence of economies of scale for small and mid-size banks, but little evidence that significant scale economies remain for the very largest banks. Finally, evidence on scope economies is weak for the largest banks that are involved in a wide variety of activities. These results suggest few obvious benefits from the trend toward larger universal banks.”

The kicker is that Stiroh is the main source cited by those claiming that bigger banks produce greater efficiencies.

The bottom line is that there is absolutely no reason not to break up the too big to fails.

By Edward Harrison of Credit Writedowns

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback. Don’t you lot get cute in the comments, claiming I am slagging Tyler off unfairly. I simply disagree – there is no evidence of a plunge protection team in that post.

Update: This phrase, “PDCF usage declined, reaching zero in mid-May 2009,” suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: “The Federal Reserve’s Primary Dealer Credit Facility.”

A lot of investors I know lamented the loss of Gillian Tett. As the Financial Times’ capital markets editor in the runup to the crisis, she had provided very insightful commentary on some of the more arcane goings-on in the financial markets. I’ve had reason to look at her older commentary (circa 2004-2005) and some of it is freakishily prescient. But then she got promoted, she went to work on her book, and her writings were less frequent and just not as crisp.

Well, we may be getting the old Miss Tett back, and we all should be careful what we wished for. This article is very much like some pieces she wrote in January 2007…..and she says we’ll know better if the “reflate the economy by creating an asset bubble” strategy will work in 6 months.

Um, first we have the ugly 6 month parallel. The real break in the credit markets started in July 2007….6 months out from her January 2007 pieces.

Second, she indicates that most observers recognize the rally is not the result of fundamentals (duh!) but the result of excessive liquidity chasing assets. She adds this:

Now, some western policymakers like to argue – or hope – that this striking rally could be beneficial, in a way, even if it is not initially based on fundamentals. After all, the argument goes, if markets rebound sharply, that should boost animal spirits in a way that could eventually seep through to the “real” economy….

Yet, what worries me is that it is still very unclear that that pile of damp wood – aka the real economy – truly will catch fire, in a sustainable way.

Tett is being way too cautious. Someone tried this very experiment once and it was a complete disaster.

In 1985, the US bilateral trade deficit with Japan had gotten so bad that even the “free markets” oriented Reagan administration felt it had to do something about it. The result was the Plaza accord, a coordinated currency intervention to push down the greenback.

It was narrowly too successful and broadly a failure. The dollar fell further than anyone wanted it to, over 50% versus the yen. In fact, two years later, another coordinated intervention, the Louvre accord, was implemented to drive the dollar back up.

Even though US imports from Japan fell, US exports to Japan barely budged. The trade barriers were structural. But the Japanese now had a very pricey currency, and their exports to other countries fell also.

So the authorities figured they’d try to stimulate consumer spending via asset appreciation. Notice how Japan’s problem then is analogous to China’s now: an economy that depends on exports with insufficient consumer spending (of course, one problem in Japan that everyone seems to forget is the small size of their homes. How can you consume a lot if you have restricted living and storage space?). The idea was that the wealth effect would lead people to spend more and raise the level of domestic growth, offsetting the fall in exports.

We know how that movie ended.

Asset bubbles beget more bubbles unless the authorities shrink the financial sector. Tett’s colleague Wolfgang Munchau wrote earlier in the week:

This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.

While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instabiliy….The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.

His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.

From Tett:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

I daresay this missive reflects some element of hyperbole. But I have quoted it at length because the question is becoming more critical. Six months ago, the financial system was in deep distress, reeling from a meltdown. Now despair and panic have been replaced not simply by relief – but, in some quarters, euphoria. Never mind the high-profile rally that has occurred in the equity markets; what is perhaps most stunning is the less visible rebound in debt and derivatives markets, as risk assets have displayed what Barclays describes as a “stellar performance”