Saturday, February 28, 2009

AIG, Maiden Lane, and Buying CDOs

I have another question concerning AIG and CDOs that maybe someone can help with. The Fed set up Maiden Lane II and III as special purpose vehicles to assist in the bailout of AIG. These funds buy the underlying CDOs that AIG wrote insurance on. Once the funds own the underlying CDOs, they can extinguish the CDS written on them (thus saving AIG from collateral calls and further writedowns). So here is the question: If one of the big problems with TARP was how to buy mortgage backed securities from the banks, how is the Fed managing to buy tens of billions of mortgage backed securities to bail out AIG? It would seem a particularly difficult transaction since the holder may own the CDO as well as the CDS, ie,, the insurance. So does the Fed just have to pay 100% on the dollar? Well, that would explain how they can get the deals done.

AIG, Foreign Banks, and the Role of Regulation

There is an underlying story in the AIG fiasco that does not get adequate attention. See, for instance, Joe Nocera's generally excellent piece in the NYT today, or for a piece from last September that makes my point really well, see this article in International Financial Law Review.

AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.

And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.

So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.

What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.

Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.

I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).

Friday, February 27, 2009

Back from Behind Enemy Lines: Redistribution Logic

See my post immediately below about my venture onto the New York Times' blog, Room for Debate.

I am really surprised, and somewhat dismayed, at the vitriol heaped on my comments, and on me personally. Wow. Several lessons to be learned there, mostly concerning the nature of the NYT readership and the curious trust that liberals give the Federal government on some issues (the wisdom of the stimulus bill) but not on others.

But one set of comments in particular stood out and showed me the redistributionist, entitlement mentality that is now quite prevalent. Look at these quotes:

The result is that 1% of America’s wealthiest families take home 20% of the nations earnings.
Think about that. Does that seem fair to you?

The other 99% of Americans must share in only 80% of our country’s earnings. While 1% of the wealthiest Americans enjoy 20% of our nation’s earnings, the
remaining 99% of us, on average, have only a chance to earn far less than 1% apiece of the money our nation produces every year.

Let's leave aside the fact that in 2006, the top 1% of the taxpayers in this country paid 40% of the personal income taxes while earning 20% of the income.

The more important issue here is the tone in the above quote: The other 99% MUST share in only 80%...the remaining 99% of us...have ONLY A CHANCE TO EARN FAR LESS THAN 1% APIECE...

No, sorry, that is not the way this country or any market economy works. Actually, everyone has the chance to get into that top 1%. It might take some effort. You are not going to get there from complaining. It might take several generations -- of parents sacrificing for their children, who then move up, and give the next generation an even better chance. I come across loads of people like that who are in the top earning categories.

It may have been forgotten by many, but the beauty of this country is indeed that everyone has opportunity to become great, and to get respect and wealth.

Thursday, February 26, 2009

Republican Governors Rejecting Fed Money?

I did a guest post on a New York Times blog tonight; they asked me to comment on why some governors might reject Federal stimulus money. Seems to me that they don't want to get caught in the Federal bear hug, but I doubt that they will actually go through with their threat to turn down the money.

At any rate, I seem to have riled up a few NYT readers.

Check it out here:

Thursday, February 19, 2009

The Obama Mortgage Plan

I understand the desire to help those homeowners who have problems with their mortgages.

But I also believe there is a need to get mortgage-related assets off the books of the banks and into the hands of less risk-averse investors. This must be the biggest potentially mutually beneficial exchange since...well, the Resolution Trust Corporation.

The new mortgage plan has a mixed set of consequences, some unintended. I fear that it throws a lot more uncertainty into the valuation process. It will also take some of the more clearly profitable mortgages out of the pools -- which could be a plus. On the first point, uncertainty, it would seem to make the valuation of mortgages and mortgage backed securities even more difficult. Who is now going to be in default? How do we assess likely default rates if the feds are encouraging the lowering of interest payments? How does all this work within the confines of contract law in the context of mortgage backed securities? Senior tranches may prefer foreclosure and liquidation to stretching things out and accepting lower payments - if they can even be forced to accept lower payments. But more to my point, who is going to bid a reasonable price to buy senior MBS from banks with this kind of uncertainty? Have we made the valuation problem easier or more difficult?

On the second point, taking out the most profitable mortgages, the plan makes it easier for mortgagees to refinance at lower rates. Great for them, and this gets full payment of principal into the hands of the trusts holding the mortgages, which will in turn pay off the senior tranches according to priority. That is good, for as those tranches are repaid, the securities are retired and the holders can book what is likely to be a profit. What is left, however, is truly the most toxic -- mortgages that cannot qualify even for these generous (moral hazard-inducing!) restructuring terms. What this implies for the valuation of the remaining lower tranches is probably not pretty.

The 2004 Leverage Regulation

I did have the chance to ask a retired risk officer from a major bank his views on the 2004 leverage regulation change.

To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.

It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.

Tuesday, February 17, 2009

Heated Arguments over Crowding Out

Will the fiscal stimulus work -- will the increase in government spending cause GDP to increase and unemployment to decrease?

One of the key issues is what economists call "crowding out". I hate to give just a simple explanation of it, because as you will see, economists have been attacking one another over simplistic (and some not too simplistic) explanations. But anyway, crowding out refers to the possibility that an increase in government spending will cause spending by other agents (especially businesses) to spend less. If that were to occur, then there might be no overall increase in aggregate demand, and no stimulus.

See here for a piece by John Cochrane at Chicago titled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" Gene Fama gives his own thoughts in a new blog feature on the DFA website. See here and here for some rather testy responses by DeLong and Krugman.

It is enlightening to read the comments on either the DeLong or Krugman sites to get a sense for who is reading those blogs.

At any rate, when I was in graduate school at UCLA in the early 80s, crowding out was a huge question. You can address it pretty well by the old IS/LM model. I am not a macroeconomist, but my casual observation from the later 80s and 90s is that the crowding out argument did pretty well, and the standard Keynesian "government spending will increase GDP" result was relegated to the "tired models" shelf, to be brought down in honor only in extreme times. Well, it certainly has come back with a vengeance.

With governments worldwide heading to the capital markets in a real big way, I don't see how we won't get some crowding out. Yes, there is another equilibrium with higher world income and higher consumption, government spending, and higher private investment too -- that is the rosy view with little crowding out and big multiplier. There is a less rosy view, with just slightly higher world income, much higher government spending, and less consumption and investment.

Sunday, February 15, 2009

Information from the NYT

Concerning my post below, The 2004 Banking Leverage Rule Change, there was an interesting comment from an anonymous poster.

I had noted a NYT article titled,"Agency's '04 Rule Let Banks Pile Up New Debt" and pointed out, first, that a quick check of Bear Stearns leverage ratios did not support the story, and second, that it would have been nice for the NYT to do a bit more work and provide the data to support or reject their hypothesis.

"Anonymous" found a very nice post on Wikipedia that gives a graph of five banks' (gross) leverage from 2003 to 2007. I will leave readers to look at the graph and make their own conclusion (my response to the comment might help). I think the graph supports my first point above, which is that the 2004 change in leverage regulation is no smoking gun.

"Anonymous" concludes with, annoyingly I have to say, "I think that I'm gonna get my info from the NYT going forward..."

Well, no. Look how easy it was for you to find that quite nice chart on Wikipedia, with (clickable!) references. Or for me to find the original data in the Bear annual report.

I think the right conclusion is: Wikipedia 1, NYT 0.

More Biased Climate Change Reporting

With a dearth of serious science showing that climate change is accelerating (indeed, even keeping pace with model predictions), it should not surprise us to see the media overstretching to attempt to maintain the momentum on public funding and policy intiatives.

Google News this morning had this article from the Washington Post: "Scientists: Pace of Climate Change Exceeds Estimates." The body of the article is essentially arguing that the pace of climate change might be stronger because carbon emissions have continued to increase and some additional positive feedbacks in the climate cycle have been identified. But unless we include the mere concentration of carbon dioxide in the atmosphere to constitute climate change, then the headline is certainly misleading.

Does anyone else want to suggest that the search for positive climate feedbacks is heavily favored over negative feedbacks? Bad science, when most effort is spent trying to confirm a theory rather than reject it.

The Climate Science site picked up on these headlines as well: "An Egregious Example Of Biased News Reporting."

Saturday, February 14, 2009

The End of Responsibility

All signs point to the end of individual responsibility. I just read an article by Rebecca Solnit for the Los Angeles Times on the Icelandic financial crisis.

Here is perhaps the most worrisome quote: "It's official. Capitalism is monstrous. Try talking about the benefits of free markets and you will be treated like someone promoting the benefits of rape."

Capitalism is monstrous? Just because the citizens of Iceland were given some very attractive prices at which to borrow, and they blindly took a bit too much advantage of those prices?

So much of the Western world is now looking for government actions to not only save us from this recession (has nobody lived through a recession before, by the way?) but to prevent us from ever making such mistakes again.

I will give the "monstrous" label to something, but it is not to capitalism, which is nothing but the flourishing of individual liberty. Monstrous is this $787 billion "stimulus" plan and the whole process by which the new politics of fear got it passed. If that process and the result is indicative of how government is going to save us from ourselves, I am afraid we have taken a turn onto the road to serfdom.

Tuesday, February 10, 2009

Welcome to the Treasury Amateur Hour

So our new Treasury Secretary comes out after having plenty of time to work out some details, and what do we get?

More uncertainty. Just what the markets and the economy need.

There is a beast in the room, and nobody wants to move because they don't know which way the beast will run. The beast of course is the Federal Government, doing their best to avoid the laws of unintended consequences.

A few quotes from the Wall Street Journal's story are very illuminating:

"But critical details of the plan remained unanswered, despite the weeks of planning leading up to Tuesday's announcement."

"Mr. Geithner said the plan to stem foreclosures would be announced in coming weeks."

"He also provided few details of the asset-purchase plan, which is designed to be done in partnership with the private sector."

"The absence of detail speaks to the thorny issues that lie at the heart of the financial crisis: how to value the toxic assets causing banks to report losses and how to shuffle aid to homeowners and stem the rise of foreclosures."

OK, these are not new issues.

The Government has two choices: One, come up with a credible and specific plan to buy toxic assets from financial institutions and support the ones that become insolvent as a result of having to take losses on the sales. Or two, step aside, and let natural market forces restore equilibrium.

Right now, the Government is effectively blocking mutually beneficial trades from taking place. Who wants to argue that financial institutions are the natural holders of these risky mortgage assets right now, instead of private investors? They never should have had such a concentration in the first place, so let's get on with the business of transferring that risk to those who are most willing and able to bear it.

UPDATE: I have to add this additional quote from Geithner's actual speech; it is just so perfect: "We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it."

Beautiful. How about you have the President ask some of those poor folks in Elkhart Indiana who "have no idea what to do or who to turn to."

Monday, February 09, 2009

The 2004 Banking Leverage Rule Change

We can expect a lot of revisionist history in the next several months, as policymakers and pundits attempt to spin the historical record to fit their interests.

We had a speaker at Tuck today who mentioned the SEC's 2004 rule change, which eliminated some leverage restrictions on investment banks in favor of capital requirements by type of asset as well as more reliance on self-regulation and reporting to the SEC. A good reference for a similar story is here in the NYT.

I have been meaning to look into this "smoking gun" for some time as it did sound intriguing. Of course, the headline is usually something like the NYT's: "Agency's '04 Rule Let Banks Pile Up New Debt." The subheading is, naturally, that we need more regulation not less and that the Bush administration was at fault.

Now there might be some issues about regulation of the banks, and I myself am very surprised at how poorly market forces seemed to enforce reasonable behavior on the part of the banks. Like Alan Greenspan, I have I guess a nostalgic view of how self-regulation should work (well).

But as to the story on the 2004 deregulation -- it simply does not hold water. I pulled out the Bear Stearns 2003 and 2006 annual reports -- before and after the regulatory change, but before falling asset prices caused an endogenous increase in liquidity.

In 2003, Bear had an overall leverage ratio of 26.4, and a net adjusted leverage ratio of 12.4. In 2006, the respective numbers were 26.5 and 13.6.

Do you think the NYT reporter could have looked that up and told us as well?