Geithner’s Brave New Regulatory World: An IMterview

March 26, 2009’s Megan Barnett asked me a few questions this morning about Tim Geithner’s plans for America’s financial sector:

Megan Barnett: Felix, what do you make of Geithner’s plan to regulate hedge funds?

Felix Salmon: Makes sense to me. It’s always a good idea to regulate things before they blow up with systemic consequences — and in this environment I don’t think we could easily cope with another LTCM.
It’s actually been kinda surprising that we haven’t had more hedge-fund blow-ups, or more systemically-damaging ones. But just because we’ve been fortunate on that front so far doesn’t mean we can be complacent.

Megan Barnett: Very true. And the regulations seems to have been a long time coming. Still, the timing is interesting — he announces it the same week he unveils the plan to buy up toxic assets. He’s looking for help from the alternative investment managers at the same time he tells them he wants more oversight of them. How ugly is this going to get?

Felix Salmon: Steve Waldman reckons that the investment managers need Geithner more than he needs them: they’re loaded up on bank debt, and need Geithner to bail them out of an investment which is looking increasingly dodgy.
Besides, the only people he’s asking for help are the huge fixed-income investors with $10bn+ portfolios, not hedge funds per se

Megan Barnett: No? The Citadels and KKRs of the world aren’t being courted for the toxic assets? I thought they were.

Felix Salmon: Well, that’s where the distinction between hedge funds and private-equity funds starts getting a bit blurred, I’ll admit. But really it’s the Blackrocks and Pimcos which Geithner really wants to attract — they’re used to making money by taking a small percentage of an enormous amount of money, rather than trying to take a large percentage of a smaller amount of money, which is what the 2-and-20 crowd do.
Plus the Citadels and KKRs want 20-30% returns, Blackrock and Pimco have more modest ambitions.

Megan Barnett: It appears that Geithner isn’t ready to talk specifics on how some of these markets will be regulated. Who do you think should have oversight of the credit default swaps?

Felix Salmon: In the present regulatory structure, the most sensible name would be the CFTC.
But Geithner seems to be making noises about turning the Fed into a new super-regulator, with a purview encompassing banks, insurers, brokers, derivatives traders, hedge funds, private equity shops, even General Electric.
thereby preventing the big problem of regulatory arbitrage (see for instance how AIG was "regulated" by the Office of Thrift Supervision).

Megan Barnett: Right. The yet-to-be named systemic risk regulator. Do you think such a regulator will be able to prevent another "too big to fail" colossus like AIG?

Felix Salmon: I think TBTF colossuses are here for the foreseeable future. But at least under a super-regulator there will be some adult supervision of them.
if things go according to plan, of course.

Megan Barnett: Do you think any of this will go too far? I mean, could it kill too much of the innovation in the financial markets?

Felix Salmon: I hope so!

Megan Barnett: Or perhaps it will encourage more?

Felix Salmon: It’s far from clear that financial innovation in recent years has been a net positive.
Financial innovation is generally prone to blowing up: financial institutions compete with each other, adding a bit more risk and a bit less understanding each time, until it all goes horribly wrong.
What’s more, if the most intelligent and inventive people start working in the real economy rather than on Wall Street, they might do much more long-term good
So yes — with any luck we’ll encourage more innovation, but less financial innovation. Which might well be a good thing all round.

Megan Barnett: So all these laid off Wall Street traders are supposed to go figure out the next big thing in cloud computing? Seems unlikely.

Felix Salmon: I’m actually more interested in what would otherwise have been the next generation of Wall Street traders.

Megan Barnett: Ah, yes. The promise of a new generation.

Felix Salmon: I’m gazing off into the distance like Barack Obama — he’s great at that, you know

Megan Barnett: Schapiro is also on the Hill today. She proposing new audits of money managers to prevent another Madoff. Considering the SEC looked at Madoff’s books and green lighted them, do you think this will do anything at all?

Felix Salmon: I think I’d be much happier with the new super-regulator taking on a lot of that responsibility. The SEC is quite possibly beyond repair.

Megan Barnett: Roubini thinks the banks may still need to be nationalized. Do you agree? Or will Geithner’s plan finally do the trick?

Felix Salmon: If the government is willing to throw an unlimited amount of money at the banks, they never need to be nationalized: insolvent banks can continue indefinitely so long as they have access to liquidity.
And most of the optimists about the bank bailout plan are looking at it as a price-discovery mechanism which will reveal which banks are insolvent and therefore in need of some kind of intervention, be it nationalization or (more likely) a standard FDIC takeover
so I’m not convinced that the Geithner plan is an alternative to nationalization
but yes, if it all works according to plan (I’d say p=0.3 on that) then nationalization will be avoided
and all the preferred shares will pay out in full
and we should all be buying Citigroup preferred stock right now as though there’s no tomorrow

Megan Barnett: And taxpayers won’t end up getting completely screwed?

Felix Salmon: In the best of all possible worlds, we actually make a profit!
(I’d say p=0.1 on that one.)

Megan Barnett: Yeah. If all the stars align perfectly.

Felix Salmon: But hey, with trillions of dollars of assets under the control of Vikram Pandit and Ken Lewis, what can possibly go wrong?

Megan Barnett: I feel so much better. Thanks, Felix!

Felix Salmon: A pleasure, Megan

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