Felix Salmon

Banks Fire Back at the US Government

Reuters Staff
Mar 11, 2009 09:03 UTC

The NYT and the WSJ both have big articles today on how highly-paid bankers are chafing in this brave new world of government restrictions on things like how much they’re paid. The NYT says that a lot of banks are itching to give their TARP funds back to the goverment, in order to give themselves more freedom of movement, while the WSJ looks at a lot of senior bankers simply leaving their jobs voluntarily, since "at the moment, no one can tell bankers whether they will or won’t get paid for the work they do in 2009".

I suspect that these two articles are part of a broader PR war between banks and the government — and I fear that the war is intensifying, which would in no way be a good thing. This crisis is big and serious enough that we really need the two biggest sources of money in the economy to be working together, rather than sniping at each other unhelpfully. Tim Geithner, with his history at the NY Fed, should be the perfect person to make that happen, but he doesn’t seem to be doing very well so far. Any bright ideas for how we can try to call a truce here, before things get worse?

Reprinted from Portfolio.com

Citigroup Questions

Reuters Staff
Mar 10, 2009 21:57 UTC

Are you reading thousand-word stories about how Citigroup managed to propel the stock market upwards on Tuesday? Bear in mind this: Citigroup rose the grand total of 40 cents per share — which means that its contribution to the 379-point rise in the Dow was a whopping 3 points. And at $1.45 a share, Citi is still, to all intents and purposes, trading at zero.

The optimism about Citi wasn’t that Citigroup itself might actually be solvent, so much as the idea that if even a seemingly-insolvent bank like Citi managed to eke out a profit this year, then everybody else in the banking sector might actually have something approaching a future.

All of which provides me a good excuse to answer some questions I just received via email from Sarah Jaffe, and then add one of my own.

First off, can you break down what’s really meant by "nationalization" as is currently being discussed by people from Paul Krugman to Alan Greenspan? What’s being called nationalization isn’t really complete nationalization, but more like receivership, right?

I can’t speak for Krugman or Greenspan, and it’s certainly true that different people mean different things by the term. I generally use it to mean a situation where the government controls the bank: the easiest criterion to use, I think, is to ask whether the government can appoint a majority of the board of directors. That’s entirely consistent with the government owning less than 100% of the equity in the bank, of course, which might be considered "complete nationalization". But it’s not receivership.

Do you remember when nationalization became a part of the debate over the financial crisis? Was it Bernie Sanders’ alternative bailout proposal, or somewhere else?

Speaking personally, I started pushing nationalization seriously in mid-January, in posts like this one. But the real debate over nationalization is older than that: I date it back to the debate over the original TARP, when there were a lot of people saying that if the government was going to inject $350 billion into troubled banks, it should get a concomitant ownership stake in return.

A USA Today/Gallup poll showed that Americans favored the idea of nationalization but were opposed to the word. We see the term "socialist" being tossed around a lot in reference to Obama, so I wonder if he’s afraid to propose nationalization because the term itself is scarier than the actual practice. What do you think?

Of course language matters, and there’s a good chance that if major banks do end up being nationalized, the government will try its best not to use the word. After all, no one has really used the word "nationalization" to describe what has happened to Frannie and AIG, despite the fact that they have surely been nationalized.

Steve Waldman wrote "We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers." Do you agree? Disagree? Is nationalizing the banks a "socialist" idea or is it in fact the proper capitalist response, expecting a return on government investment of tax dollars?

Nationalizing banks can be a socialist idea, if it’s done in the way that, say, Francois Mitterrand did it in 1981. If you’re an ideologist who believes in "the common ownership of the means of production, distribution and exchange", then you’ll naturally want to nationalize the banks. On the other hand, the likes of Alan Greenspan are hardly socialists, and it’s an equally natural consequence of the idea that capitalism is all about letting businesses fail. If you have a bank which is too big to fail, and the government is forced to step in with public funds in order to keep that bank alive, then it’s invidious and full of moral hazard to let the former owners retain any of the upside. That’s much more capitalistic than socialistic.

Is it primarily the giant banks, like Citigroup and Bank of America, that are in trouble, while smaller institutions are just fine?

Yes, pretty much. Obviously the FDIC has been closing down quite a lot of smaller institutions of late, but they’re not systemically important, and most smaller institutions really are fine.

Finally, my own question:

I bought some tickets on the internet, and paid using my Citibank credit card. The gig is in New York, where I live, and the tickets were priced and paid for in dollars. But when I got my credit card bill, there was a 3% "foreign transaction fee" added on top, on the grounds that the website in question — although it billed in dollars — was actually located in the UK, not that that’s remotely obvious by looking at it.

When I phoned Citibank to ask about this, they seemed a bit confused, and couldn’t work out whether the "foreign transaction fee" was for simply sending money abroad, or whether it was for currency exchange. In any case, they said, it wasn’t their fee, it was a fee imposed by MasterCard, and I should really take this up with MasterCard. They transferred me, and MasterCard weren’t particularly helpful, but did say that they’d never charge more than 1% for anything.

My favorite part of the conversation with Citibank was when I asked how I was meant to know that the website had a foreign billing address and that therefore I would be charged this 3% fee. Oh, they said, you should phone them up and ask before you buy anything from them. Does Citi really think that I should try to get through on the phone to any website I’m thinking of buying from, just to make sure that they don’t have a foreign billing address? Any light that anybody could shed on this whole issue will be gratefully received.

Reprinted from Portfolio.com

Was it All the Fault of the Quants?

Reuters Staff
Mar 10, 2009 21:13 UTC

The most emailed article on nytimes.com today is Dennis Overbye’s piece on quants — which has already resulted in something of a smackdown from Rick Bookstaber.

I’m not a huge fan of the Overbye piece, and not only because his sidebar on David Li and the Gaussian copula function seems weirdly familiar to me. The whole thing seems overwrought, somehow: is finance really "a world in which a few percent one way can land you in jail"? Did Black-Scholes really manage to seemingly "guarantee profits" in options pricing? And does the existence of the volatility smile really invalidate most quants’ models?

I know at first hand how hard it is to write about quantitative finance for a lay audience without oversimplifying massively. And Overbye gave himself such an enormous remit — everything from volatility smiles and Gaussian copulas to big-picture stuff about the rise of the quants and the criticisms of Nassim Taleb — that there’s simply no way he could have really got up to speed on all of this material in time for his deadline.

I also know that I’m not the intended audience here. But the fact is that Overbye has made it all too easy for his readers to simply blame the quants: he certainly doesn’t help himself by referring nonchalantly to "the ultimately disastrous growth of credit derivatives" amid other nods to popular prejudice, like the idea that "one bad bet can doom a hedge fund".

As Bookstaber says, it wasn’t really the quants’ fault; it wasn’t even really the risk officers’ fault. If you’re looking for bankers to blame, blame the executives, who were willfully blind to everything that the risk officers were telling them about tail risks. It’s the executives who took the numbers generated by VaR or copula calculations and treated them as something certain, rather than something highly volatile.

But another article blaming bank executives for willfully being blind to risks wouldn’t be fresh or new, so now the caravan seems to have moved on to the quants. Which is fair enough for a day or two — they’re hardly blameless, after all. But let’s not lose sight of the bigger picture.

Reprinted from Portfolio.com

Quick Hits

Reuters Staff
Mar 10, 2009 05:46 UTC

I’m about to get on a plane, and don’t have the time to get to all of the stuff I want to write about. So a few quick hits:

Paul Krugman grapples with the question of where to draw the line in the capital structure when you nationalize a bank:

Some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

My gut feeling is that equity gets wiped out, preferred debt gets a haircut, and senior unsecured debt is untouched. But Krugman is right that bloggers and pundits are the last people who should be making such determinations: you really need the kind of detailed analysis that only a team of Treasury wonks can come up with.

¶ Krugman’s blog entry is partly a response to Alan Blinder, who does a good job of running through most of the strongest anti-nationalization arguments, and some of the weaker ones, too. The column is, however, weakened by the way in which it ends up advocating a good-bank/bad-bank solution in which the government takes all the downside while getting very little upside.

¶ And John Hempton and Warren Buffett both hint that they might be interested in investing in the bad banks, should they ever get the opportunity.

Myron Scholes wants to "blow up" the derivatives market — unwinding "all contracts at mid-market prices". This is an astonishingly bad idea which would devastate the cash markets. Let’s say you’re a bank which has hedged your loan exposure through buying credit default protection. If you’re forced to unwind the CDS contract, yes, you might make a profit on it, but at the same time you’ll be left with a large amount of unwanted credit exposure which you’ll want to dump onto the open market. And no one wants that. Besides, it’s not at all clear that the CDS market in particular, or derivatives markets in general, have caused anything like enough damage to warrant these kind of drastic measures.

Josh Marshall gets an email saying that "derivatives claims are not stayed in bankruptcy" and that therefore AIG’s policyholders are actually junior to its CDS counterparties. This is not good regulatory policy.

A credit trader has a very good and extremely wonky post on what went wrong at AIG. This looks as though it’s going to be a fantastic new blog in the fixed-income space.

James Kwak says that "most financial advice floating around is worth less than nothing": he’s right.

¶ Edward Lam has a 29-page paper on the subject of bank capital.

¶ The trustees of the Conserve School in Wisconsin also control the Central Steel and Wire Company; they seem to be happy to sacrifice the former in order to maximize the value of the latter. There’s something nasty going on here, with echoes of the Brandeis scandal — where, incidentally, all the blame was pretty much shouldered by the president, with the trustees getting off very lightly. The press should do a much more assiduous job of holding trustees to account, since no one else will.

¶ And without meaning to be rude about Joe Hagan, who wrote a very good profile of Vikram Pandit, it’s worth noting that both he and the editors of New York magazine were happy with this:

“He was talking about fat-tailed risks fifteen years ago,” says a former colleague from Morgan, referring to the concept eventually popularized in Chris Anderson’s 2007 book, The Long Tail.

Clearly levels of financial sophistication in the mainstream media remain extremely low, even when the subject matter is finance. Fat tails and long tails are entirely different things — long tails, pretty much by definition, are thin, not fat.

But more to the point, bankers have been talking about fat tails for a very long time indeed. Similarly, they love to talk about advising their clients not to do M&A deals. But in the real world, precious few bankers actually did anything about fat tails, just as the empty tombstone generally existed more in theory than in practice. Most bankers can talk fluently about the right thing to do. Almost none of them actually do it.

Reprinted from Portfolio.com

Negative Global Growth

Reuters Staff
Mar 9, 2009 07:52 UTC

The World Bank’s pronouncement over the weekend is sobering:

The global economy is likely to shrink this year for the first time since World War Two, with growth at least 5 percentage points below potential.

If gross world product is on the order of $50 trillion, that’s $2.5 trillion of real economic output foregone as a result of this financial and economic crisis — in just one year.

As recently as last April, I was saying that "it’s pretty much impossible for the entire world to register negative growth in any given quarter" — and now the World Bank is predicting that the entire world will register negative growth over an entire year. All I can hope for now is that this will be the only year in my lifetime that this will happen.

Reprinted from Portfolio.com

Geithner to Citi?

Reuters Staff
Mar 9, 2009 05:58 UTC

I’m late to Joe Hagan’s profile of Vikram Pandit, and especially this intriguing passage about the decision about whom to replace Chuck Prince with as CEO of Citigroup:

Rubin immediately lobbied to have Pandit replace him, but there was unexpected resistance from a number of board members, including Alain Belda, chairman of Alcoa, and C. Michael Armstrong, the former AT&T CEO, who did not believe Pandit was ready to lead and thought Citi had overpaid to get him in the first place. Meanwhile, Citigroup founder Sandy Weill was advocating for Tim Geithner.

Weill doesn’t exactly have a stellar track record when it comes to picking Citi CEOs: he ousted his able heir apparent, Jamie Dimon, and then promoted instead the hapless Prince. But with calls for Geithner’s resignation from Treasury already growing loud, there might be a certain logic to Geithner moving back into the banking system from Treasury. After all, Geither is de facto running Citigroup already, while Summers is de facto in charge of US economic policy — why not make both positions explicit?

Reprinted from Portfolio.com

Larry Gagosian, Too Big To Fail?

Reuters Staff
Mar 9, 2009 05:26 UTC

David Segal’s NYT profile of Larry Gagosian slaps the TBTF label on him:

Mr. Gagosian has achieved the contemporary art market’s version of too big to fail, though for reasons that have nothing to do with toxic assets. The glamour and networking energy that he has brought to the business added a zero to the price of just about everything, Ms. Bortolami says. If his business were to fold, the new buyers he brought to the market, as well as a lot of added, buzz-laden value, would disappear along with him.

I think there’s an element of truth here — which scares me. Could it be that Gogo falling under a bus would have a bigger adverse effect on the art market than the Dow plunging by 50%? If we learned anything from the astonishingly successful Yves St Laurent sale in Paris, it’s that it’s pretty much impossible to underestimate the degree to which the art world assigns enormous dollar values to anything with glamor and buzz. And given that the number of YSL collections coming to market is now zero, we’re back to the status quo ante — which is that if you want glamor and buzz, you look first and foremost to Larry.

I trust Gagosian made so much money in the boom years that he’s now something of a buyer of last resort. Because if he’s genuinely in trouble — and the NYT gives no real indication that he is — then that might well seal the fate of the contemporary art market for a decade or more.

Reprinted from Portfolio.com

Berkshire, Leverage, and Triple-A Ratings

Reuters Staff
Mar 9, 2009 04:36 UTC

On Saturday I said, without spelling things out, that all insurance companies are leveraged financial institutions. This resulted in pushback from Cap Vandal:

Property casualty companies don’t tend to use leverage, unlike some life companies. They fund assets using their own capital and policyholder funds. Nothing close to the type of leverage used by banks or even some of the life insurers. Berkshire with huge amounts of excess capital to support their insurance operations and $23 billion in cash and cash equivalents is remarkably unleveraged.

The question here is really how you think of leverage. If you think of it as borrowing money, then yes Berkshire — like many insurers — "is remarkably unleveraged". But I think of leverage as something rather bigger than that. For instance, if you borrow money and buy stocks, hoping that the rate of increase in the stocks will be greater than your cost of funds, that’s classic leverage. If you replicate that trade using call options and no borrowed money, have you really made the leverage disappear?

When I say that insurers are leveraged, what I’m thinking about is their equity-to-liabilities ratio. At a bank, that ratio is normally about 10%, and as we’ve seen, it can erode to zero with alarming speed. At an insurer, if you consider that the liabilities comprise the face value of the policies in effect, then the equity-to-liabilities ratio can be much lower, below 3%. Which makes insurers, on their face, much more leveraged than banks.

That doesn’t mean they’re riskier than banks. A bank which marks its liabilities to market can easily see them fall in value by more than 10%, thereby wiping out its equity. An insurer’s market-linked investments, by contrast, tend to be in the numerator, not the denominator, of the equity-to-liabilities ratio. So in that sense market declines can’t wipe an insurer out in the same way that they can a bank.

Insurers and banks both rely on diversification to shore up their future: if a bank’s loans all soured at once, it would go bust overnight, and if an insurer’s policies all became due simultaneously, the same thing would happen. So banks count on different borrowers defaulting at different times, and insurers count on a lack of disasters. A big hurricane hitting Miami or New York would wipe out many property insurers; a serious bird flu pandemic could do the same thing for life insurers. Berkshire has been quite good at minimizing its event risk — there aren’t many disasters which cause a huge surge of car-insurance claims, for instance — but the fact remains that its contingent liabilities are many multiples of its claims-paying abilities, which is why I consider it leveraged.

Being leveraged is not the same as being risky, and Berkshire’s triple-A credit rating might well be justifiable, if there really is no conceivable way that a lot of its insurance policies will ever be asked to pay out at once. I’m just not sure that we have any way of knowing that: in the past, when people have tried to quantify the benefits of diversification, disaster has resulted.

So it’s worth looking quite closely at triple-A ratings, to see exactly how they’re arrived at. One reader asked me this weekend how asset-backed securities get triple-A ratings, and whether it was always something to do with Gaussian copulas: the answer is no. There are basically three ways that an asset-backed security can get a triple-A rating: diversification, overcollateralization, and wraps.

Ultimately, all three methods, if you follow the string far enough, rely to some degree or other on diversification and a lack of correlation: even the US government wouldn’t take long to default if everybody stopped paying taxes at once. But some sources of reassurance are more reassuring than others: if a company has been consistently profitable for years, is likely to be consistently profitable in the future, and has more cash on hand than it has in debt, for instance, then the chances of that company defaulting on its bonds are slim.

At Berkshire Hathaway, I’m unclear on exactly what its real and contingent liabilities comprise, and I’d be happier if it didn’t have a triple-A rating which it felt a strong need to protect. When you invest money or buy insurance, there’s always some risk that you won’t get the payout you’re expecting. And if anybody tells you that there’s no risk at all, it’s time to get a little suspicious.

Reprinted from Portfolio.com

Souring FHA Loans

Reuters Staff
Mar 9, 2009 03:18 UTC

Well, that didn’t take long. In November, BusinessWeek had a big cover story on the way in which dodgy subprime lenders were moving into the formerly safe-and-boring world of FHA loans. And now the shoe is dropping:

In the past year alone, the number of borrowers who failed to make more than a single payment before defaulting on FHA-backed mortgages has nearly tripled, far outpacing the agency’s overall growth in new loans, according to a Washington Post analysis of federal data.
Many industry experts attribute the jump in these instant defaults to factors that include the weak economy, lax scrutiny of prospective borrowers and most notably, foul play among unscrupulous lenders looking to make a quick buck.
If a loan "is going into default immediately, it clearly suggests impropriety and fraudulent activity," said Kenneth Donohue, the inspector general of the Department of Housing and Urban Development, which includes the FHA.

Annoyingly the WaPo story can’t find space in almost 2,300 words to ever tell us the rates at which FHA loans are souring: we’re told that the immediate-default rate has "nearly tripled", for instance, but we’re not told the absolute default rates. The closest we get is this:

More than 9,200 of the loans insured by the FHA in the past two years have gone into default after no or only one payment, according to the Post analysis.

I haven’t been able to work out where the FHA reports the total number of loans that it originates; the best thing I’ve found so far is this chart, showing FHA originations rising from about 60,000 a month in January 2008 to over 140,000 in August. So very roughly I’d guess that over the past two years the FHA has insured about 2 million loans. If that’s the case, then the immediate-default rate is about 0.5%. But some hard numbers would be very welcome here.

Update: Kevin Drum finds the numbers:

There were roughly 500,000 FHA loans originated in 2007 compared to 1.4 million in 2008.
In other words, the number of FHA loans has tripled in one year. And the number of instant defaults has tripled too. The amount of fraudulent activity appears to have held pretty steady at about 0.5% of all FHA loans.

Which would seem to put the front-page WaPo story into the "extremely misleading" category. How much can we trust the WaPo assertion that growth in immediate defaults is "far outpacing the agency’s overall growth in new loans"? My guess is not much, especially given that the lead writer on this story, Dina ElBoghdady, has demonstrated herself to be quite innumerate in the past.

Reprinted from Portfolio.com