Opinion

Felix Salmon

Why We Still Need Securitization

Reuters Staff
Mar 27, 2009 11:07 UTC

The NYT’s op-ed page is positively infested by econobloggers today: there’s not only myself, but also a certain Princeton economics professor whose blog you might have noticed. His column today echoes the big Simon Johnson essay in the Atlantic, bemoaning the decades-long rise in the power of the financial sector, which still seems to have US governments both red and blue entirely captive:

Mr. Summers needs to get out more. Quite a few economists have reconsidered their favorable opinion of capital markets and asset trading in the light of the current crisis.
But it has become increasingly clear over the past few days that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.

I’m sympathetic to this view: financial intermediation, in its various forms, should never account for 41% of total corporate profits, as it did this decade. That’s closer to a Ponzi scheme than it is to value creation. But I disagree with the distinguished professor on the subject of securitization.

The key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption…
I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

I have a feeling that, contra Krugman, securitization really does hold out a lot of promise for the banking system going forwards. Much of the current crisis stems from the fear that too-big-to-fail institutions are in fact insolvent. And while one can talk about interconnectedness as being just as important as size, size still matters: if you have a trillion-dollar balance sheet, you’re too big to fail. And so any financial technology which can reduce the size of a bank’s balance sheet is a good thing.

Securitization — real securitization — is a great way of moving assets off a bank’s balance sheet. The problem is that starting in the late 1990s, with JP Morgan’s Bistro deal, banks stopped taking their assets, bundling them up into securitized bonds, and selling them off. Instead, they kept the assets on their balance sheets, and sold off synthetic CDOs which, according to their models, perfectly hedged the credit risk of the assets in question. Thus, instead of getting smaller, banks’ balance sheets got much, much bigger. And when the models proved to be flawed, the write-downs that the banks needed to take on their "super-senior" assets (the ones which supposedly had no credit risk at all) amounted to hundreds of billions of dollars.

CDOs are not eligible to be bought as part of Treasury’s bank bailout plan. Instead, the plan calls for investors to buy the actual underlying assets, thereby reducing the size of the banks’ balance sheets. This is a good thing. And any sustainable recovery will be predicated on the existence of more such deals: risk being moved from the books of people who don’t want it, onto the books of people who do. The problem with a lot of what looked like securitization over the past decade was that many banks thought that they’d sold off all their risk, when in fact they hadn’t. The way to solve that problem is to move back to securitization 1.0, not to abolish securitization entirely.

Reprinted from Portfolio.com

Unhelpful Metaphor of the Day, Poker Edition

Reuters Staff
Mar 27, 2009 09:02 UTC

Here’s how Gerald Seib leads his WSJ column today:

In poker, there’s a maneuver called "all-in," in which a player pushes all his chips to the center of the table in one big bet.
By that standard, President Barack Obama is conducting an all-in presidency.

He might have gotten the idea from Peter Nicholas, who says that Obama is "going all in, in poker terms". Or Deborah McAdams, who says that "in poker terms, the Treasury and the Fed have gone ‘all in’". Or Mike Larson, who writes that "The Federal Reserve has done it now. In poker terms, it’s gone ‘all in’". Or Bob Pinzler, with a column on the economic crisis which uses "Going ‘all in’" as a headline. Or Tim Reid, whose headline is "Barack Obama bets the farm in $4 trillion poker game". Etc etc.

Can we please retire this stunningly unhelpful meme? For one thing, it’s responsible for altogether far too many scare quotes appearing in the mainstream media. And more to the point, the metaphor breaks down on a moment’s reflection. Seib explains:

The budget attempts to launch at the outset most of the big policy initiatives the president has in mind for his term. It has money for a new health plan, envisions a cap-and-trade system for limiting so-called greenhouse gases, invests big money in alternative energy, and continues the flow of dollars into education started in the economic-stimulus package…
The Obama team could have made another choice; it could have been incremental, seeding in some items now, while promising to launch others over time.

Seib’s basically saying here that all of Obama’s big policy ideas are in the budget. But that’s not what going all-in means, in poker. At the card table, going all-in means that you can’t be bluffed or negotiated with: it’s a bullying take-it-or-leave-it proposition. It also holds out the possibility that you can multiply your wealth at a stroke. It’s the opposite of the long hard slog of grinding it out: it’s a big and flashy gamble which leaves no room for strategy or even tactics. And while there are occasional government actions which might come close to fitting that bill — Saddam Hussein’s invasion of Kuwait, perhaps — presenting a budget to Congress simply isn’t one of them. Sorry.

Reprinted from Portfolio.com

Raising Citi’s Kimono

Reuters Staff
Mar 27, 2009 08:26 UTC

I love this chart, from The Big Money:

Citi-pie_1.jpg

The good news, of course, is that it’s not just the Legacy Assets which are rising in value — the Unlimited Metrocards are, too! A few more fare hikes, and Citi will surely be solvent again.

(Via Cottrell, who also links to a startling list of vacant Treasury communications positions. These things don’t need Congressional approval, why are they all empty?)

Reprinted from Portfolio.com

What Should Be Happening to Toxic Bond Prices?

Reuters Staff
Mar 27, 2009 03:39 UTC

Consider three assets. Asset A is a basket of subprime mortgage-backed bonds, sitting on the balance sheet of JP Morgan Chase. Asset B is an identical basket of subprime mortgage-backed bonds, being traded in the secondary market. And Asset C is a credit default swap written on that basket of subprime mortgage-backed bonds.
The Geithner bank bailout plan is released. What would you expect to happen to the prices of Asset B and Asset C?
If you’re Krishna Guha of the Financial Times, you’d reason something along these lines: Thanks to the availability of cheap government funding to buy it, Asset A will rise in price. Since Asset B is identical to Asset A, then Asset B will rise in price too. And since the spreads on Assets A and B have both tightened, then the spreads on a CDS written on that asset must be tightening too, thanks to the CDS-cash arbitrage. So expect the CDS spread to narrow, just as the yield on Assets A and B has fallen.
Well, guess what. If you look at the market, Asset B has not risen in price, and the spread on Asset C has not tightened. And Krishna Guha is worried:

The plan’s modest impact on toxic asset prices raises questions as to the sustainability of the rally in bank stocks. It is a reminder that even this plan, which most experts believe is well crafted, may not work.

I, on the other hand, would not expect the price of Asset B to rise, nor the spread on Asset C to fall.
After all, Asset B is likely not eligible to be purchased as part of the Geithner bank bailout plan. So why should its price rise? If anything, one would expect its price to fall: investors holding Asset B and who are eligible to get funding to buy Asset A are likely to dump Asset B today, in anticipation of buying Asset A tomorrow. Now there might be a bid for Asset B from banks hopeful that they will then be able to turn around and flip it in the government auction, but somehow I doubt that’s a trade many banks would get particularly excited about these days — although there are always exceptions.
As for Asset C, the availability of cheap funding to buy Asset A has no effect whatsoever on the underlying default probabilities for that particular basket of subprime mortgage-backed bonds — so you wouldn’t expect CDS prices or spreads to move at all. If anything, you’d expect the CDS spraeds to widen, since investors who are about to buy lots of subprime assets might well want to start hedging that position in the CDS market, giving themselves some downside protection.
Yet Guha is perfectly happy quoting ABX and LCDX prices — which are credit default swap indices — as indicia of what’s happening to toxic-asset prices.
The real problem here is that financial journalists find it pretty much impossible to get out of the no-arbitrage mindset: we’re used to living in a world where a thousand hedge funds descend on any possible arbitrage and close it in milliseconds. But that’s not today’s world. We live instead in a world of massive CDS-bond basis spreads and many other arbitrages too.
And of course, there’s the narrower problem that journalists — including Guha’s colleague Gillian Tett, whose book I’m reading now — have a habit of looking at the level of the ABX and using that as the actual trading level of subprime mortgage-backed bonds, in cents on the dollar. It isn’t.
So never mind all of Guha’s elaborate theories about how the lack of price action in the ABX, in the wake of Geithner’s announcement, might mean that there isn’t as much of an illiquidity premium as policymakers seem to think, or that the Geithner plan simply isn’t big enough. Both of those things might be true — but there’s no way you can possibly deduce them from looking at bond and CDS prices.
(HT: Scheiber)

Reprinted from Portfolio.com

Extra Credit, Thursday Edition

Reuters Staff
Mar 26, 2009 23:36 UTC

How to Conjure Up $500 Billion: I have an op-ed in Friday’s NYT on the political realities surrounding the bank bailout, and the way in which the FDIC is the big winner here.

The Quiet Coup: A long, must-read essay by Simon Johnson tying together a lot of the themes he regularly explores elsewhere into one very coherent whole. Sobering.

The purple panda principle of financial regulation: Randy Quarles gives good quote.

The crisis — and Geithner plan — explained: Another Brad DeLong Q&A.

Liquidity and the Current Proposal by the US Treasury: Some smart thinking from David Merkel.

Reprinted from Portfolio.com

Ponzi Update

Reuters Staff
Mar 26, 2009 15:45 UTC

Remember Millennium Bank, the Ponzi scheme in St Vincent & the Grenadines? Well, the SEC has finally noticed it, which means that non-bloggers can now accuse it of being a Ponzi too.

Meanwhile, Alan Stanford is implausibly saying that he wasn’t running a Ponzi scheme at all:

"He’s not a swindler," Stanford’s lawyer, Dick DeGuerin, said in a phone interview today. "This isn’t a Ponzi scheme. He was able to pay back every investor until the regulators came in like storm troopers."

Hear that, Stanford investors? It wasn’t Alan Stanford who stole your billions, it was the regulators! I do wonder where they put the money.

And my 5pm meeting at the Portfolio offices today with a hedge fund accused of being a Ponzi was cancelled at the last minute, so it seems they’re not going to come in and show me their audited accounts after all. I’m afraid, however, that this one needs some actual reporting before I can write more about it: the fund’s lawyers have teeth and aren’t afraid to bare them. But even if this particular fund turns out to be kosher, be assured there are a lot more Ponzis out there. If you see something with suspiciously consistent and positive returns, and if you have no idea how those returns are generated, then tread with extreme caution.

Reprinted from Portfolio.com

Geithner’s Brave New Regulatory World: An IMterview

Reuters Staff
Mar 26, 2009 09:44 UTC

Portfolio.com’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

Reprinted from Portfolio.com

The FDIC’s Brand New Job

Reuters Staff
Mar 26, 2009 08:23 UTC

Steve Waldman puts his finger on the mission-creep problem at the FDIC:

It’s as if an insurance company that ordinarily refuses to cover homes in hurricane states suddenly offered policies only to purchasers looking to build homes on Gulf-coast barrier islands.

Waldman in general does a great job at explaining how the FDIC’s new insurance is an entirely different animal from its old insurance — for one thing, entire banks don’t need to go bust before it kicks in. The FDIC was good at its old job. But that’s no reason to believe it’ll be good at its new one, too.

Reprinted from Portfolio.com

Citi’s Michael Klein Gets $5.5 Million Retention Bonus on Departing

Reuters Staff
Mar 26, 2009 08:10 UTC

Does Citigroup’s tone-deafness know no bounds? Last week it was the $10 million office renovation; this week, it’s retention bonuses paid, AIG-style, even to people who are leaving:

Mr. Klein, who headed Citigroup’s investment banking operations, was given a retention package in cash and stock worth $19.3 million. Even though he announced his departure a few months later, the board nonetheless paid him his full $5.5 million cash bonus in connection with that award. That was on top of nearly $28.8 million in two other cash payouts — one due on March 31, the other in October — for agreeing not to work for several Citigroup rivals.

Why do boards suddenly go all squishy when employees leave? They forgive loans; they throw in $5.5 million "retention bonuses"; they generally act as though the departing employee has them over a barrel. It’s very weird — and, in this case, it’s bound to come back to haunt them.

Reprinted from Portfolio.com

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