Felix Salmon

Reader Steve Santini emails to ask:

I am a big proponent of the idea that if something is to big to fail, it is too big to exist. I am also a big fan of the idea that the large banks need to be broken up, in addition to regulated further. However, I feel that the government is powerless to do this. Probably because they lack the ability and courage to do so. But what about the market. It occurred to me recently that in a theoretically free market the customer is the counterforce which acts against gross accumulation of power. If customers were to take their deposits from the large banking institutions and place them in cooperative banks and small regional banks, this would have the same affect of leveling the playing field. What are your thoughts on this matter? Big banks offer pitiful interest on money that they lend and they charge exorbitant fees which contribute significantly to their profit, so it does not even make sense to do business with them (although I understand the advantages – more ATM’s, theoretically more services, etc.)

It’s a great idea, but I’m not sure it’s likely to work, for a number of reasons. For one thing, America’s biggest banks generally got that way through acquisition, rather than growth. It’s all well and good banking with a smaller bank, but when that smaller bank is taken over by a larger one, are you really meant to go through the hassle of switching banks all over again?

What’s more, having a large deposit base is certainly a nice thing for any large bank to have, but it’s not necessary. Many banks fund themselves in the wholesale market rather than through deposits, and although that leaves them open to a lot of funding risk, Treasury and the Fed have repeatedly proved themselves willing and able to step in and make sure that they will act as the liquidity provider of last resort to any bank which is having difficulties funding in the wholesale market.

Finally, the obvious place to move one’s money is a credit union. I’m a huge fan of credit unions — I even sit on the board of one — but thanks to the effort of the banking lobby, credit unions are highly constrained in where and how they can operate. Any given American probably has a choice of no more than two or three credit unions they’re allowed to join, and many are allowed to join no credit unions at all which offer a remotely acceptable degree of accessibility and convenience.

So one way to bring down the power of the big banks would simply be to allow credit unions to accept deposits from anybody, rather than only from tightly-defined fields of membership. But the chances of that happening, right now, are precisely zero. In the meantime, the whole credit union system, and especially the smallest and most important credit unions, is teetering on the brink, thanks to the fact that highly responsible lenders, which have proved themselves able to underwrite loans so well that their default rates are very low, are being forced to bail out a small group of highly-irresponsible “corporate” credit unions, which don’t even have individual members, and which lost billions of dollars on mortgage-backed instruments.

The fact is that if the government isn’t going to force the banks to shrink, there’s nothing that consumers can do about the phenomenon of too-big-to-fail banks posing an enormous systemic risk to the economy. It’s out of our hands: it’s all up to Tim Geithner, the former CEO of the New York Federal Reserve. Whose shareholders are the largest banks in America. So don’t expect too much in the way of banking-sector shake-ups from him.

David Wessel has an interesting idea today: while the bank stress tests were a good idea at the time they were announced, in February, a lot has changed since then, and none of it in a good way. Most obviously, the tests’ worst-case scenario is now looking more like a base-case scenario, making the tests less credible. What’s more, the very announcement of the stress tests’ existence caused all manner of confusion and second-guessing in the markets, none of which was helpful. And most profoundly, Congress passed executive-compensation rules which mean that no banks have any interest in accepting government funds should they be found to have insufficient capital.

For me, the fact that all these things managed to happen so quickly after the stress tests were announced is an indication that the stress tests probably weren’t such a good idea in February after all. But never mind that: as Wessel says, “Treasury has to deal with the world as it is, not as it hoped it would be”. And that means being extremely transparent about both the tests themselves and their results.

Near the beginning of the crisis, in the early months of 2008, it was still possible for Treasury to attempt a “trust us, we know what we’re doing” approach to bank regulation. That won’t fly any more. Treasury has to internalize the show-don’t-tell rule which is commonly hammered into journalists. Because no, we don’t trust them to know what they’re doing. Especially when the official org chart still looks like this.

Back in March, Rick Bookstaber published a blog entry entitled “The Fat-Tailed Straw Man”, which seems to imply that Nassim Taleb attacks Wall Street practices on the grounds that its practitioners believe in normal distributions.

The result of that blog entry, and of a few other criticisms of Taleb in various places, is that Nassim has now published an extremely useful technical appendix to The Black Swan. It includes substantially all his relevant scientific and technical papers, and essentially comprises a gauntlet being thrown down to those who would criticize him. If you want to attack my ideas, he’s saying, that’s fine, but please first do me the favor of looking at where they’re laid out in detail, as opposed to where they’re laid out in newspaper quotes or in a literary book.

There is certainly a lot of confusion in the public mind when it comes to philosophical arguments about fat tails and risk management, and it’s easy for journalists to distill things into easy soundbites about normal distributions and the like. I, for one, would like at some point to write about Taleb’s important paper on Errors, Robustness, and the Fourth Quadrant, which looks at the history of thousands of data series going back decades — but I haven’t found a very clear way of trying to explain its details in English.

The Black Swan has proved to be a very popular book largely because it doesn’t even attempt to do that: instead it talks philosophically about the conclusions one draws after looking at the data. But if you want to attack Taleb for drawing the wrong conclusions, I think he’s right: you shouldn’t attack the book, but rather the empirical research which underlies it.

Chris Wilson has the best graph of the day: an interactive map of US job losses since the beginning of 2007. Play the whole thing through once, and then take a closer look at what happens from month to month — especially from April 2008 to February 2009. And pity poor Detroit.

I do have a question about the scale, though: the “50,000 jobs” circle seems as though it has a much larger area than five of the “10,000 jobs” circles would have. But I don’t think they’re being silly and just working on the radius or the diameter, either. I wonder what they used for that.

Update: Chris Wilson provides graphical proof that the areas are right!

Many thanks to Jeffrey Benner of Moody’s, who responded to my blog entry yesterday with some very useful information about downgrades and default rates.

Firstly, the 13.8% downgrade rate in the first quarter means that Moody’s downgraded 13.8% of all its corporates in the first quarter alone: it’s not an annualized rate, and Moody’s therefore downgraded a higher percentage of the companies it covers in the first quarter of 2009 than it does in a typical year.

As for absolute ratings quality, I haven’t managed to get good data on that. But Moody’s does have good data on default rates, and has even provided a couple of charts: the first shows how the spike in annual default rates is expected to surpass the 1991 and 2002 peaks, while the second puts those peaks into perspective going back to 1920.

The second graph is particularly interesting to me, since it really puts the Great Moderation in perspective. A couple of years from 2004 through 2007 doesn’t make a Great Moderation; for that you really want to look at the period from say 1943 to 1970. One of the consequences of the rise in the pace of financial innovation of late is that the global financial-services industry could take a really very short-lived decline in default rates and credit-market volatility, and turn it into something so dangerous as to create the worst global recession in living memory. Once upon a time, you could go for decades without seeing the default rate rise over 3%. Nowadays, the chase for return on equity won’t ever let that happen.

I’m very excited to see Ryan Avent off to a storming start at my old home; if you’re not sure who he is, he gives himself a pretty comprehensive introduction here. Ryan is one of the smartest and most perspicacious bloggers out there, and it’s great that he has thrown off the anonymity of Free Exchange: blogging does not generally work well with the kind of anonymous psuedo-omniscience that the Economist specializes in.

Ryan has already managed to encapsulate the problem with the government’s stress tests:

If the administration releases information suggesting that the tested banks are all basically fine, then the data is worthless. Markets will go on speculating on which banks are in the most trouble (and possibly be more pessimistic, generally, based on the government’s bungling of the tests). If the administration provides meaningful information of any kind, on the other hand, markets will naturally assume that the weakest looking banks are the weakest banks, and will begin trading accordingly.

The way out of this problem I think is for the government to recapitalize the weakest banks before it releases the stress-test results, and then to release post-money stress tests showing that, as a result of its recapitalizations, all the tested banks are basically fine. It’s a risky strategy, but I don’t think Treasury has much choice at this point.

As far as its financial statements are concerned, Goldman Sachs’s 2008 ended in November. Its 2009 began in January. In between was possibly the worst month in its history.

Heidi Moore is charitable:

The move effectively eliminated a very ugly month from Goldman’s official annual financial results for both 2008 and 2009, although that was likely not the bank’s intent.

John Hempton is less so:

Am I surprised that Goldies had an “orphan month” and stuffed the bad news in it? No. If you were – then obviously you are new to investment banking.

I suspect that when it comes to bonus time at Goldman, December 2008 will never matter. The 2008 bonuses will be paid based on the 2008 fiscal year, while the 2009 bonuses will be paid based on the 2009 fiscal year. And those $1.3 billion of losses in December — losses which will never show up in any annual report — will be conveniently ignored by the compensation honchos.

Attention Eliot Spitzer: just when you think things can’t get any more shameless, they do. Your hopes that stakeholders will finally start throwing their weight around when it comes to compensation will never come to pass.

Update: Goldman tells Floyd Norris that “the change in fiscal year was required when it converted to a bank holding company”. But as Norris notes, relegating the December results to “a table deep in the announcement” was not in the requirements.

The WSJ leads today with a story on what it calls “Bernanke’s PR Push“, saying that the Fed chairman “is waging a public-relations offensive” and conducting a “campaign for openness”. This is good in the short term, but I’m not sure it’s good in the long term.

Alan Blinder gets the problem exactly right:

“The American public is seeing things happening that it doesn’t like and doesn’t understand and nobody is really explaining it to them,” says Alan Blinder, a Princeton professor and former Fed vice chairman. “That was true in the Bush administration and it remains largely true in the Obama administration. The Fed is filling the void.”

The only really good communicator on Obama’s economic team is the president himself. Summers is bad at talking in public, with his remarks being ill comprehended by the American people up to and including the faculty of Harvard. Geithner famously flubbed his first major presentation as Treasury secretary so badly that his do-over was conducted far from any television camera. And so it falls to Bernanke to provide the clear explanations of economic policy that the American public so desperately wants.

The problem, of course, is the one of Fed independence: if Bernanke becomes the person best able to explain the Obama administration’s economic policy, it becomes much more difficult for him to credibly say that he is genuinely independent of the White House. As Greg Ip explains:

The controversy also comes at a delicate moment for the Fed. Two governors’ seats are vacant and Ben Bernanke’s four-year term as chairman ends next January. The Fed also needs favours from Congress: it would like authority to issue debt securities to soak up the excess liquidity its rescue operations have created, or for the Treasury to have authority on its behalf. The Treasury is seeking to revamp financial rules and give the Fed more sway over the financial system. Hostile congressmen could seize on such initiatives to impose changes that the Fed doesn’t want.

What’s more, Bernanke is far from secure in his job:

Friends and associates of the central bank chief were appalled in November when word leaked out of Mr. Obama’s transition team that Mr. Summers could be a successor to Mr. Bernanke.
“It was a terrible thing to start lame-ducking the chairman of the Fed a year before his term is over,” says Mr. Blinder.

In many ways, Bernanke is taking on responsibilities which should properly be those of the Treasury secreatary rather than the Fed chairman. Maybe, if Summers gets his way and takes Bernanke’s job, Obama might consider moving Bernanke to Treasury? Geithner’s not an economist by training so maybe he shouldn’t just fill the empty position at the NEC, but it does make sense to put him in more of a technocratic advisory role — where he shines — as opposed to his current executive role, where he does seem to be struggling.

In any case, I’m glad that Bernanke is coming into his own and putting his professorial skills to good use: having someone with the ability to speak English is surely better than having no one.

Any interest in buying shares in a highly-opaque financial institution which has been receiving billions of dollars from the US government but doesn’t want to do that any more; which is happily diluting itself in the midst of a hugely volatile and nervous market; and which generally acts in the imperious we-know-best, don’t-ask-questions tradition of all the best Ponzi artists? No? Well, you’re in good company: after the bank sold $5 billion of stock at $123 a share yesterday, the shares promptly plunged to close at $115 apiece, making everybody who participated in the offering feel like something of a schmuck.

Indeed, Goldman’s share offering yesterday is particularly distasteful in that in came fresh on the heels of Goldman’s first-quarter earnings report — a report which, according to no less an authority than BlackRock’s Peter Fisher, was mostly made up of one-off AIG-related earnings.

The AIG tale is important to keep in mind here, because the money flowing from the US government, through AIG, and ultimately to Goldman in January and February is possibly only half the story. The other half is Goldman’s famous counterparty hedging. Goldman is well known for having a more sophisticated counterparty hedging operation than any other bank; it claims — and I believe it — that all its AIG exposure was hedged. But what exactly did these famous counterparty hedges consist in? We can speculate endlessly about CCDS and the like, but there’s a rumor going around that a significant part of the hedge was a simple old-fashioned short position in AIG stock. And if that’s the case, Goldman ended up getting paid out both on the default protection it bought from AIG and on the hedges it took out against AIG being unable to make those payments. Talk about non-recurring earnings.

In the absence of much real-world primary-markets activity, Goldman’s prop desks are working hard to keep the firm’s profits up: according to my colleague Jonathan Ford, the value of Goldman’s principal equity trades in the first quarter principal equity program trades in the latest weekly data was an impressive 4.2 times the business it did for customers. In other words, Goldman is reverting to being the overgrown hedge fund which we thought was being quietly wound down when it became a bank holding company.

So yes, on the one hand the government has no business supporting a systemically-highly-risky hedge fund like Goldman Sachs with TARP money and bank charters. At the same time, Goldman has no business saying “thank you very much” for the financial-system bailout, but politely trying to decline participation in it by handing back the TARP funds. Like it or not, Goldman is a central part of the financial system, which means that it’s a central part of any bailout strategy. It can’t unilaterally say no to that, and I hope that it gets slapped down by Treasury as definitively as it was slapped down by the stock market yesterday.

Wells Fargo Q1 Profits Packed with Accounting Gain: Cowen comments.

New bond trading rules target disclosure on pricing: In Canada. Doing it elsewhere wouldn’t be such a bad idea either, retail investors often get ripped off in the bond markets.

Eye on the Bailout: A new blog from ProPublica, tracking bailout funds.

Can anybody tell the difference between a level and a direction any more? Not at the FT, it would seem, which ran a story yesterday under the headline “Credit quality of global groups at 25-year low”. Here’s how it begins:

The credit quality of global companies has deteriorated to levels not seen for more than a quarter of a century, according to Moody’s Investors Service.

The ratings agency said the ratio of companies having their credit ratings cut versus the number of companies being upgraded – an indicator of declining credit quality – had reached its highest level since 1983.

Of course, just because the rate of decline of ratings is at a 25-year low does not mean that the absolute credit quality of global companies is at a 25-year low.

And even the rate of decline doesn’t seem to be all that bad, once you read on:

During the first quarter of 2009, the rate at which borrowers were having their ratings cut reached 13.8 per cent, highlighting the negative credit climate in the first part of the year, analysts at Moody’s said.

“This downgrade rate is higher than pre-economic crisis figures,” said Jennifer Tennant, Moody’s analyst. For the whole of 2006, the downgrade rate was 10.2 per cent, and the average rate from 1983-2009 was 12.5 per cent per year.

All of these numbers seem to be annualized rates, and if the downgrade rate was 10.2% in 2006, at the height of the Great Moderation, then a rise to just 13.8% today seems positively modest — especially when the long-term average is 12.5%.

But the story is confusing: it goes on to say that the long-term upgrade rate is just 7.9%, which would seem to imply that on a net basis, credit quality has been deteriorating steadily for a quarter of a decade at least, with downgrades nearly always outnumbering upgrades. Is that really true? After its first two paragraphs, I don’t trust this FT story to enlighten me on such matters.
And more to the point, does anybody even care what Moody’s thinks any more? Wouldn’t it be better to just look at default rates and credit spreads, rather than ratings, which are horribly lagging indicators even at the best of times?

Larry Summers just gave an interview to CNBC’s Maria Bartiromo in which neither side was particularly impressive. Bartiromo managed to go the entire interview without asking Summers about about the fact that he seems to be bought and paid for by Wall Street. And Summers proved himself incapable of even answering Bartiromo’s softballs:

BARTIROMO: And it leads me–it leads me to sort of a more thoughtful, broader idea here, and it feels like there’s a bit of a competition going. On the one hand, the government is saying to the banks, `Look, you need to lend more,’ lend, lend, lend, get the credit moving again,’ since credit has been stripped in this economy, literally, five quarters. On the other hand, the government is saying, `We’re performing stress tests and you need to get your capital levels at an appropriate level.’ So why would a bank lend when they know that they’ve got to get their credit level–they’ve got to get their capital levels up?

Mr. SUMMERS: Well, I think the focus of the stress test is going to be on levels of capital rather than capital ratios. And so the focus is going to be on making sure that institutions raise capital or take other kinds of steps to assure that they have capital that enables them to support their existing loans and puts them in a position–puts them in a position to expand. And that’s really where focus–really where the focus is going to be. Nobody’s looking to use the stress test as a vehicle for forcing institutions to deleverage and reduce their lending activity. Rather, the action’s going to be on the capital side, and that’s where you’re supporting a stronger economy and more lending that enables more growth.

“The focus of the stress test is going to be on levels of capital rather than capital ratios” means nothing — it’s utter blather. Summers, here, is simply bloviating: he’s not even attempting to answer the question. Does the government want the banks to lend freely, or does it want them to hunker down behind fortress balance sheets with vast amounts of tier-one capital? You’ll get no insight from Larry Summers on that front.

But at least he’s smart enough to pick an interviewer who won’t ask him the really tough questions, like whether his actions as Treasury secretary helped to pump up the financial-services bubble whose implosion we’re all now suffering through, and whether he owes the American people an apology. Instead, he’ll continue to simply ignore the irate.

(This is doing the rounds, not sure where it started, but possibly here.)

This is my new favorite Amazon page: it lists the top books by Harry S Dent. It’s best read countdown-style, from the bottom up. The top three are great: in third place is “Bubble After Bubble in The Ongoing Bubble Boom: Oil Bursts, the Housing Bubble Fades and Now Stocks Emerge Into a Greater Bubble that Finally Ends in 2010“. That one was published in 2005. Then in second place comes Dent’s 2006 book, “The Next Great Bubble Boom: How to Profit from the Greatest Boom in History: 2006-2010“. Finally is his most recent book, published in January this year: “The Great Depression Ahead: How to Prosper in the Crash Following the Greatest Boom in History“.

But don’t worry, you don’t need to buy his books. If you register by April 20, you can attend Dent’s seminar in Scottsdale, Arizona for a mere $1,045! Hear Harry talk — in person — about how to “protect your finances” from the current “spike in energy costs”! Of course, he doesn’t tell you how to protect your finances from snake-oil salesmen. But maybe you can learn that the hard way.

(HT: Lex)

The great Larry Lessig emails me to point to a Newsweek article he wrote back in October, which I missed at the time. It’s entitled “Why The Banks All Fell Down”, and Lessig asks whether there’s a connection between his theory there, on the one hand (properly Lessig ascribes it to Avinash Persaud), and my story about the Gaussian copula function, on the other.

Here’s Lessig:

The models governing our financial system were developed in the 1950s. They were built, as Persaud explains, upon the assumption that “each user is the only person using them.” That assumption may have made sense when only the Rand Corporation (which developed the models) had the data to act upon them. But as Persaud wrote in the Financial Times in March, in “today’s flat world, [where] market participants from Argentina to New Zealand have the same data,” the assumption is nothing short of nuts. As the market shifts, the models used by all the major investment banks “throw up the same portfolios to be favored and those not to be.” This is the Heisenberg uncertainty principle for financial markets: by being observed, the observed gets changed. The global, simultaneous and practically instantaneous “adjustments” lead “the herd” (a.k.a. our financial system) right off the cliff.

The financial system is indeed full of models which make sense if only one person uses them, but which become extremely dangerous if everybody starts to use them. Here’s the relevant bit of my Wired story:

The real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

The financial markets were reminded of this in the summer of 2007, when simultaneously all the formerly-very-successful quant and stat-arb hedge funds all blew up at the same time. Bryant Urstadt wrote the definitive article on the blow-up for the MIT Technology Review, which is hidden behind a registration firewall here; the gist is that all the funds were following much the same strategy (something called “pairs trading” is mentioned), and that as a result asset classes become highly correlated which were never correlated in the past.

In 2007, the damage was limited: there was a lot of fallout in the world of hedge funds, but the stock market continued to rise, and the systemic implications seemed to be contained. But the adoption of the Gaussian copula function was much more widespread than a bunch of hedge funds: it was embraced at pretty much every CDO origination and trading desk on Wall Street. And when the entire financial system starts using essentially the same model, the systemic devastation which can result is enormous.

So yes, when Persaud talks about “the market-sensitive risk models used by thousands of market participants”, he’s very much referring to things like the Gaussian copula function, which proved to be one of the best ways ever invented of shunting risk off into the tails. He’s probably also talking about the near-universal adoption of Value-at-Risk, which as Joe Nocera explains does a great job of allowing managers to ignore the tails, no matter how much risk is in them.

Persaud says that there are important implications for regulatory policy:

This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

The problem is that it’s very unclear what the alternative is. The lesson of the failure of Basel II is, indeed, that you can’t trust banks to judge their own internal risks very well. But the whole reason why Basel II was created in the first place is that financial instruments are so complicated these days that it’s very easy to do an end-run around simpler regulations.

My feeling is that the best way to go is to set some very clear and simple rules, much as the Spanish central bank did, and refuse to allow banks to build enormous businesses doing things that the regulators don’t understand. And secondly to place a cap on banks’ balance sheets — I think something around $300 billion is reasonable, and that there’s no reason why any bank should be bigger than that. Alternatively, if you are bigger than that, then you have to become much more constrained in what kind of activities you’re involved in: you should basically just be doing plain-vanilla deposit-taking, borrowing, and lending.

That wouldn’t prevent future financial crises outright. But it would probably stop them from causing a major global recession.