Felix Salmon

Too big to rescue

Felix Salmon
Jun 19, 2009 18:28 UTC

Paul Krugman is surely right about this:

I think of the pursuit of a world in which everyone is small enough to fail as the pursuit of a golden age that never was. Regulate and supervise, then rescue if necessary.

There will always be too-big-to-fail banks, no matter where the current debate leads us. When I say that banks’ balance sheets should be capped at $300 billion, I’m not for a minute saying that $300 billion is small enough to fail; I’m just saying that such banks are small enough to rescue. Too big to fail we can cope with, by rescuing banks rather than letting them fail. Too big to rescue we can’t cope with. And right now, the big four banks in the US are too big to rescue. Which is scary.


Prof. Krugman seems to be looking at it solely from an economics standpoint. I think that overlooks issues like regulatory capture and too much political influence (what Simon Johnson calls the banking oligarchy).

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Reverse converts and Vincent Fernando’s straw man

Felix Salmon
Jun 19, 2009 15:21 UTC

How long can this debate over reverse converts go on? I’m not sure, but I’m willing to put up one more blog entry on the subject, since Vincent Fernando is both misrepresenting my views and giving me the opportunity to make an important broader point.

Fernando seems to think, on zero evidence, that I’m saying reverse converts are simply too risky for retail investors. But I never said that, and I never would. Pretending that I said that allows Fernando to make a cheap and obvious shot: pointing to all manner of other investments (like simply buying individual stocks) which are even riskier, and which I don’t want to ban. He then can accuse me of being inconsistent, or illogical, or hypocritical, or worse.

I have no problem with people taking on risk — especially upside risk. Never mind individual stocks, they’re more than welcome to disappear off to Vegas, if they’re so inclined, and put thousands of dollars on a single number in roulette. (That said, no stockbroker has any business putting his client into a roulette gamble, no matter how much commission he’s getting from the house.)

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

I’m not saying that no investor should ever buy or sell options. But any investor who does play in the options market needs to know exactly what she’s doing, and why. In stark contrast, the way that reverse converts are sold makes every possible effort to hide the fact that they’re a put-selling strategy — even unto calling them “bonds” and disguising the proceeds you get from selling the put as being a “coupon”.

There are two big reasons why a high-risk stock is a much better investment than a reverse convert. For one thing, stocks generally go up over time: they’re a positive-sum game. And for another thing, stocks have a lot of upside: while it’s certainly possible that you can lose all your money when they go to zero, it’s also possible that you can double your money, or more, if they spike upwards. Reverse converts, by contrast, have massive downside (all the downside of the stock) but no upside beyond the “coupon” which you expect to receive all along.

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game. Bond investors, as a rule, are always better off in bond funds than they are picking and choosing their own bond portfolio, not least because the trading costs for bonds, if you take account of the enormous bid-offer spreads shown to retail investors, are a good order of magnitude bigger than they are for stocks.

At least with bonds, however, there is a bid-offer spread: a market actually exists in them. Next time you’re offered a reverse convert from your broker, ask him to find you one on the secondary market and see what he says. There’s zero liquidity in these things, which means zero price transparency: there’s no indication whatsoever what their market price is, just because there isn’t a market price for them. That’s always a bad sign — and it’s a very strong indication that they shouldn’t be sold by stockbrokers. A broker should always be willing to buy and sell any instrument he’s dealing in: when he’s selling but not buying, at any price, then something very fishy is going on indeed, and you’re almost certainly getting needlessly ripped off.


I was late to see this post Felix. I have one question in response. So you don’t think they are too risky for investors? If you don’t think they are too risky then your argument against them falls apart. While you may not have explicitly stated “I think they are too risky” I think it is fair to say that you implied this in your arguments against them… especially since your arguments will have trouble standing if indeed you don’t think they are too risky for retail investors.

What’s Citi doing to Pandit?

Felix Salmon
Jun 19, 2009 13:41 UTC

Breakingviews today has a very odd column saying, essentially, that Vikram Pandit should keep his job despite the fact that since he took over at Citigroup, he’s made a large number of serious mistakes and has done almost nothing right.

The thing which most struck me about the column, however, was the photo which accompanies it, of Pandit sporting a double chin of Larry Summers proportions. It’s not just Pandit’s dot portrait which is changing, it seems, it’s Pandit himself. Here’s a recent shot of Pandit, on the right, next to his official Citi headshot, on the left. Maybe the real question shouldn’t be whether Pandit’s good for Citi, but rather whether Citi is good for Pandit.



Felix Salmon: -1 point
Reuters: -100 points

This is not business, and we are not idle housewives looking to gossip.

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Thursday links stick their head in the sand

Felix Salmon
Jun 18, 2009 21:14 UTC

Jonah Lehrer on why investors should ignore the markets and the financial press

Paul Smalera comprehensively demolishes the idea that micropayments might ever save Time Inc

Larry Summers is not in touch with his uncle, Nobel laureate Paul Samuelson. How very… Larry.

Skeel and Partnoy define CDOs as credit derivatives. Not sure that’s really necessary, or helpful.

If you thought regulators were captured by Wall Street, just wait till you see financial journalists!

Looking at the yield curves in the US and Canada, it seems that the Fed has committed itself to no rate hikes until 2010

Quotes of the times: “$2.7 trillion may sound like a lot of money, but“…


I love this definition: “We define credit derivatives as financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers.”

Sounds like a corporate bond fits this category pretty well.

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Unemployment datapoint of the day

Felix Salmon
Jun 18, 2009 20:53 UTC

Brad DeLong reminds us, in case we’ve forgotten, how much worse things are now than we feared they would be last December:


Does this mean the recovery plan has failed? Or that it was even more necessary than we thought at the time? Or both?


Most absurd is how quickly they estimated the “Recovery Plan” would work. They have unemployment starting to level off in Q1-2009, when they knew full well a stimulus package couldn’t be passed until at least 50 days in to the quarter after the Inauguration. So by Q2 the effect on jobs is supposed to be well and truly underway, when in fact the money from the almost-instantaneously-passed stimulus is just starting to trickle out.

If it’s not an aphorism it should be: “You don’t need a graph to tell the truth, but you do to sell a lie.”

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How ETF investors fare

Felix Salmon
Jun 18, 2009 20:08 UTC

John Bogle’s mutual fund vs ETF analysis has now appeared, and it seems I was right: Bogle makes no attempt whatsoever to distinguish between buy-and-hold ETF investors, on the one hand, and ETF noise traders, on the other. (Or, to put it another way, he makes no attempt to restrict the ETF investors he’s looking at to those who would otherwise buy mutual funds.)

That said, Bogle’s analysis is pretty interesting — especially when he says that the average investor in Vanguard’s S&P 500 mutual fund actually outperforms the fund itself by 2.8 percentage points. Is that a result of dollar cost averaging, do you think?


Broad-market index funds/ETFs can outperform the underlying index by lending securities to short-sellers, since gains from this can outweigh their negligible trading costs. For example, Vanguard’s total stock market index has 7% turnover, and much of that can be handled either by trading with other Vanguard funds (or via ultra-low-cost dark pool transactions. Thus their trading costs are probably within spitting distance of zero, and most of what they call expenses has to do with account management (toll-free numbers, printing and postage costs, etc).

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Dean Starkman loves Gretchen Morgenson

Felix Salmon
Jun 18, 2009 18:42 UTC

Dean Starkman has a 4,148-word love letter to Gretchen Morgenson in The Nation; it’s far from clear that his feelings are reciprocated, despite the fact that he calls her “the most important financial journalist of her generation”, and dismisses her critics as trying to start “arguments about wallpaper design in a burning house”.

Starkman spends a full 827 words on just one of Morgenson’s stories — the one which which ran in September about Goldman Sachs’s exposure to AIG. Everybody from Lloyd Blankfein to Tim Geithner took issue with the story, and the NYT ran a correction a couple of days later, and it’s quite clear that the story was written without any consideration of Goldman’s counterparty hedging operation — which was, and is, the most sophisticated such operation on Wall Street. Goldman swears up and down that its exposure to AIG, while large, was fully hedged; neither Starkman nor the New York Times has come up with any evidence to the contrary. Yet somehow Starkman has still managed to persuade himself that “the story stands”.

Starkman is also curiously blasé about the conflicts inherent in the fact that Morgenson writes both news stories and opinion columns. This violates a key principle, as laid out by the NYT’s top editor, Bill Keller:

I think you are more likely to present a full and fair-minded story if your objective is not to bolster an argument, but to search out the evidence without a predisposition – including evidence that might contradict your own beliefs. Once you have proclaimed an opinion, you feel compelled to defend it, and that creates a natural human temptation to overlook inconvenient facts or, if I may borrow a phrase from the famous Downing Street memo, fix the facts to the policy.

Starkman, by contrast, skates over the issue, saying only that Clark Hoyt’s disapproval of the Morgenson conflict — he concluded that “I would not have reporters writing opinion about the subjects they cover” was “not very convincing”.

If you’re a columnist who also reports, it’s paramount that you feel free to change your opinions over time, otherwise you are bound to end up writing news stories which are consciously or unconsciously tilted so as not to contradict ideas you’ve previously committed yourself to holding. Morgenson, I think it’s fair to say, is not the kind of person who changes her mind. And that makes her dual status as reporter and columnist highly problematic. The NYT should let her do one or the other, but not both.


Second on Tanta’s defenestration of GM.

I’m with kman on the GS story, and there’s an easy way to tell if GS was telling the truth: after U/S/ t/a/x/p/a/y/e/r/s/ AIG gave GS the $20B it was “owed,” have GS reveal who the counterparties on the other side were.

The Henry M. Paulson, Jr., Retirement Trust, LLC. is more likely to be on the list than UBS, SocGen, or ING.

Rant of the day: Taibbi on Blankfein

Felix Salmon
Jun 18, 2009 16:20 UTC

Remember Lloyd Blankfein’s kindasorta apology for his role in the financial crisis? It went like this:

While we regret that we participated in the market euphoria and failed to raise a responsible voice, we are proud of the way our firm managed the risk it assumed on behalf of our client before and during the financial crisis.

Matt Taibbi is, I think it’s fair to say, unimpressed.

Has an act of contrition ever in history been more worthless and insincere? Even Gary Ridgway did a better job of sounding genuinely sorry at his sentencing hearing — and he was a guy who had sex with dead prostitutes because it was cheaper than paying live ones.

Generally speaking, when one apologizes for having done a bad thing (like for instance destroying the world economy), it is good form to wait at least until the end of the sentence to start bragging again.

Taibbi’s promising much more of this in Rolling Stone next week: it should be fun.


Really, Felix? You’re usually spot-on with your links but Taibbi’s got to be one of the most obnoxious writers out there. Every piece of his seems to be both (a) full of inaccuracies and (b) insufferably snarky. What do you get out of his rants?

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Putting an end to too-big-to-fail: An IM exchange

Felix Salmon
Jun 18, 2009 15:40 UTC

The central banks in both the UK and Switzerland seem to be utterly fed up with the fact that their banking systems are full of too-big-to-fail banks. What can they do about it? I asked Peter Thal Larsen, in London:

Felix Salmon: Peter, it’s looking as though regulators in both the UK and Switzerland have reached the point at which they don’t want to have any too-big-to-fail banks at all. Is there a serious possibility that the likes of UBS, Credit Suisse, Barclays, RBS, HSBC etc will be split up into small-enough-to-fail chunks?

Peter Thal Larsen: It’s definitely the hot regulatory topic of the moment. I’m not sure we’re yet at the point where big banks are going to be broken up. But central bankers are clearly drawing a line in a sand: if banks are going to become large, they cannot do so on the taxpayers’ ticket.

FS: Yet it’s impossible for a bank with a trillion-dollar balance sheet not to be TBTF, right? And TBTF just means that ultimately taxpayers will pick up the bill if the bank runs into problems. So short of breaking up TBTF banks, what other options are there for taxpayers to lose that contingent liability?

PTL: Well, there’s a couple of options, neatly summarised by Mervyn King last night. You can force TBTF banks to hold much higher levels of capital as a form of insurance. Or you develop a bankruptcy process that allows you to wind down even large, complex banks in an orderly way. Though I’m still not clear how this would work in practice.

FS: King also suggested that separating retail banking from investment banking might be a good idea. Do you think that might help? My view is that given what happened to eg Northern Rock and Lehman Brothers, it’s far from clear that doing one thing badly is better than doing both things.

PTL: I don’t think a new Glass-Steagall is the answer. It’s too difficult to draw a line between the two activities, and if you do so without international agreement you just create an arbitrage opportunity. As you say, even narrow banks can fail. But my sense is that this is a stick that King is wielding in order to force banks to think seriously about the alternatives.

FS: So let’s say I’m a TBTF bank, and I’m feeling chastened by King’s speech. What can/should I do? Unilaterally break myself up for the Greater Good?

PTL: I doubt it will get to come that. But the TBTF banks do need to come up with a way of persuading the authorities that they can fail without costing the taxpayer a fortune. King described this as banks making a will. It may be complex, but it’s the least bad option. The alternative is that regulators will come up with more draconian solutions, as the Swiss did today.

FS: What’s the probability that the Swiss draconian solution is going to make its way into reality? And is it basically a combination of higher capital adequacy standards with a promise that if a bank gets into trouble, its retail-facing components would be saved while the rest of the bank would be allowed to fail?

FS: And isn’t there a basic credibility problem with all such promises? Aren’t they a bit like the US government saying that Fannie Mae and Freddie Mac debt didn’t have a US government guarantee?

PTL: Credibility is certainly a big issue. Though the Swiss seem to have made more progress on this than the rest of us. They’ve already pushed through higher capital requirements for UBS and Credit Suisse, and are now talking about having the power to rescue only the utility-like parts of those banks if there is a future problem. But the really explosive stuff is what they’re threatening to do if they can’t get agreement on new rules. They are talking about capping balance sheet size or asset-to-GDP ratios. So UBS and CS have a big incentive to co-operate.

FS: I’ve been throwing around a number of $300 billion as a sensible cap on balance sheet size. What do you think of balance-sheet caps?

PTL: It’s a blunt instrument, but it has the benefit of being simple and hard to game. As with all these rules, though, it needs some kind of international agreement to be workable. And it’s not enough in itself. Northern Rock’s balance sheet was $200bn, but it still had to be rescued because Britain didn’t have a proper deposit insurance scheme.

PTL: The other question, to which I don’t know the answer, is whether we need big banks to serve multinational companies. Or are we saying that only the US and China can have big banks, because they’re the only countries that can afford to rescue them?

FS: A cap makes sense as a step in the right direction, no? Big US banks aren’t going to be able to suddenly redomicile themselves if the US enacts a cap, and neither are the big Swiss banks. It might not be sufficient, but I don’t see the harm. As for servicing multinationals, you need international reach, for sure, but you don’t need a trillion-dollar balance sheet. Advice requires no balance sheet, and if you want to extend a loan, you can just syndicate it.

PTL: On size, I suspect you’re right. Ideally, you would put in place some kind of automatic factors that acted as a brake on banks getting bigger. In the past, banks had an incentive to become TBTF because they got cheaper funding if counterparties believed they would be bailed out. If you have a credible bankruptcy process, or make them hold more capital the bigger they get, banks will have to prove that there is a commercial logic to being big. Best to use the threat of a cap as a way of forcing banks to come up with a better solution.

FS: I like that, phone up the IIF and say “come up, by year-end, with a better way of counteracting incentives to grow too big, or else we’ll implement a hard cap”. When a banker knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.

PTL: That’s it. Use bankers’ naked self-interest to the public advantage. Which is why I think bankers have a real incentive to come up with a workable bankruptcy process. It’s their best hope for getting the government to leave them alone in future.


Just in case you missed this proposal:

Banks should pay for their own bailouts
Banks should pay for their own bailouts. That’s the intriguing idea being floated by Paul Tucker, one of the Bank of England’s deputy governors.
http://www.telegraph.co.uk/finance/break ingviewscom/5436731/Banks-should-pay-for -their-own-bailouts.html
By Hugo Dixon 03 Jun 2009, Breakingviews.com
Published: 2:23PM BST
Not only would such a scheme protect taxpayers from the cost of banks’ future folly; it might even discourage banks from running into trouble in the first place.
The need for governments to rush to the help of banks every few decades seems to be an unfortunate fact of life. If the banking system is on the brink, it can’t be allowed to collapse. But the burden of paying for the bailout shouldn’t fall on the public purse.
This is where Tucker’s idea comes in. The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated – and then collected from the industry via a levy.
Banks that didn’t get into trouble would no doubt scream that it was unfair to tap them to bail out their prodigal brethren. But it is certainly a lot less unfair than picking taxpayers’ pockets.
Of course, the first port of call should be the troubled bank itself.
Its shareholders – and ideally bondholders – should be squeezed before any of the more sensible banks have to pay up. But if a bank’s collapse is deemed to constitute a systemic threat, it is perfectly reasonable to ask the rest of the industry to contribute. After all, other banks are the primary beneficiaries if the system doesn’t collapse. The approach would be somewhat similar to the one used in many clearing houses: if one member defaults, there is a whip round other members to pay its debts.
What’s more, the knowledge that such a levy would be imposed might help stop banks running into trouble in the first place. Conservative banks would have a strong incentive to watch their racier brethren and report their behaviour to teacher.

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