Felix Salmon

It’s not the regulators, it’s the politicians

Felix Salmon
Aug 29, 2009 10:02 UTC

Aditya Chakrabortty has a UK perspective on financial reform:

The first chapter of Alistair Darling’s July white paper on banking reform was devoted to explaining just how important the City is to the UK economy. The Treasury’s ledger of revenues from financial services did not include a debit column that listed the amount lost on institutional bailouts and tax avoidance – of course it didn’t. Put to one side, if you can, the watchdogs’ manifold failings in the run-up to the banking crisis. In the debate over reforming the City there has been none of the regulatory capture that economists usually fret about – where the regulators forget about the public interest, and rig the rules to suit the very sector they’re meant to be supervising. There is, however, plenty of evidence of political capture. This isn’t just a New Labour problem; it applies also to David Cameron and George Osborne, whose policies are nowhere near as tough as their rhetoric – and to Barack Obama’s administration, which, on everything from regulating bonuses to handing out taxpayer money, appears to have turned into an unglamorous subsidiary of Goldman Sachs. A cast like this means the prospects for real reform at next month’s G20 summit of major economies in Pittsburgh are depressingly slim.

I think that making the distinction, as Aditya does here, between “manifold failings” and “regulatory capture” is a very useful thing to do. A regulator who failed is not necessarily a captured regulator.

Aditya’s also right that the real problem here is that regulators are appointed by politicians, and it’s the politicians who are captured. The banks don’t need to capture their own regulators: all they need to do is capture the politicians who appoint them. If you’ve got Phil Gramm deciding who gets appointed, you’ve won your battle before it’s even fought.

This is one more reason why consolidating regulatory power in the central bank is a good idea: even if the central bank isn’t totally independent, it’s more independent than any other regulatory agency is ever going to be, and therefore less likely to become filled with political hacks. Say what you like about the Fed, you’re not going to see it demonstrate the kind of premeditated spinelessness that the SEC commissioners showed over most of the past 10 years. If we want effective regulation, we’re going to have to remove power from politicians, many if not most of whom receive enormous campaign donations from precisely the companies they would regulate.


I have liked the ‘outsourcing regulatorship’ idea the best so far
http://baselinescenario.com/2009/08/08/f illing-the-financial-regulatory-void/

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When bankers turn honest

Felix Salmon
Aug 28, 2009 18:30 UTC

Peter Thal Larsen notes that the former CEO of JP Morgan Cazenove is now admitting that investment banks overcharge. This jibes with my experience in Switzerland: at one dinner I sat next to the former CEO of a large Swiss bank, who was very happy to admit that private banks gouge their clients by charging a low 1% management fee but then stuffing their clients’ accounts with own-brand structured products, all of which come with enormous fees and commissions attached. Could it be that one silver lining to the financial crisis is an outbreak of honesty among former bank executives?


For TED is revealed; I yield

Why pay? Perhaps because, for a moment, at least, they believe.

The first thing to get in your head is that every single
Girl can be caught – and that you’ll catch her if
You set your toils right…

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Don’t worry about the FDIC

Felix Salmon
Aug 28, 2009 08:15 UTC

Rolfe Winkler has a good, detailed snapshot of what’s going on at the FDIC. But I’m not nearly as worried about the state of the US deposit-insurance fund as he is. As I’ve said before, the FDIC can’t run out of money. Conceptually, it has simply been faced with a choice up until now — do you raise money from banks, in deposit insurance premiums, before banks start going bust and need an FDIC bailout, or after? Congress made the decision that is should be the latter, when they barred the FDIC from charging such premiums between 1996 and 2006.

That’s really not much of a problem. As Rolfe shows, now that banks are failing in large numbers, the FDIC is charging insurance premiums again, and will certainly continue to do so until any money it borrows from Treasury is paid back. Its credit line, of up to $500 billion, is more than enough to cope with the bank failures coming down the pike, which means that the only real question is how much of that credit line it will have to draw down, and how long it will take to pay it back.

Rolfe is right that “the deposit insurance fund is tiny compared with the total amount of deposits that are insured” — but it doesn’t need to be anything but tiny, because if push comes to shove, there’s essentially unlimited liquidity just sitting there for the asking. It’s the government which is insuring deposits: the FDIC is simply the entity created by the government to administer the deposit-insurance program, and the size of the fund is a way of keeping score and making sure that over the long term the US banking system pays at least as much in insurance premiums as the FDIC spends in bailing out failed banks.

What’s more, even if the 2006-7 vintage of loans will continue to underperform for years, that doesn’t mean, as Rolfe seems to think it means, that there will be a large number of FDIC bank bailouts for years as well. Banks are inherently profitable institutions, and with interest rates at zero they’re inherently very profitable institutions. Loan losses can and will to a large degree be covered by operating profits, and/or the raising of new capital. Remember that depositors are at the very top of the capital structure: not just stockholders but bondholders too need to be wiped out before the FDIC takes any losses. Look at the recent rally in the prices of both bank stocks and bank bonds: it means (a) that the market is pricing in a much lower risk of failure at such institutions, and (b) that it’s much easier for those banks to raise new money if they need to.

So yes, the FDIC insurance fund might go for a little while with a negative balance. But that’s nothing to lose any sleep over. The FDIC deficit, unlike the national debt, is sure to be paid off, in full, over time. And insofar as the government needs to loan money to the FDIC, it will end up making a small profit on that loan. If only the same could be said for most other government spending!


debt issued by a SPV is usually issued to the public as trust preferred stock which is not the same as secured debt. Trust Preferred stock would have the same status as subordinated debt in a holding company in the event of a deposit failure, ie, worthless.

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Good and bad financial innovation

Felix Salmon
Aug 27, 2009 23:42 UTC

Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)

That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.

First, they address securitization:

Securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

Sure, nothing, on its own, produced the colossal boom and bust we’ve just lived through. But securitization is as much to blame as anything else, if not more so. Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway. And it made bond investors comfortable with the idea of buying structured products tested only by models, as opposed to actual analyzable liabilities of real-world entities. You can’t phone up the CFO of a special-purpose entity and ask him how things are going. And lending in general works when there’s a relationship between the borrower and the lender. Securitization severs that relationship, which is harmful.

I’d also take issue with the idea that anything which expands the pool of money available for lending is, ipso facto, a good thing. To the contrary, things which expand the pool of money available for lending can serve only to inflate credit bubbles. In general, lending shouldn’t be easy to come by; and it should in principle always be just as easy to issue equity as it is to issue debt. We’re nowhere near that point right now, and securitization only serves to drag us further away from it.

Johnson and Kwak then attack the credit default swap:

Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments.

The CDS, pace financial innovation, did not in and of itself underprice credit risk: it was simply a measure of credit risk. And indeed for most of the history of the CDS market, the basis on CDS was positive: as you’d intuitively expect, the cost of insuring a certain credit against default was higher than the spread on that credit’s bonds. You couldn’t lock in a risk-free return by simply buying a security and insuring it against default. So if the CDS market was underpricing risk, the bond market was underpricing risk even more. It was only after the credit market imploded that the negative-basis trade started becoming possible. So you can’t really blame a negative CDS basis for any part of the crisis.

Yes, it’s clear, in hindsight, that AIG, in particular, was underpricing credit risk. But that has nothing to do with the structure of the CDS market more generally. Instead, the problems with AIG surrounded the fact that it only ever sold credit protection, and never bought it; and that once it had sold protection, it used its triple-A credit rating to avoid having to put up any collateral against those positions or otherwise be forced to protect itself against loss. AIG in general, and AIG Financial Products in particular, did a lot of things wrong. But that’s not the fault of the CDS market.

Johnson and Kwak are right that regulators should be inherently suspicious of financial innovation; they’re possibly too polite to mention that this is largely because most financial innovation comprises, at its heart, some kind of regulatory arbitrage. (Securitization being no exception.) I agree also with the idea of standardizing CDS documentation, although it should be said that that is already happening to a large extent. I’m not at all sure, however, that standardized CDS will be much easier to regulate than the customized CDS of old. It’s not the customization which is the problem, it’s trying to get a grip on net positions, in a market which is constantly in flux. The way to solve that problem is to simply let the market continue down the road of the past six months, where CDS are increasingly being shunned as an asset class in favor of good old-fashioned bonds.

Johnson and Kwak then finish with a list of good financial innovations we might encourage: banking the underserved (a no-brainer), reforming health insurance (yes, but let’s not debate that here), and finally this:

We need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

This I’m much less sure about. You can be sure that no matter how good the financial education provided, the consumers of that education won’t end up being better educated about financial affairs than large and supposedly sophisticated investors, such as municipalities and pension funds. The problem with investors who made bad choices during the boom wasn’t that they were insufficiently educated: it was rather that they were educated too much. Financial education breeds overconfidence, and overconfidence was a much more important cause of the crisis than insufficient education was. If a strong CFPA prevents truly harmful products being sold to consumers, that’s the best we can hope for: a mass education program isn’t practicable and wouldn’t work even if it were implemented. The last thing I want is Robert Shiller being unleashed on the public, telling them that they can hedge the value of the equity in their houses by buying derivatives on house prices.

So thank you, Simon and James, for fighting the good fight. But this clearly isn’t the last word on the subject.


The flaws with CDSs are plain right in this blog entry.

Fact 1: AIG only ever sold, and never bought, credit protection.

Fact 2: AIG’s credit rating remained AAA until the bitter end.

Why was AIG able to do what they did for so long? Why hadn’t AIG lost its AAA long before? Because their CDS situation was incomprehensible, even to themselves.

Gaute, makes an excellent point about complexity. CDSs complexity comes from the fact that the probability of future defaults cannot possibly be known with any any reasonable precision.

Moreover the CDS market has demonstrated that it is a total joke. Last November, Berkshire’s five-year CDS spreads were at 475 BP.

The fact that there is a market and trading does not mean anything. Just look at AIG, FNM etc.

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The economics of private schools

Felix Salmon
Aug 27, 2009 08:59 UTC

Pockets has a spectacularly good comment on my blog entry about the charitable status of private schools which would more than deserve elevation as an entry of its own were it not for the fact that (s)he has gone into even more detail here and here. The main insight is that the “top” schools tend to advertise themselves and compete on the basis of how well their pupils do in exams, what universities they get into, that kind of thing. And that they can boost those numbers substantially by giving scholarships and bursaries to super-smart poorer kids:

UK private schools are among the best schools on the planet, and I was lucky enough to attend one. Saying that they maximise profits isn’t saying that they’re manipulative or evil or bad (I wonder if this is what’s annoying people?). They’re staffed with many lovely, caring individuals (like lots of other profit-maximising companies!), and through scholarships/bursaries they offer a great trade to smart poor kids – we’ll give you an amazing education, if you allow us to charge other kids to sit next to you.

Given that the schools would do this even if they didn’t have charitable status, it’s not clear why we’re giving it to them. As Pockets writes:

If you wanted to convince me of a private school which is acting charitably, not profit-maximising, then you’d have to describe a system where pupils take the entrance exam – and then the low-scoring poor children are offered bursaries. That’s a school which is gambling on its ability to raise standards among disadvantaged kids. But no private school does that, and with excellent reason: the cost could be lower league table results for the school.

Matt Yglesias also makes a point about private schools which I should have made initially:

They’re certainly not charities. And as best one can tell, their main impact on the common weal is negative, drawing parents with resources and social capital out of the public school system and contributing to its neglect.

You’d have to believe that New York City’s public schools would be both better funded and free of this kind of nonsense if a larger portion of the city’s elite were sending their kids to them.

There’s an analogy here to the studies showing the beneficial effects of homeownership. The problem is that two effects get mixed up: on the one hand, people who own their own homes do tend to live better lives. But on the other hand, those are the kind of people who would probably live better lives anyway, and by moving away from rental neighborhoods they effectively ghettoize those left behind. Similarly with private schools, especially in areas where a high percentage of local kids gets educated privately (like where I grew up, in Dulwich): the local public schools can be very bad indeed, despite the huge number of rich and highly-educated parents in their catchment area. To put it in economist-speak, private schools inflict a negative externality on the quality of education in the neighboring state-run schools.

Incidentally, pace another comment in the original thread, Greenpeace is not a registered charity in the UK — at least the headline organization which most people think of when they think of Greenpeace, Greenpeace Ltd, is not a charity. Not everybody in the non-profit space is a charity, and there’s no particularly good reason why all private schools should be charities, either.


This is a great example of someone who has received a better than average education. Although public schools provide the opportunity, the motivation and the broader aspects of a whole approach is often left to the parents. Such things as sporting, music, the arts are all added extras in the public system. Social diplomacy is also another area that is not explored to its fullest potential in the public schools. Province schools pay for the expectation that students learn social behaviors, are confident and also skilled in many activities outside of the class room. Our ABC although important, are not the single factor that ensures a stand out success for the individual.

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40 pages of hedge-fund letters

Felix Salmon
Aug 26, 2009 21:22 UTC

Market Folly has the 24-page second-quarter letter from Elliott Associates, while the 16-page memo from Howard Marks of Oaktree is here. Both have moments of brilliance, and are better financial writing than anything you’ll read in a newspaper or magazine this month. Of course, they’re openly talking their book. But you guys are smart enough to discount for that, and come away with some pretty sharp insights.


“…better financial writing than anything you’ll read in a newspaper or magazine this month.”

Good grief! What newspapers and magazines do you read?

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Guaranteed bonus quote of the day

Felix Salmon
Aug 26, 2009 17:28 UTC

“I will only say one more thing here tonight, and it’s about the subject that’s close to most of us – and that is remuneration. We have to realize that remuneration has to be something that we earn. It can’t be guaranteed. I see so much so often in recent weeks of those dreaded two-year, three-year guarantees coming back into the market. And if there’s one thing I could ask all of us tonight, it’s to reflect before we sign the next guaranteed bonus for our colleagues across the industry. Because the reality is that we are destroying ourselves when we do it. We need to reward people with objectives that are clear, that are long-term, and that are given to people who are committed to our industry.”

–Michael Geoghegan, CEO of HSBC, addressing a room full of international bankers in London. Take that, Carney.


OJ: “the reason why banks have to pay guarantees is that they have lied to so many recruits over the years you would be mad to move without one.”
this is particularly true for HSBC. the comment by the CEO is self-serving, his bank has a reputation and not a good one, although juvenile bloggers don’t know this, hence the uninformed post.

Shrinking banks

Felix Salmon
Aug 26, 2009 17:16 UTC

I was high when I gave my presentation on risk to the Zermatt symposium this morning — 8,471 feet above sea level, to be precise, in an idyllic place called Riffelberg. Who needs wifi when you have views like that. In any event, it went quite well: after all the high empirical seriousness of the past couple of days, I think that the attendees enjoyed me blowing off steam by telling them that we had to do something which of course we won’t do at all: abolish the tax-deductibility of interest, move in general from a world of debt finance to a world of equity finance, and, insofar as there is credit in the world, encourage that credit to be in the form of loans rather than bonds.

“I wondered where you were going there,” said Princeton’s Harold James after I was done, adding that he thought for a while that I was going to propose moving, essentially, to a world of Islamic finance. Doesn’t Islam essentially prescribe from a religious perspective exactly what I was prescribing from a practical perspective?

Yes, it does. One of the themes of my talk was that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. Investors didn’t want risk, and investment banks made billions of dollars, during the boom, by waving their magic securitization wands and seemingly making that risk disappear. In Islam, high religious authorities are tasked with looking at complex structures designed to circumvent the prohibition on paying interest; in western finance, the ratings agencies played a similar role, blessing highly complex structures (CPDOs, anyone?) which otherwise investors would never have touched.

There followed lunch, and a spectacular walk even higher, to the Gornergrat (10,210 feet) before we descended back to Zermatt on the famous railway to hear Professor James give his presentation, which was very good. James quoted Mervyn King, the governor of the Bank of England, as saying that “the behemoths of global finance have been global in life, but national in death”, and said this posed a problem for small, open countries, including Switzerland, which in general did well during the boom. Such countries just aren’t big enough, he said, to cope with a domestic banking crisis and embark upon a major Keynsian counter-cyclical spending spree at the same time, especially when such spending has to be financed abroad.

More generally, James sees big banks splitting up, becoming increasingly regional and/or national, and the sheer number of banks falling substantially, not least in the US, which has a huge assortment of small banks. The happy medium, he said, is somewhere like Canada, which has a manageable number of large, boring banks which in general don’t venture too far abroad. That sounds right to me, and I suspect that the upshot might be felt very keenly in Mexico, nearly all of whose banks are foreign-owned. Given (a) that the Spanish government has neither the inclination nor the ability to conduct a bank rescue in Mexico; (b) that there are questions over the health of BBVA, the owner of the largest bank in Mexico; and (c) that bank failures are managed by the regulators in the parent country, I can see moves afoot to pressure BBVA into selling Bancomer. The story could be repeated in Brazil and Chile for Santander.

James also raised an intriguing hypothetical, a propos the new nationalism which he sees emerging in the banking industry — how might the world look instead had Dick Fuld sold Lehman Brothers to the Koreans? It’s fascinating to wonder whether that one failed deal might have made an absolutely enormous difference in the future of global banking, between continued globalization and the beginning of deglobalization, if that is indeed what we’re now embarking on.


Felix –

Your oft-repeated thesis that “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds” deserves an award as one of the best insights of our time.

It seems to me that a large part of this ‘overcaution’ is really due to central banks, sovereign funds, insurance and pension funds, and other large pools that have a very limited mandate as to how they can invest. These large pools and their limited mandates haven’t changed much at all through this crisis.

Meanwhile, the big reliable AAA credit remaining is sovereign debt, now available in abundance. If in our brave new world, non-economic bond players are the planets that control the tides, then bond vigilantism may be out of the picture. In the present case, central banks are not getting good market signals. Instead of a healthy rise in yields when too much stimulus is given, they are getting no response. At some point in the not-so-distant future, it will be suddenly found that the non-economic bond buyers simply have insufficient funds to meet the supply of bonds offered by central banks. Sovereign bond offerings may simply fail. Interest rates may spike more sharply than we have ever seen and we will wonder, where was the market signal?

Looking at global sovereign debt loaded into the budgetary pipeline, this spike event may not be far off, it will be global, and then what will the banks do?

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The tyranny of the CPM

Felix Salmon
Aug 26, 2009 02:50 UTC

Why is online advertising so cheap compared to the cost of reaching 1,000 people in any other medium? Anybody whose answer involves oversupply or excess inventory should read Jim Spanfeller:

The only medium in recent history that has had true advertising scarcity is network television, and, with this year’s upfront, one might suggest that even this is no longer true. In every other case there has been either unlimited inventory available (magazines and newspapers) or limits that have rarely, if ever, been reached (radio, cable and spot TV).

Jim’s right that web publishers, in selling off “remnant” inventory at hugely discounted rates, are shooting themselves in the foot. All they’re doing is making it easy for media buyers to get bargains, and devaluing the very idea of online advertising. Indeed, in another sharp insight, he writes:

Some buyers will point to activation levels (clicks, signups or outright sales) as indicators of the relative worth of specific inventory. This is completely understandable as a guideline. But giving it too much weight is problematic. For example, we now know that 16% of web users generate 80% of clicks and that this 16% represents the lower income and education segments of the total user base. Do we really want to be held accountable as an industry by metrics generated by the lowest common denominator and a minority of users to boot? I can’t think of too many successful models using these types of metrics.

These metrics drive the conversation and the core objectives of online advertising away from demand creation (which is basically the definition of advertising) to demand fulfillment or, put another way, direct response. There is nothing wrong with direct response; every other medium has it, and the industry drives huge value for both marketers and media. But direct response is not advertising—it is something different.

In other words, if you’re looking at your clickthrough rate, you’re not participating in the web equivalent of an advertisement, you’re participating in the web equivalent of junk mail. If publishers don’t want to be in the junk-mail business, they should be very wary about going down the clickthrough path.

The irony of Spanfeller’s column is that he’s the outgoing president and CEO of Forbes.com, which was one of the first journalistic websites to aggressively maximize its pageviews at the expense of the user experience. Auto-refresh, slideshows, cutting stories up into multiple pages — all of these tricks make reading content online that much less pleasant, and thereby cheapen the value provided to advertisers. There’s a reason that Vogue doesn’t put ads in the middle of its fashion stories — it’s presenting the best possible editorial product it can to the reader, and advertisers are happy to pay a premium for that. Online, there are very few equivalents, because of the tyranny of the CPM.

I’d love to see a world where the price of online advertising was a function how many unique visitors saw that ad unit, rather than how many times it was served. That’s much more how the print world works. Instead, we’re stuck in a junk-mail paradigm which benefits no one.


Web ads once were sold mostly per-view, not per-click. The advertisers discovered that they could get away with paying for clicks only, so they did.

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