Felix Salmon

The upside of regulatory paralysis

Felix Salmon
Sep 27, 2009 03:21 UTC

Joe Nocera explains one downside to having a single powerful regulator:

Our problems would have been much, much worse if we had implemented Basel II. I guess this is one of those times when the paralysis created by all our overlapping bank regulators saved us.

This is true: power can always be used for good or for ill, to regulate or to deregulate, to give the banks more of what they want, or less. But that doesn’t mean that paralysis is a good thing. It just means that governments have to be super-careful not to let regulators be captured by the banking industry. Which, in places like New York and London, is much easier said than done.

What were the consequences of the CFMA?

Felix Salmon
Sep 25, 2009 20:22 UTC

Newsweek.com is doing a big month-long series on the end of the decade, and, inevitably, it’s going to feature lots of listicles. One of them is a list of the top ten “history altering decisions” — seemingly-small moves that had massive consequences. Each one is going to be written up, and Newsweek has asked me for a very short essay (just 200 words or so) on the consequences of Bill Clinton signing the Commodity Futures Modernization Act in 2000.

Top of mind at Newsweek are the Enron collapse and the unregulated rise of the CDS market — can those fairly be ascribed to the CFMA? Are there any other key consequences of the CFMA’s passage which I should include? Newsweek has given me full freedom to crowdsource this, so if you ever thought you might have a CFMA blog entry in you somewhere, now’s the time to write the thing, or just leave a comment here. Thanks!


CFMA enabled Enron. It enabled Enron’s highly leveraged, risky derivatives trading. That trading was funded by short term borrowing and Enron was undone by a good old cash crisis when credit lines were withdrawn by banks overnight. When, much too late, the SEC paid attention, it focused mostly on Fastow’s off-balance sheet fraud and other accounting chicanery. Andy’s antics and AA’s coverup were clearly illegal and to an agency needing to wield a hammer, they were suitable nails. So we ended up with SOX but nobody focused on the
some of the most important lessons of Enron’s downfall. No attention to risky derivatives, no attention to liquidity risk arising from short term funding, no attention to leverage. Indeed, in 2004, the SEC agreed to let the I-banks expand their leverage, a decision high on the list of contributors to the debacle. Enron was a harbinger of the fall of Bear, Lehman, Merrill and others but attention wasn’t paid.

Another key decision that led to the mess was FASB’s 2003 decision, under intense pressure from banks, to exempt QSPEs used for securitization from consolidation.

Other factors were important but not so easy to tie to a particular act or time. At what point do you say the Fed should have realized the money supply needed tightening? How to categorize the many sins of omission such as the Fed’s failure to deal with poor underwriting
standards or the NY Insurance Commissioner’s failure (and inability?) to deal with AIG’s FP division. Where to start on the failings of the NSROs?

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Regulatory reform: The pessimism panel

Felix Salmon
Sep 25, 2009 20:09 UTC

I enjoyed the discussion last night about financial regulation between Joe Stiglitz, Jesse Eisinger, and Roberta Karmel.

Stiglitz and Eisinger, especially, were on form. Stiglitz has an interesting and rather international take, having chaired a panel with a typically long UN name: the Commission of Experts of the President of the General Assembly on Reforms of the International Monetary and Financial System. And Eisinger seems to be getting increasingly curmudgeonly — a very good thing too, in this world of ultra-short memory spans and massive releveraging.

Stiglitz is a fan of the Polish framework. Poland, he says, has one overall regulator, which then has separate commissions with solid institutional knowledge for each of the areas, like insurance and banking, which need to be regulated. He also like the way that the Poles index the salary of the regulator to salaries in the financial sector. Financial-sector salaries are taxed at a set percentage to fund the regulator’s salary, ensuring that the regulator’s salary keeps up with financial-sector wage inflation.

He’s not a fan of the Fed, however, and had a good one-liner:

The Fed had more powers than it used before the crisis. Saying that we’re going to give them even more powers not to use doesn’t seem to me to solve the problem.

Eisinger, too, had his share of one-liners:

It’s a question of regulatory will to regulate. We had a problem not of deregulation but unregulation: we had somebody like Harvey Pitt, who had an attitude of being against regulation; we had Chris Cox who, as far as I can tell, had an attitude of pro sleep. All the structure in the world can’t really remedy these problems.

Stiglitz agreed. “The problem of regulatory capture is persistent and real,” he said, adding that one way to address the problem is to move to a rules-based rather than a principles-based system, hardwiring the regulatory system and giving the regulator less leeway.

Stiglitz’s most contentious view is probably the idea that the entire financial bailout was unnecessary:

We’ve really extended the safety net beyond to big to fail, and my view is that there’s been no convincing argument that any of this was ever needed. It was based on the notion of fear — that if you didn’t do it, the whole financial set of markets would fail. Economics would have suggested that if you did a debt to equity conversion, converting long-term debt into equity, the financial institution would be well capitalized, there would be no reason to panic, and there would be more confidence in the market. But those who saw an opportunity to use scare tactics to get what they wanted did use those scare tactics, and it worked.

Eisinger largely agreed:

There’s a crystallizing conventional wisdom, certainly out of Washington, that it worked. It was ad hoc, it was messy, it was poorly planned, but in the end all this fumbling from Bernanke and Geithner and Paulson ended up working. The evidence for this is that the stock market is up: people have this idea that the stock market represents the economy. That’s a very dangerous consensus forming, because the regulatory reforms do really nothing to address too big to fail. If everybody’s thinking that these gifts to Wall Street banks really got us out of the crisis, then it’s not really hopeful that they’ll address this in any serious way.

Jesse asked Joe whether he thought there was more systemic risk now than there was a year ago. “Yes,” said Joe, “very much so. Things are much worse now than they were a year ago. Structurally things are worse.”

If there was a problem with the panel, it was that the lefty pessimism of Stiglitz and Eisinger wasn’t really counterbalanced at all by anybody more constructive about what had happened. But that’s fine by me: my feeling is that we need all the lefty pessimism we can get right now. It’s our only hope at substantive regulatory reform



There was a time when Fisher, Knight, Simons, Viner, and Milton Friedman, were all considered Free Market Advocates, believe it or not. The Chicago Plan of 1933 was a Free Market Plan as well. I think that the others I mentioned would all consider themselves Free Market Advocates too.

I also advocate:
1) A Negative Income Tax ( M. Friedman, Charles Murray )
2) Milton Friedman’s Universal Health Plan. ( Also Hayek )
3) Milton Friedman’s Plan in the essay “A Monetary and Fiscal Framework for Economic Stability”.
4) The Legalization of Drugs

I could go on. Following Adam Smith, I believe that there is a role for govt. Believe it or not, he favored the govt intervening in banking and monetary matters. I also follow Edmund Burke, who was a Whig. Add Bagehot and Keynes, and you’ve pretty much got one person who advocates every position I advocate.

It seems that libertarian is now thought by some to mean only Mises and Rothbard, and the people who follow them. That’s fine with me. My first choice for a posting name was Don the Burkean Whig, but I thought that that was even more problematic than Don the libertarian Democrat. I do like paradoxes, as did Schumpeter, so it could be that I’m drawn to the idea that only the Democratic Party would give my views a real hearing.

I’m sorry that I gave such a long and detailed answer, but I’ve just finished the second draft of a novel of 359 pages and 190,000 words, so I’m still up tonight in a very good mood.

Take care,


Spin at the FDIC

Felix Salmon
Sep 25, 2009 15:23 UTC

No one seems to be a fan of the trial balloon which went up on Tuesday, suggesting that the FDIC borrow money from “healthy” banks. No one, that is, except for Jamie Dimon, who jokingly told Sheila Bair at the Clinton Global Initiative this morning that he thought she was a good a credit and that he would probably be willing to lend her some money if she needed it.

What’s becoming increasingly clear, though, is that the point of the idea is to capitulate to the banking system generally, by multiplying the alternatives to the first-best solution — a simple FDIC special assessment on the banks. The banks probably wouldn’t mind very much if the FDIC tapped its line of credit at Treasury instead of borrowing from JP Morgan and others. What they would mind is taking a direct hit to their equity and capitalization ratios by having to pay unrefundable cash to the FDIC.

Here’s Taunter:

The plan, to put it in plain language, makes no sense.

Why would the FDIC borrow at all? The FDIC – the Federal Deposit Insurance Corporation – is funded by a levy charged to all banks. When the insurance fund runs low, the banks have a supplemental levy. It is the banks’ obligation to keep the FDIC fund topped up.

And here’s Jonathan Weil:

The question Bair posed should be a no-brainer. Borrowing taxpayer money to bail out the FDIC should be an option of last resort reserved for unforeseen emergencies.

Borrowing from banks instead of Treasury, of course, is just as bad, or possibly even worse, since it only serves to take an explicit loan, on which Treasury receives interest, and replace it with an implicit government guarantee, for which Treasury doesn’t get paid at all.

At the moment, the banks are happily sitting on artificially inflated capital ratios, a function of the fact that they never had to pay much money into the FDIC insurance fund and the fact that the FDIC is seemingly reluctant to ask them to pay, today, the real and present cost of its multiple bailouts. Rather than address the issue straight on, the FDIC is trying to come up with clever financial solutions which only really serve to kick the problem down the road. Unfortunately, given that the FDIC seems to be on exactly the same page as the banks it nominally regulates, there’s very little chance that the correct answer to the question — a special assessment — will happen.


By the way, FDIC’s increase in credit line was a bill originally called “The Depositor Protection Act of 2009″ but for some reason got sneaked into the “Credit Card Accountability Responsibility and Disclosure Act of 2009.”

$500 billion of our tax money under the miscellaneous section of the credit card bill… shocked yet?

That money should only be used to pay depositors at future failed banks and is not meant for sharing losses in FDIC’s current PPIP auction like this:

FDIC “gave half the upside to an investment fund – ‘Residential Credit Solutions of Fort Worth, a three-year-old company founded by Dennis Stowe, a veteran of the subprime mortgage industry – and kept all of the downside to itself”
seekingalpha.com/article/163317-ppip-jus t-baffling


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The weird resignation of Brandeis’s president

Felix Salmon
Sep 25, 2009 13:37 UTC

The latest chapter in the Brandeis fiasco is that president Jehuda Reinharz is resigning, just one year after signing a new five-year employment contract. The official letters don’t once mention the name “Rose”, which is insane: how can Reinharz say with a straight face that he “will leave the University in good condition with a strong foundation on which to build in the future”, even as there’s still enormous uncertainty over the question of whether the university will have to sell millions of dollars from the Rose’s art museum just to make up its funding shortfall?

Reinharz explicitly denied, in an interview with the Brandeis Hoot, that his decision had anything to do with the Rose — while admitting that PR surrounding his resignation would be handled by the same crisis-management firm that was hired after the Rose news broke and the university’s own communications officers utterly botched the way they dealt with the announcement. There’s certainly nothing in Reinharz’s stated reasons for his resignation (“It is now time for me to enter the next chapter of my professional life”) which explains what has changed since a year ago, when Reinharz signed his five-year contract.

With any luck a new president will be found soon, who has no personal association with the decision to close the Rose — and who might be able to better cope with the attention now being paid to that beleaguered museum.


Felix Salmon
Sep 25, 2009 05:24 UTC

Indiviglio defends securitization by saying it should have been done right, in which case it would never have taken off — Atlantic

Konczal’s requiem for the vanilla option — Rortybomb

37signals is now a $100 billion company, after investors bought 0.000000001% of the company for $1. Genius! — 37signals

The flack-to-hack ratio rises above 2 — BusinessWeek

This is the most amazing map of NYC I’ve ever played with — Oasis

Is this the greatest headline ever? — Twitpic


If you’re inclined to reply to this statement: “Salmon’s claim that “no one really knows” what’s in a securitization is common perception. It’s also completely false.” you might find this article useful: http://www.housingwire.com/2009/09/25/se curitization-group-launches-code-to-trac k-loans/

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The uses of Kiva

Felix Salmon
Sep 24, 2009 19:44 UTC

In the wake of my blog entry last month saying that people shouldn’t invest in microfinance, I had the opportunity to meet yesterday with Premal Shah, the president of Kiva. Kiva is an interesting case, and I don’t consider Kiva’s lenders to be microfinance investors — not least because they get no interest on their money. The best-case scenario is that they’re paid back what they lend, and the worst-case is that they lose it all. That’s not much of an investment.

With Kiva, the interest is more literal — they take a real interest in the individuals to whom they’re lending. That’s why Kiva loans are structured as loans to individual borrowers, rather than as loans to the local microlenders. Lending to microlenders is the way that most microfinance finance is structured, and it’s the logical way of doing things. But there’s less human-as-opposed-to-financial interest there. At Kiva, says Premal, “What makes it all work is the story engine.”

Premal says that when visitors to kiva.org lend money, the rate of return they’re looking at is social impact, rather than anything financial. That makes sense. And indeed they have a much greater risk appetite than most socially responsible investors: they’re reasonably happy to take modest losses, especially when it’s a result of circumstances outside the borrower’s control, such as exchange controls imposed by the government in question.

Given the fact that Kiva has a greater risk appetite than most investors, it tends to work at the riskiest end of the microfinance spectrum — places like Iraq and Liberia. That’s pretty cool. But it does share a couple of structural problems with the world of microfinance investors more generally. The first is that there’s too many dollars and too few microlenders: what’s really needed is not more money, but more people in rural areas willing and able to lend it.

The second problem is the way in which much microfinance investment is at heart a gussied-up carry trade: investors fund in dollars and then lend out, at very high nominal interest rates, in foreign currencies. Kiva has started to address this problem with an opt-in scheme whereby lenders take FX risk after the first 20% of local-currency devaluation, thereby preventing microlenders from having to pay back, in local-currency terms, much more than they borrowed. It’s a start, but I don’t like the way that microlenders have to opt in: it should rather be opt-out, since the scheme is free. The microlenders who opt out will have privileged access to the minority of Kiva users who don’t want to take any currency risk, but those users shouldn’t really be lending money to foreign-currency borrowers in the first place.

My feeling is that where Kiva works best is in giving ordinary Americans a real connection to policies and people in far-flung countries; it’s also probably the best way in which microfinance lenders can take advantage of dollar-denominated funding. That said, such microlenders should always look for grants before loans, and for local-currency funding before anything in dollars. So Kiva, while not necessarily a last resort, should maybe be the second-to-last place they look for capital.

Update: I’ve realized this was pretty unclear in that I use the term “lenders” to refer both to the Kiva visitors, lending in dollars, and to the local microlenders, lending in local currency. So I’ve changed all the “lenders” to “microlenders” where appropriate. Of course the Kiva visitors can be considered microlenders themselves, but that just gets confusing.


Considering the other end of the transaction, I’d much rather get money from a microlender and pay interest, than have some rich (relatively) busybody from some moralistic country far away prying into my life.

Putting insolvent banks back on their feet

Felix Salmon
Sep 24, 2009 18:50 UTC

Paul Volcker, in his testimony today, talks at some length about the necessity that the government has a new form of resolution authority:

I also believe an approach proposed by the Administration and others should be supported. The basic concept is to provide a new “resolution regime” for insolvent or failing non-bank institutions of potential systemic importance.

The problem here is the “non-bank” part of Volcker’s proposal. Since he explicitly excludes “banking and insurance organizations already subject to substantial official regulation”, it’s not obvious how many companies would be covered by this proposal — GE? Citadel? One or two others, tops?

The real question, which Volcker ducks in his testimony, is the government’s willingness and ability to use its existing regulatory powers to force some kind of debt-for-equity conversion at banks. You can’t use the bankruptcy regime for this, because banks can’t declare bankruptcy without failing: as Jesse Eisinger pointed out to me in an IM conversation, bankruptcy is cashflow positive for most companies, but it’s cashflow negative for a bank.

It would have been great if the government could simply have forced some kind of debt-for-equity conversion at Citi and Lehman and AIG, perhaps combined with some kind of governmental liquidity support. Yes, there would have been a nasty ding to the credit markets, especially since many bondholders aren’t allowed to hold equity. But the financial system would have been put on a much more sustainable footing going forwards, and the choas of Lehman’s bankruptcy might well have been avoided.

So yes, I’m all in favor of a new resolution regime. But let’s get serious about applying it to banks before worrying about whether we should apply it to a handful of systemically-important non-banks as well.

(Related: John Gapper on the Volcker testimony. Recommended.)


I believe the chaos of Lehman’s bankruptcy resulted primarily from the fact that Paulson changed horses mid-stream. He bailed out Bear – he bailed out Fanny and Freddie – then apparently his concerns for being known as “Mr. Bailout” forced him to let Lehman head into the current of chaos on its own.

And it failed.

And every financial institution then knew that Lehman’s fate would be their own without a federal bailout. They were all teetering on a foundation built sky-high on leverage.

So panic ensued.

Now it appears we’re doing everything in our power to create a regulatory framework that will have no teeth, no power and nothing much to regulate, after all the exclusions are considered. What we’ll end up with is a financial sector riddled with moral hazard, but acting with the same propensity for risk as before – because they know the feds will be there to pick up the tab for their failure…. TBTF is even bigger today than one year ago.

Against the securitization contrarians

Felix Salmon
Sep 24, 2009 17:08 UTC

As Stacy-Marie Ishmael says, “there has been an outbreak of contrarian thinking on the links between ratings, securitisation and the mortgage market” of late. She points to a paper by Ronel Elul, while Zubin Jelveh, who has been following the contrarian line for a while now, picks up on a different paper by Ryan Bubb and Alex Kaufman.

But the fact is that none of these findings are all that powerful. Elul, for instance, essentially confirms that securitization causes a decline in performance: “a typical prime ARM loan originated in 2006 becomes delinquent at a 20 percent higher rate if it is privately securitized,” he writes, and the fact that a similar pattern can’t be seen in subprime loans is basically just a function of the fact that “very few subprime loans were actually held in portfolio” — substantially all of them were destined for the securitization machine.

As for the Bubb-Kaufman paper, the chart that Jelveh picks up on shows a good 90% of subprime mortgages getting securitized. Can that really suggest, as Jelveh says, that securitization might not be to blame for the decline in lending standards? If lending standards dropped at the same time as the securitization rate soared, I’d say there’s a strong correlation between the two, and a pretty good prima facie case for a causal relationship too.

At heart, it all comes down to information: loans are stronger and more desirable than bonds, because a bank intends to hold its loan to maturity and does a lot of underwriting, shoring it up with covenants. Bonds, by contrast, are often held only briefly, and are often bought by investors who do precious little fundamental analysis; what’s more, they simply don’t have the kind of granular information that bank lenders have. And securitizations are even worse than bonds — no one really knows what’s in them, and they’re ultimately based more on models than on shoe-leather underwriting. So it’s entirely predictable that the boom in mortgage securitization was bad for the overall quality of the debt. And attempts to show otherwise are ultimately doomed.


Your comments on Elul are good, but if you read page 7 of the paper carefully it sounds like any subprime loan that stayed in the portfolio stage of securitization for one year after origination was designated as having a “final investor type” of “Portfolio” loan even if it was securitized the next year. Hmm.

The author’s explanation of the use of a one year window for “final” status would be interesting.

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