Paul Krugman is right to be worried about the unintended consequences of the AIG bailout:

We’ve greatly increased the chance of a Japanese-style lost decade, with I would now give roughly even odds of happening. Why? Because bank-friendly policies have squandered public trust in all government action: try talking to the general public about stimulus, and it’s all confounded in their minds with the deeply unpopular bailouts.

I do fear that the Obama administration has done a bad job of separating the financial-sector bailouts, on the one hand, from the stimulus bill, on the other. And if the general public starts conflating the two, there’s no chance of any more stimulus, no matter how needed it might be.

Part of the problem is that Tim Geithner was so vocal about the urgent necessity for both of them, dating back to his tenure at the Fed during the Bush administration. If he comes out and says that a second stimulus is needed, the obvious rejoinder will be “well you said that about the AIG bailout too”. And there’s no good answer to that.

As Dean Baker notes, Neil Barofsky’s report on the 100% payments to AIG’s counterparties is the news of the day. It’s sexy stuff, revisiting the dramas of the week of Lehman’s collapse, and of course going into great detail about the way in which the crisis’s designated villain, Goldman Sachs, walked away with billions of dollars of taxpayer money despite saying they never asked for it nor particularly needed it.

I agree with Barofsky that, in hindsight, the payments should have been made at less than par; TED has a good explanation of how that could have happened, given sufficient aggression. After all, it’s not like Treasury wasn’t being run by a hard-charging former investment banker at the time.

But I’m maybe slightly more sympathetic to the Fed than most — or at least I understand how this happened. It shouldn’t have happened, that’s true: for the sake of putting a knife into the moral-hazard trade, some haircut — any haircut — should definitely have been imposed, even if it was only the 2% that UBS offered to accept.

But the government owned AIG, which created the situation that Germans call Anstaltslast: the fact that state-owned companies simply don’t default on their obligations. The government was also battling a major crisis using the only weapon at its disposal: enormous amounts of liquidity. When you’re putting out a fire, you don’t stop to worry that large amounts of liquidity are going to end up where you don’t particularly want them — the important thing is putting out the fire.

So yes, given a bit more aggression and foresight, the Fed could have tried to cram down a haircut onto AIG’s counterparties. But at the time, no one was particularly interested in being harsh to the global financial sector; instead, they were trying to rescue it. With hindsight, it now seems that companies like Goldman Sachs have turned out to be the biggest winners, paying out billions of dollars in bonuses even as the rest of the country struggles with an extremely nasty recession. But that wasn’t particularly foreseeable. And so although I agree with Barofsky that the Fed and Treasury should have been harsher on the counterparties, I do understand why they weren’t.

Andrew Ross Sorkin confirms what most of us have long suspected:

One of the frustrating parts of researching my book came when I finally got to ask the question of Wall Street chief executives and board members that you just raised: Do you have any remorse? Are you sorry? The answer, almost unequivocally, was no. (Or they just didn’t answer.) They see themselves as just one part of a larger problem, with many constituencies to blame.

Many of the most senior members of management on Wall Street now consider themselves “survivors,” as if they were cancer survivors or something. That’s the word they use. While many of them are self-aware enough to politely nod at the notion that they received help and were part of the problem, they seem reluctant to acknowledge they were “rescued” or “saved.”

One of the key drivers of the crisis was the hubris and general lack of humility of senior bank executives. This is connected to the issue of executive pay: almost everybody thinks he deserves what he’s earning. But the only way you can deserve an eight-figure pay package is if you’re really on top of what’s going on in your bank. Ergo, everybody thought they were on top of what was going on in their banks, even when they weren’t; lower pay and more humility would have helped enormously in curtailing some of the most egregious excesses.

If bank executives (with the notable exception of John Reed) see no need to apologize for destroying the global financial system, they are still part of the problem and are very unlikely to be part of the solution. Which bodes ill for the future.

I had a very interesting conversation with Bob Pozen yesterday evening; his new book is out now, and I highly recommend it. It’s the first crisis book to make a detailed series of specific recommendations about what needs to be done going forwards — or, in the words of the book’s subtitle, “how to fix the US financial system”.

These recommendations are sprinkled liberally throughout the book, and are helpfully presented in bold type. Whenever I came across one, I scribbled the page number on the back flap of my copy, in one of four columns. The first column was recommendations I agreed with, or which were at least a step in the right direction; the next two columns were for recommendations I thought didn’t make complete sense or were questionable, and the final column was for recommendations I thought were bad ideas. The final tally looked like this:

As you can see, Pozen seems to be right (or at least in broad agreement with me) the overwhelming majority of the time. And as you can also see, he makes a lot of recommendations, on everything from accounting standards to insurance regulation. Tyler Cowen is quite right to give the book a rave review.

I’m not in agreement with Pozen on everything: he thinks, for instance, that it’s crucially important to get the securitization market up and running again — complete with tranche structures which require sophisticated modelling — while I think that securitization is inevitably going to be used to shove risk into tails and appeal to investors who don’t fully comprehend what they’re buying.

I’m also not fully convinced by one of Pozen’s big ideas, which is that banks should have small and professional super-boards which, rather than simply rubber-stamping the decisions of the CEO, take a much more active interest in the way the bank is run; Pozen has in mind here the governance structures at companies owned by private-equity shops. (Indeed, he wants to encourage more private equity companies to own and invest in banks.)

My view is that the rates of return targeted and required by private-equity investors are far too high for banking, which should be a boring industry, and that even if safeguards are put in place to stop PE-owned banks from lending to sister companies, management at such institutions will try as hard as they can to bend the rules to maximize leverage and profits. And that they will be positively encouraged to do so by their small super-boards.

Pozen, on the other hand, is fundamentally bearish on the business of banking, telling me that “if all you do is make traditional loans, you will lose money and you will go bankrupt”. I don’t think that’s true, but insofar as it is true of banks, it’s also true of investors who buy securitized loans originated by banks — so securitization is not really a solution to the problem. More generally, I don’t like the idea of creating a banking system where banks run around trying to make money on clever innovations because they’re losing money on their core loan products. It sounds like a recipe for disaster to me.

Some of Pozen’s other ideas are really good, though, like capping FDIC guarantees on bank debt at 90%. He also thinks that AIG Financial Products should declare bankruptcy, perhaps along with the parent company, which would give its counterparties a lot of incentive to settle their claims at say 70 or 80 cents on the dollar.

What’s pretty obvious though is that most of Pozen’s recommendations will not be enacted. Which raises the obvious question: if we don’t do this, what’s going to happen to the financial system and the economy? Pozen’s answer: we will have more crises, they will be increasingly severe, and they will be increasingly frequent. I agree.

One of the tragedies of the current crisis is that far too many people consider it to be an anomaly, a once-in-a-century event. It isn’t. The recipe for this crisis — a complex global financial system with large imbalances and inadequate controls — remains in place today. And financial crises are common things: even if you exclude emerging markets, there’s generally one somewhere in the world every year or two.

We can’t afford the trillions of dollars it would cost to rescue the world from the next crisis — yet at the same time we’re doing very little to minimize its effects or the probability of it happening. It’s a very risky game that we’re playing, and it’s liable to end in tears. Which is one reason why I’m so keen on Paul Volcker’s idea that we should eliminate the tax-deductibility of debt interest. That’s a big one: so big, indeed, that Pozen doesn’t dare even consider it in his book. But that’s the kind of ambition that we need to have if we’re going to seriously curtail crisis risk in the global economy.

Update: Pozen writes to say that he thinks some of his proposals — like regulating hedge funds and derivatives, as well as reforming loan securitization — will indeed happen. He also adds:

I was exaggerating when I said that traditional commercial loans would lead to bankruptcy as a way to driving home my point that traditional unsecured loans have a terrible risk-return relationship — with no upside and a lot of downside.

Still, if that’s true of the loans, it’s true of the securities made from them, too. So it’s hard to see how securitization is the great solution that Pozen thinks it is.

Richard Painter, who drafted and approved the ethics agreement signed by Hank Paulson when he became treasury secretary, has come to the conclusion that such agreements can never really work as intended:

This essay concludes that government ethics law in its current state is not up to the task and that the United States is not prepared to implement bailouts in a manner that will instill public confidence. Although these problems could be alleviated through stricter ethics rules or a more systematized approach to bailouts, most solutions would be more costly than the problems they attempt to solve. Bailouts thus impose a substantial burden on government ethics that may be impossible to remove, in addition to the economic cost bailouts impose on taxpayers. Designing a bailout free economy may be the only acceptable alternative.

Painter’s essay is excellent, and highly recommended, precisely because he offers no solutions to what is an intractable problem. Here’s a little bit:

Requiring Treasury officials coming in from Goldman Sachs or other investment banks to dump their bank stock and stock options may not have been enough when they retain close ties to their former employers. There were also probably too many senior Treasury Department officials from Goldman; perhaps there were too many from the banking industry in general.   

This is very true. The saga of the government’s response to the financial crisis is one where all the key decisions are made by bankers, be they of the commercial, investment, or central variety. In a parliamentary system like the UK’s, the finance minister is an elected representative of the people. Of course, as we’ve seen in the UK, that doesn’t necessarily make bank bailouts any more taxpayer-friendly. But at least it serves as some kind of check on the banking industry bailing itself out whenever it gets into trouble.

The impression I get from the current spate of crisis books is that the likes of Paulson and Geithner became entirely consumed with the problems in the financial sector, and viewed political considerations, and the will of the people more generally, as an obstacle to be overcome rather than as any kind of guiding light. That may or may not have been a good thing. But either way, it’s fundamentally undemocratic.

Steven Rattner’s first-hand account of the automaker bailout is self-serving (of course), but still very much worth reading. He’s very much the office-bound technocrat: “we recognized the importance of a trip to Detroit,” he writes at one point, “so in March, several of us made the journey”. Well, yes, that would probably make sense.

At the same time, this financier understands clearly and intuitively that in bankruptcy proceedings, seniority of creditors doesn’t matter:

The lenders were particularly aggrieved that the UAW’s health-care trust, which ranked below the secured creditors, was slated to exchange an $8 billion existing claim for $4.6 billion in notes and 55% of the equity in the reorganized company. While arguably close to a 50% haircut, it was a higher-percentage recovery than we were offering the banks.

The lenders felt that this represented an ideological decision by the Obama administration to tilt in favor of labor and against capital. That was simply not the case. At no time during our months of work did the White House ever ask us to favor or punish any stakeholder.

Many other unsecured creditors — notably, suppliers and consumers holding warranties — actually received 100¢ on the dollar. The fact was, Chrysler had to have workers, suppliers, and customers to succeed and therefore needed to give them more than called for by their rank in the capital structure…

The outcome of the Chrysler restructuring had virtually nothing to do with the heavy hand of government and everything to do with the fact that Treasury was the reluctant investor of last resort.

Every stakeholder did better under our plan than they would have in the alternative: a liquidation, in which the lenders would have gotten far less than the $2 billion they wound up with.

Rattner’s job was to create a viable company, not to maximize recovery for bondholders. If those creditors wanted to put their own new money into Chrysler, and run it themselves, they were more than welcome to. But even the government came very close to simply letting Chrysler fail, until it worked out the magnitude of the knock-on effects on jobs at dealers and suppliers. No one else would put a penny in, and the fact that TARP money was found for the automakers meant that hundreds of thousands of jobs, and billions of dollars, were saved. The creditors really were lucky to get what they got.

Normally, when I admit that I was wrong, I don’t get a lot of responses basically saying “no, you were right the first time round”. But this time, when I admitted I was wrong about bank nationalization, I’ve received a lot of pushback along those lines. Charles’s comment is representative:

Really ? How did you come to that conclusion? As far as I can see, the “saved” banks are retreating on lending to SME and retail, stuffing their balance sheet with safe bonds (mainly govies) and recapitalizing themselves by taking advantage of the steepness of the yield curve. This has enormous opportunity costs for the taxpayer (these long bonds coupons will have to be paid one day…), depresses the “Real” economy, and is as close to “free lunch” for the banks than anything. The government, and the taxpayers, bear the burden of banking sector losses and get nothing in return. A nationalization has the same risks, but enjoys the potential upside.

One key point of my post was that the Obama administration is very good at tempering its initiatives with a clear-eyed view of what is possible and what isn’t. In the case of the decision not to nationalize the banks (which, it’s worth emphasizing, is different from a decision never to nationalize the banks), I think we’re seeing a real appreciation of the breadth of the possible unintended consequences, as well as the practical impossibilities involved in the government trying to run such an enormous banking book with so many different and competing parts.

How much of the decline in bank lending to individuals and small businesses is due to a drop-off in demand, and how much is due to banks’ increasing risk-aversion? It’s hard to say, but the former is clearly important, and having government-owned banks wouldn’t change that. Such lending is normally much more profitable than the big wholesale loans which banks have increasingly been keen on extending of late; that says to me that they’d be perfectly willing to make smaller loans if only there were reasonably high-quality demand out there. I might be wrong, but even if I am, it’s hard to see how government ownership would change things: government simply doesn’t have the ability to micromanage bank lending at that level.

The reason why I wanted to nationalize the banks is that they were suffering from a major liquidity crisis, and they were insolvent on a mark-to-market basis. In that situation, the government essentially has two options, when the banks are too big to fail. It needs to provide liquidity either way; the only question is whether it does so while taking ownership, or whether it leaves the banks to continue in their existing form, in the hope that the markets will recover and they will no longer be mark-to-market insolvent.

The latter is much easier, and is pretty much what happened. It also has the added advantage that you don’t have government ownership driving out private-sector risk capital. As an anonymous Treasury official says in Lizza’s piece, “People had money to put into banks. The nationalization crowd would have had the government putting all that money in.”

It’s true that when the government determines that a certain bank is too big to fail, and then lowers interest rates to the point at which the yield curve becomes steep, the result is a recapitalization of that bank through easy profits. And yes, those profits go to the bank’s private shareholders. You can call that a free lunch. The alternative, for taxpayers, is the possibility of a very expensive lunch indeed. Here’s Lizza again:

Furthermore, Summers said, there was a medium-term risk that nationalized banks would lose value, in the same way that the act of foreclosure decreases the value of a home. Summers pointed to the example of Sweden, which was regularly cited by economists who favored nationalization. But Summers noted that Sweden didn’t nationalize for two and a half years, by which time the situation had become so severe—interest rates had reached a hundred per cent—that there were no other options. In addition, Nordbanken, the largest bank nationalized in Sweden, was already eighty per cent government-owned. Summers concluded by emphasizing that nationalization was a strategy that governments turn to only after it is very clear that nothing else can work.

One of the problems facing Summers and Geithner when they made this decision was how to get the wholesale market in bank debt moving again. (Remember the TED spread?) Given that they couldn’t nationalize thousands of banks at once, and given that nationalization was tantamount to an admission that the banking system was insolvent, non-nationalized banks would have found it pretty much impossible to find funding at any level, and there might well have been a much larger number of bank failures than we’ve seen to date.

The fact is that nationalization is a negative-sum game. Just because banks are making large profits now, doesn’t mean that they would have made just as much under government ownership. And the political noise surrounding just about any decision that any nationalized bank made, especially as regards pay and bonuses, would have made any other kind of reform (healthcare, financial-regulation, you name it) even more difficult than such things have turned out to be sans bank nationalization.

Now that the results of the stress tests have been made public and the debt market has recovered impressively, there’s a strong case to be made that the banking system is no longer insolvent. If we could get here without the incredibly drastic measure of nationalization, that’s a good thing. Yes, we might have lost a bit of potential upside on our hypothetical equity stake in the big banks. And yes, it’s very depressing to see a large chunk of that upside going to the very bankers who helped drive the economy into the current recession in the first place. But let’s not kid ourselves that the nationalization option would have been trivially superior in all respects.

Robert Pozen has an interesting idea:

In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.

James Kwak tries to flesh it out:

Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi and BAC and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

One has to be careful when using the term “bankruptcy” with respect to banks, because I think what we really want here is a massive debt-for-equity swap which keeps the bank viable in some form, rather than outright liquidation (which is what banks have to do if they file for bankruptcy). Given the fact that recovery rates for unsecured bank creditors in liquidation are very close to zero, few creditors would be likely to object to such a thing. Is such a thing possible under the government’s existing resolution authority? I’m unclear on that, but I’m definitely interested in the details of Pozen’s proposal.

One big problem here is that such a plan can’t really be institutionalized ex ante: the last thing we need is an incentive for too-big-to-fail banks to borrow short rather than long, because there’s a semi-explicit government guarantee on all of their funding less than 60 days. Or maybe the Fed could force all banks to have no more than x% of their unsecured debt in the form of commercial paper.

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.)

George Bush speechwriter Matt Latimer has an astonishing tale of what the economic crisis looked like from inside the White House — and it’s a must-read, even if GQ does force you to click the “next” button ten times in a row to read it.

Latimer starts off by describing Hank Paulson as “pretty much a nonperson at the White House”, and it goes downhill from there:

Pundits on TV started asking why the president wasn’t saying more and what he was going to do. The answers were: We had nothing to say and no one had any idea.

The central event in the narrative is a speech that Bush gave on the economy, trying to push the abortive first version of TARP:

The president directed us to try to put elements of his proposal back into the text. He wanted to explain what he was seeking and to defend it. He especially wanted Americans to know that his plan would likely see a return on the taxpayers’ investment. Under his proposal, he said, the federal government would buy troubled mortgages on the cheap and then resell them at a higher price when the market for them stabilized.

“We’re buying low and selling high,” he kept saying.

The problem was that his proposal didn’t work like that. One of the president’s staff members anxiously pulled a few of us aside. “The president is misunderstanding this proposal,” he warned. “He has the wrong idea in his head.” As it turned out, the plan wasn’t to buy low and sell high. In some cases, in fact, Secretary Paulson wanted to pay more than the securities were likely worth in order to put more money into the markets as soon as possible. This was not how the president’s proposal had been advertised to the public or the Congress. It wasn’t that the president didn’t understand what his administration wanted to do. It was that the treasury secretary didn’t seem to know, changed his mind, had misled the president, or some combination of the three.

Clearly Paulson didn’t much care about currying favor in the White House:

We wrote speeches nearly every time the stock market flipped. Meanwhile, the White House seemed to have ceded all of its authority on economic matters to the secretive secretary of the treasury. The president was clearly frustrated with this. I was told that at one Oval Office meeting, he got very animated and exclaimed to Paulson, “You’ve got to tell me what you’re doing!” (In the weeks that followed, Paulson changed his spending priorities two or three times. Incredibly, he’d been given the power to do with that money virtually anything he pleased. All thanks to a president who didn’t understand his proposal and a Congress that didn’t stop to think.)

If nothing else, this surely gives Paulson full license, in case he felt he needed it, to unload on Bush in his own book. There never seemed to be much light between the White House and Treasury at the time. But in hindsight, it seems that there was no love lost between them at all.