James Pethokoukis

The St. Louis Fed had put together a “financial stress index.” It incorporates a number of financial variables.  And it looks a whole lot better than it did two years ago.

Don Rissmiller of Strategas looks at how the lessons of the US financial crisis could instruct policy responses for the EU and its Greece problem:

1) The TARP-like option: this is essentially spending government money to buy bad debt, and the European bailout packages have moved in this direction. The political challenge
was always getting money authorized to help those that appeared to be spending beyond their means. This still appears to be where we are now in the EU, despite some progress
with the German vote.

2) The PPIP-like option: the challenge with spending government money in the U.S. was that the authorization process was burdensome. Hence, the next suggestion was a ”public private investment program” (PPIP). The challenge with PPIP (it never got off the ground) was how to get banks to sell assets in an illiquid market, which presumably would not be as large an issue with government debt. But the key features of the program – including non-recourse leverage and a sharing of profits – were indeed well thought out. No European option of this sort appears on the table currently, however.

3) The Monetization option: When the Fed finally started participating with “all available tools”, including buying mortgage securities, the U.S. market stabilized. This is certainly a politically tough option for the ECB. Should it come to it, however, the option of doing nothing certainly seems like a much worse policy mistake.

4) Cutting Spending: Greece already appears to have lost some sovereignty, as the Lisbon treaty has required sharp adjustments. These cuts can be some of the most politically challenging items, though as the governor of NJ has demonstrated, they are not impossible.

5) Europe Bank Guarantees: the risk of a “run on the bank” seems to be creating additional uncertainty, though the amount of deposits that would have to be guaranteed would presumably be quite large. The FDIC guarantee plan in the U.S. could provide some guidance for Europe, however.

And Larry Kudlow also has some thoughts on that last option of Rissmiller’s:

So it’s my contention that the Europeans must now embark on a similar program. The EU/IMF rescue plan, which consists of $1 trillion in loans and loan guarantees for government sovereign debt, must be expanded to include a blanket loan guarantee for all European bank debt, short term and long term. A Europe-wide, centralized, deposit-guarantee system should also be developed. Right now bank deposits are insured by individual countries, like Greece. This is not credible. (Hat tip to investor David Kotok for this deposit-guarantee thought.)

A loan-guarantee program to backstop the banks in Europe and sovereign debt will put an end to this crazy Greek drama that is pulling down markets everywhere and threatening the economic recovery. As a free-market advocate, I don’t like this sort of government intervention. But we’re talking emergency here. Systemic global emergency. … These bank-loan guarantees would be temporary, perhaps a year in length. And they would buy time for the essential budget restructuring necessary to slash spending and curb the welfare-state excesses in southern Europe, or perhaps all of Europe. These government-shrinking steps will free up private-sector resources to spur growth.

Karen Shaw Petrou at Federal Financial Analytics asks a good question:

Last Friday, we outlined the systemic-risk implications of the growing EU crisis. In the days that followed, LIBOR spreads tightened, funding dried up and our fears only rose. So, we were a bit surprised to hear a senior U.S. bank regulator tell a radio audience Thursday morning not to bother their heads about any prospects that the European crisis could wash ashore. That was, of course, followed in a few hours by a classic systemic-risk crisis on the exchanges. Was the U.S. regulator keeping the game-face on so as not to scare the children? Or, more worryingly, are U.S. regulators still unprepared for another bout of systemic risk, whistling in the dark much as they did when they told us that subprime-mortgage risk couldn’t spill over?

That bankers disdain their new Washington overlords is no surprise. To many of them, Congress is plagued by “unnerving ignorance” and a refusal to admit its own role in the financial crisis. At least that is how a controversial JPMorgan report puts it. Impolitic perhaps, but not inaccurate.

It’s one thing to discuss such grumbles in the executive suite. It’s another to explicitly lay them out in a widely disseminated research report, accompanied by data and a full-color chart for emphasis — in the midst of the delicate financial reform debate in the U.S. Senate, to boot. But that’s what JPMorgan’s James Glassman did in a May 3 economic note.

In last week’s Senate committee interrogation of Goldman Sachs executives, senators displayed “confusion about our market economy,” according to Glassman, along with plenty of unearned self-righteousness. He snarkily noted that the economic implosion of rust-belt Michigan, home of Carl Levin, the committee chairman, had nothing to do with esoteric derivatives.

It’s not news that many senators appear to have only a tenuous grasp of the financial industry. But Glassman’s larger point is more relevant. It’s not just that Congress doesn’t understand what Goldman, as a market-maker, does — it’s also that elected officials may not recognize that the financial crisis was rooted in Washington as well as Wall Street.

A similar point is made in new study by Ross Levine of Brown University, “An Autopsy of the U.S. Financial System.” Bankers may have rushed to create fancy new securities, but it was legislators who enabled risky behavior by housing giants Fannie Mae and Freddie Mac — and failed to instill watchdogs like the Federal Reserve and the Securities and Exchange Commission with the backbone needed to rein in risky activities. In detail, Levine makes these points that illustrate the role of Congress:

1) Credit Ratings Agencies. While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities. … Rather the evidence is most consistent with the view that regulatory policies and Congressional laws protected and encouraged the behavior of NRSROs.

2) Credit Default Swaps. I am suggesting that the evolution of the CDS market, the fragility of the banks, and the Fed’s capital rules illustrate a key feature of the financial crisis that is frequently ignored. The problems with CDSs and bank capital were not a surprise in 2008; there was ample warning that things were going awry. Senior government policymakers created policies that encouraged excessive risk taking by bankers and adhered to those policies over many years even as they learned about the ramifications of their policies.

3) The SEC and Investment Banks. Consider three interrelated SEC decisions regarding the regulation of investment banks. First, the SEC in 2004 exempted the five largest investment banks from the net capital rule, which was a 1975 rule for computing minimum capital standards at broker- dealers. Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that induced the five investment banks to become “consolidated supervised entities” (CSEs): The SEC would oversee the entire financial firm. Specifically, the SEC now had responsibility for supervising the holding company, broker-dealer affiliates, and all other affiliates on a consolidated basis. Third, the SEC neutered its ability to conduct consolidated supervision of major investment banks. … The combination of these three policies contributed to the onset, magnitude, and breadth of the financial crisis. The SEC’s decisions created enormous latitude and incentives for investment banks to increase risk, and they did.

4) Fannie and Freddie. Deterioration in the financial condition of the GSEs was not a surprise. … But, Congress did not respond and allowed increasingly fragile GSEs to endanger the entire financial system. It is difficult to discern why. Some did not want to jeopardize the increased provision of affordable housing. Many received generous financial support from the GSEs in return for their protection. For the purposes of this paper, the critical issue is that policymakers did not respond as the GSEs became systemically fragile. Again, I am not arguing that the timing, extent, and full nature of the housing bubble were perfectly known. I am arguing that policymakers created incentives for massive risk-taking by the GSEs and then did not respond to information that this risk-taking threatened the financial system.

Of course, even senators who do understand finance may choose to indulge in ignorant-seeming grandstanding for political and electoral reasons. JPMorgan, in turn, has distanced itself from Glassman’s views, presumably to smooth any ruffled political feathers. Even if the bank’s management secretly agrees with its economist, it’s about as likely to say so as members of Congress are to admit their enormous shortcomings.

Some talking points/analysis on the  Chris Dodd retirement

1. Makes it more likely Ds keep CT Senate seat, but also a sign of voter discontent with incumbents. Welcome to the U.S. Senate Richard Blumenthal, who says he will run.

2. Makes it more likely that financial reform will be bipartisan, Dodd wants this to be a legacy moment for him. But the GOP may stall.

3. I predicted Dodd would retire when he announced his support for Bernanke. (Yes!) Opposing him would have been the smarter political move.

4. His Banking committee replacement in 2011 is likely Tim Johnson, considered friendly to the financial services industry. Hard to see a Glass Steagall repeal getting through a committee run by him.  Byron Dorgan, by the way, was a G-S guy and he is leaving, too. Sweeping financial reform happens now or never.

Responding to Ben Bernanke’s defense of Fed interest rate policy, my pal Barry Ritholtz lays out a crisis timeline (the only thing missing is various US housing policy initiatives):

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

Already, the crazy ideas are returning, such as mortgage cramdowns. But more could be on the way in 2010, says the great Dan Clifton of Strategas (bank bonus tax, American version?):

We are entering a period where bank profits are increasing but lending is declining. Bonus season is on the horizon while job growth remains negative. And bank lobbying on financial regulation is increasing while politician’s approval ratings are declining. Adding even more fuel is that with government spending up and tax revenues lagging, sovereign fiscal issues are rising to the top of policy matrix.

Henry Blodget explains how to prevent TARP 2.0 when the next financial crisis hits, which the WH embrace of TBTF makes more likely:

What’s the solution?

Debt that automatically converts to equity when a bank’s capital ratio falls below the required level.  What does that mean? It means that equity holders will still get hit first if the bank makes dumb-ass loans. But it also means that if the bank makes so many dumb-ass loans that its equity gets wiped out, bondholders, not taxpayers, will pick up the rest of the tab.

How does it work?  When the bank’s equity falls too far, some of the convertible bonds convert to equity, thus restoring the bank’s capital ratio. This happens automatically, without bankruptcy or fuss. It happens without surprise. It happens without threatening to bring the whole economy to its knees. It happens without Congressional moaning and hand-wringing and without Treasury secretaries dropping to their knees to beg and plead.

Bondholders who buy these bonds–now called CoCo’s, or “contingent convertibles”–know full well what they are buying, and the bonds are priced to reflect the equity conversion risk. Lloyds just sold a bunch of these in the UK, and there was a market for them.

To fix the banking system, all regulators would have to do would be to require banks to issue enough CoCos that they could withstand financial Armageddon without the taxpayer getting involved. The banks’ ability to make huge bets (and huge bonuses) with small amounts of equity would be preserved, so perhaps the bank lobbyists would agree to stand down for a while. The world could rest assured that SOMETHING had been done to prevent the same mess from happening all over again. And we could all return to peace, happiness, and prosperity.

The oversight panel led by television funnywoman Elizabeth Warren has concluded that TARP has been asset for the economy. Except for this part (in the panel’s own words):

1) It is apparent that after fourteen months the TARP’s programs have not been able to solve many of the ongoing problems Congress identified. Credit availability, the lifeblood of the economy, remains low.

2) In light of the weak economy, banks are reluctant to lend, while small businesses and consumers are reluctant to borrow.

3) In addition, questions remain about the capitalization of many banks, and whether they are focusing on repairing their balance sheets at the expense of lending.

4) The FDIC, facing red ink for the first time in 17 years, must step in to repay depositors at a growing number of failed banks. This problem may well worsen, as deep-seated problems in the commercial real estate sector are poised to inflict further damage on small and mid-sized banks.

5) Large banks have problems of their own. Some of them, waiting for a rebound in asset values that may still be years away, continue to hold the toxic mortgage-related securities that contributed to the crisis. Consequently, the United States continues to face the prospect of banks too big to fail and too weak to play their role adequately in keeping credit flowing throughout the economy.

6) The foreclosure crisis continues to grow.

7) Furthermore, the market stability that has emerged since last fall’s crisis has been in part the result of an extraordinary mix of government actions, some of which will likely be scaled back relatively soon, and few of which are likely to continue indefinitely. The removal of this support too quickly could undermine the economy’s nascent stability.

While strong government action helped prevent a worse crisis, it may have done so at a significant long run cost to the performance of our market economy. Implicit government guarantees pose the most difficult long-term problem to emerge from the crisis. Looking ahead, there is no consensus among experts or policymakers as to how to prevent financial institutions from taking risks that are so large as to threaten the functioning of the nation’s economy. Congress is currently grappling with this issue as it considers how to respond legislatively to the financial crisis. It is clear that a failure to address the moral hazard issue will only lead to more severe crises in the future.

Me: Oh, and then you have the devolution of TARP into a slush fund to bail out AIG, union auto workers and congressional Democrats worried about how the high unemployment rate will hurt their 2010 chances. Thus the new jobs bill. But it did stop the panic, unless you believe John Taylor that it really made the panic worse through uncertainty.

Some self-incriminating evidence (Bernanke in his own words) supplied by David Leonhardt of the NYTimes:

* July 1, 2005 (responding to a CNBC question about whether there was a housing bubble and whether it could cause a recession): “It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”

* May 17, 2007: “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

* July 18, 2007 (a month before the subprime mortgage market began having problems and five months before the recession began): “Employment should continue to expand. … The global economy continues to be strong. … Financial markets have remained supportive of economic growth.”

* Feb. 28, 2008: “Among the largest banks, the capital ratios remain good, and I don’t expect any serious problems … among the large, internationally active banks that make up a very substantial part of our banking system.”

* June 9, 2008 (six months into the recession and three months before the financial panic began): “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.”

* May 5, 2009: “Currently, we don’t think [the unemployment rate] will get to 10 percent.” (Five months later, the rate reached 10.2 percent.)