From the Times:

Dominique Strauss-Kahn told the CBI annual conference of business leaders that another huge call on public finances by the financial services sector would not be tolerated by the “man in the street” and could even threaten democracy.

“Most advanced economies will not accept any more [bailouts]…The political reaction will be very strong, putting some democracies at risk,” he told delegates.

“I do believe that the financial sector needs to contribute both to the costs of the financial crisis and to reduce recourse to public funds in the future,” he said.

Me: In the US, TARP and bailouts are already transforming the political landscape, giving rise to the Tea Party movement and creating anti-Wall Street sentiment on the left and right.

When both Paul Krugman and the WSJ editorial page are hammering you, as they are Geithner, either you are doing something really right or really wrong.

First Krugman:

For the A.I.G. rescue was part of a pattern: Throughout the financial crisis key officials — most notably Timothy Geithner, who was president of the New York Fed in 2008 and is now Treasury secretary — have shied away from doing anything that might rattle Wall Street. And the bitter paradox is that this play-it-safe approach has ended up undermining prospects for economic recovery. For the job of fixing the broken economy is far from done — yet finishing the job has become nearly impossible now that the public has lost faith in the government’s efforts, viewing them as little more than handouts to the people who got us into this mess.

Now the WSJ:

In the fall of 2008 the New York Fed drove a baby-soft bargain with AIG’s credit-default-swap counterparties. The Fed’s taxpayer-funded vehicle, Maiden Lane III, bought out the counterparties’ mortgage-backed securities at 100 cents on the dollar, effectively canceling out the CDS contracts. This was miles above what those assets could have fetched in the market at that time, if they could have been sold at all.

The New York Fed president at the time was none other than Timothy Geithner, the current Treasury Secretary, and Mr. Geithner now tells Mr. Barofsky that in deciding to make the counterparties whole, “the financial condition of the counterparties was not a relevant factor.”

This is startling. In April we noted in these columns that Goldman Sachs, a major AIG counterparty, would certainly have suffered from an AIG failure. And in his latest report, Mr. Barofsky comes to the same conclusion. But if Mr. Geithner now says the AIG bailout wasn’t driven by a need to rescue CDS counterparties, then what was the point? Why pay Goldman and even foreign banks like Societe Generale billions of tax dollars to make them whole?

This means a more complete explanation from Mr. Geithner of what really drove his decisions last year, how he now defines systemic risk, and why he wants unlimited power to bail out creditors—before Congress grants the executive branch unlimited resolution authority that could lead to bailouts ad infinitum.

Again, all this focus on Wall Street pay distracts from more important issues.  Gary Becker summarizes:

I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash. These executives bought large quantities of mortgage-backed securities and other securitized assets because they expected this to increase the average return on their assets without taking on much additional risk through the better risk management offered by derivatives, credit default swaps, and other newer types of securities. They turned out to be badly wrong, but so too were the many financial economists who had no sizable financial stake in these assets, but supported this approach to risk management.

The experience of other financial crashes also does not indicate that either the level or form of compensation of top financial executives were major factors in precipitating these crashes. Thousands of banks failed during the Great Depression, as did hundreds of American savings and loans institutions during the 1980s, without heads of these institutions in either case getting particularly high pay, or pay that was mainly in the form of bonuses and stock options. My impression is that this same conclusion applies to the Mexican bank crisis of the mid 1990s, and the Asian financial crisis at the end of the 1990s.

The generous bonuses and stock options received by financial executives may often have been unwarranted, but they are being used as a scapegoat for other more crucial factors. Financial institutions underrated the systemic risks of the more exotic assets, and apparently so too did the Fed and other regulators of financial institutions. In addition, large financial institutions may have recognized that they were “too big to fail”, and that they would be rescued by taxpayer monies if they were on the verge of bankruptcy because they took on excessively risky assets.

If I made of list of factors contributing to the recession and financial crisis, Wall Street pay would come in around 6th, after 1) easy monetary policy; 2) TBTF; 3) US housing policy; 4) global savings glut/China labor shock; 5) Wall Street group think.  Yet pay is where so much energy is being directed at this issue thanks to its populist appeal. America hates TARP so Washington needs to make amends by hammering execs at TARP recipients.

Now two other takes. First, Marginal Revolution:

There is no way this will work as advertised.  If the administration actually follows through, most of these executives will quit and get higher paying jobs elsewhere.  Executives not directly affected by the pay cuts will also quit when they see their prospects for future salary gains have been cut.  Chaos will be created at these firms as top people leave in droves.  Will the administration then order people back to work?

Here is Naked Capitalism:

The point is that the collection of these scalps will do nothing to comp levels ex these firms. The companies that also enjoy implicit government guarantees are free to do the “heads I win, tails you lose” game of privatized gains and socialized losses. And Ken Lewis is the poster child of why these measures are completely meaningless. He sacrificed his 2009 pay, but will still collect $125 million when he departs Bank of America.

If the government is going to backstop the industry (and this isn’t an “if” anymore), it needs to limit those firm’s activities to what is socially valuable and regulate them heavily to contain risk taking. As we have said, reining in executive pay (and note there is no will to do that anyhow) is not an effective approach. Those employees who don’t like that are free to decamp and raise money in ways that do not involve the regulated firms in any way, shape, or form, save perhaps counterparty exposures on very safe, highly liquid instruments.

A great point made by the Tax Foundation about the National Association of Realtors and its support of the homebuyer tax credit:

When the economy is recovered, is the NAR going to support its elimination? Not a chance. There’s a better chance of Glenn Beck being appointed to Obama’s cabinet than NAR ever advocating for eliminating a tax preference for housing.

Assuming the homebuyer credit is extended to June 30, 2010, come May next year the NAR and NAHB lobbyists will be on Capitol Hill again saying that the economy still hasn’t recovered. And then when it’s extended for another year and the economy is fully recovered, they’ll be saying things like “we can’t afford to go back to where we were 18 months ago with lower home prices.” By then, it will be permanent, and any time discussion of repealing it or scaling it down is brought to the forefront, NAR will cite how home prices are going to fall if it’s repealed. You get what Milton Friedman called a tyranny of the status quo, or an endowment effect of a tax provision.

In an FT piece, Daniel Yergin lists the many competing explanations for the financial crisis: 1) too much leverage; 2) rapid financial innovation; 3) wrongheaded or incomplete regulation; 4) government home ownership policies; 5) high US indebtedness; 6) too much greediness, not enough fear; 7) bubblicious easy credit; hubris from years of global growth; 9) global securitization as a transmitter of crisis; 10) the oil spike; 11) intrinsic evil of capitalism.

Me: The media already has its narrative: markets failed. Now it’s time for government to reassert its authority. That is the political dimension. But there is obviously a policy dimension as a well. And we are seeing the “market failed” explanation play out in Washington where Wall Street is under attack and the housing bubble is being reflated.

The most devastating part of the NYTimes piece on Paul Volcker’s lack of influence on WH economic policy comes into the very last sentence of the piece:

So Mr. Volcker scoffs at the reports that he is losing clout. “I did not have influence to start with,” he said.

Me: I can’t believe Volcker is also too thrilled with what’s been happening lately with King Dollar. Yet the focus of the story is how the WH is ignoring Volcker’s advice to separate banking from investing and trading, a de facto restoration of the 1933 Glass-Steagall Act.

Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities. … The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.

Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail. On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.

Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.

Banking expert Bert Ely sees things differently:

Had Glass-Steagall never been enacted, had it been repealed much earlier than 1999 …  the Big Five investment banking firms … might not have become as focused as they did on buying, securitizing, and trading subprime, Alt-A, and option-ARM mortgages. While the large commercial banking companies also engaged in mortgage securitization and originating nonprime mortgages, they did not get as deeply involved in those activities as did the investment banks. Arguably, then, had the separate, distinct investment-banking industry been melded into mainstream commercial banking years ago, today’s mortgage and financial crisis would not be as severe as it is, or may not have occurred at all.

Yes, the treasury secretary talks to bankers, says the Associated Press:

The calendars, obtained by the AP under the Freedom of Information Act, offer a behind-the-scenes glimpse at the continued influence of three companies — Citigroup Inc., JPMorgan Chase & Co. and Goldman Sachs Group Inc. — whose executives can reach the nation’s most powerful economic official on the phone, sometimes several times a day.

But as my pal John Carney of Clusterstock points out, he’s isn’t talking to everybody:

But these generalized claims miss something important: not all banks are equal in the eyes of Treasury Secretary Tim Geithner. Today the AP revealed that Geithner doesn’t give equal access to all of the banks, or even all of the largest banks. Likewise, being one of the biggest, most well-connected investment banks doesn’t get you close to Geithner. Instead, it’s a small select group of financial firms that have Geithner’s ear, at least judging by a review of his phone records.

Who is Geithner chatting with on the phone.?

• Goldman Sachs
• JP Morgan Chase
• Citigroup

Most obviously left off the list are Bank of America, Wells Fargo and Morgan Stanley.

Me: To me, the interesting question is to what extent Geithner shares Wall Street’s world view, and how that has influenced policy. He certainly is sensitive to the systemic nature of these institutions and their role in the financial system, which is why he was a voice against nationalization or debt-for-equity ideas. As Megan McArdle put it earlier this year:

It’s easy to blithely say “Why don’t they just make the bondholders take a haircut?”  Harder when you think about who those bondholders are:  insurers.  pension funds.  the bond component of your 401(k).  Financial debt makes up something like a third of the bond market, and the largest holders are pensions and insurers.

The insurers are the biggest problem, because they’re just so heavily regulated.  They’re not allowed to hold risky assets.  Convert their bonds to equity and they will be forced to dump that equity at prices that will trend towards zero.  Many insurers will see their capital impaired below the regulatory limits, requiring a government bailout.

Pension funds are the next biggest problem.  They’re already in big trouble because of stock market declines.  The bonds are the “safe” portion of their portfolio, the stuff that’s supposed ot be akin to ready cash.  Convert their bonds to equity–or worse, default–and suddenly they’re illiquid and even further underwater.

Nor is the 401(k) problem small.  Bond funds are typically held most heavily by the people closest to retirement; they’re for income, not capital gains.  What is your mother going to do when a third of her mutual fund income gets converted to equity that produces no cash and can’t be sold because the insurers have all had to dump their shares on the market at once?  Or simply disappears into the land of bankruptcy lawsuits?

I think what Geithner et. al. fear is that nationalizing or reorganization will put the government on the hook for massive and immediate losses in both the banking system, and the “safe” entities that lent it money

:

From his blog:

Two weekends ago the big news was the one-year anniversary of the Lehman Brothers bankruptcy and the ensuing panic. But when you look at the data, the real one-year anniversary of the panic is closer to now.

In the four weeks from Friday September 12, 2008, just before the Lehman bankruptcy, through Friday October 10, the S&P 500 fell by a huge 28 percent. But the decline was relatively modest (3 percent) in the first two weeks of that period, from September 12 to September 26, a year ago today. It is not unusual to see that size of change in a one or two week period. The real panic (the remaining 25 percent of that 28 percent decline in the S&P 500) occurred later, from September 26 to October 10. If you look at interest rate spreads or stock prices in other countries you see the same timing. Such facts have led me and others to be skeptical about the commonplace claim that it was simply the decision not to intervene and bail out Lehman’s creditors that triggered the panic. Rather I focus on the chaotic rollout of the TARP which began later and continued through October 13 when its ultimate use was finally defined.

Ed Yardeni and mark-to-market accounting:

Do you recall “Time of the Season” sung by The Zombies in 1968? The Q3 earnings season is about to start. For the third quarter in a row, there will be fewer zombies in the S&P 500. These were the living dead companies that finally died during 2008, or they survived and are mostly coming back from the dead. Many of them are in the Financials sector. They could deliver some big positive earnings surprises during Q3 thanks to the suspension of mark-to-market accounting on April 2. … The Doomsters were quick to add up all the write-offs they projected as the financial crisis intensified largely as a result of the death spiral attributable to marking the value of assets into the oblivion of extremely illiquid or nonexistent markets. It was insane that the MTM rule wasn’t suspended sooner. Yet both Ben Bernanke and Hank Paulson insisted that it would be unwise to change the rule in the midst of a crisis. They were dead wrong as evidenced by the extraordinary rebound in the stock market ever since March 12, when Rep. Gary Ackerman, my Congressman, leaned on Robert Herz, the head of FASB, to suspend the rule, which is what he did on April 2. The grand total of all the write-offs attributable to the financial crisis is now likely to fall quickly.