What you don't understand is that spending is already at or near record levels. According to the White House, spending has more than doubled since 2000 and is due to increase yet again in 2011 to a record 3.8 trillion. If this isn't stimulus spending, I don't know what is. Yet I and many other common people, have absolutely no faith that this record spending is being spent wisely and will lead to future economic growth.
http://www.whitehouse.gov/omb/budget/Historicals
Year Receipts Total Outlays Deficit
2000 2,025,191 1,788,950 236,241
2001 1,991,082 1,862,846 128,236
2002 1,853,136 2,010,894 -157,758
2003 1,782,314 2,159,899 -377,585
2004 1,880,114 2,292,841 -412,727
2005 2,153,611 2,471,957 -318,346
2006 2,406,869 2,655,050 -248,181
2007 2,567,985 2,728,686 -160,701
2008 2,523,991 2,982,544 -458,553
2009 2,104,989 3,517,677 -1,412,688
2010 2,162,724 3,456,213 -1,293,489
2011 estimate 2,173,700 3,818,819 -1,645,119
The government sector is too large and needs to be restructured. People need to be shifted to jobs in the private sector, government needs to stop trying to be everything to everyone. The fact is that even with Boehner's plan, we would still have record levels of spending along with record projected deficits. That's why his plan is a huge compromise plan that is a win for Democrats already, asking for more is plain insulting. Look at the numbers and take $90 billion off of the outlays and off of the deficit. Does it even matter? Does it change the big picture? Be reasonable.
If these small cuts can't be enacted, what chance is there of real cuts in the future? No, people have been pushed against a wall and can't back up anymore. The fact that Boehner can't even get an agreement to freeze spending at 2011 levels shows how much he's backed down and enough is enough.
Showing posts with label finance. Show all posts
Showing posts with label finance. Show all posts
Saturday, July 30, 2011
Saturday, May 22, 2010
Financial Regulation and Credit Default Swaps
CDS isn't involved in just insurance, it's used in CDOs to make synthetic bonds. If I write a CDS on GM bonds, I get paid the "premium" as long as GM doesn't default. If they do default, I must pay the contract amount and I receive the defaulted bonds in return (or I receive the liquidation value of the defaulted bonds back). I also have to put up collateral that pays the risk-free Treasury yield. Add it all together and you have something very much like a GM bond where I would receive interest payments as long as GM doesn't default and if they do, I lose my initial purchase (contract amount) minus whatever I can receive for the defaulted bonds (liquidation value).
The theory is to separate risk from investment. What if I just want to take on the risk of GM bonds without having to actually lend GM money, thus tying up my precious capital? With a traditional bond, I need to loan GM X money for a period of years and I will get X money back at the end assuming there is no default. What if I don't want to tie up that capital but still want to take on that risk? Well let someone else lend GM the money, I'll write a CDS on it and sell it to them. There, they just transferred the risk to me and I didn't have to lend GM any money (though I still have to put up collateral usually). Now that the other guy has a risk-free asset, he can then purchase more bonds up to the risk limit set by the risk management team. That's how it's supposed to work in theory. Of course, in reality his insured GM bond isn't risk free, if I go under, his insurance is worthless.
I think the problem lies with leverage and leverage ratios. CDS can help firms manage their risk without making big capital intensive moves. Selling GM bonds from your portfolio means that you have to find a buyer with the money, and then you're left with the problem of what to do with the money you just got. Where to put it? Why not just buy a CDS contract instead? That way, you get rid of the risk and don't have the problem of what to do with the excess cash.
When risk is being pawned off in an endless cycle, it can become hard to tell exactly how much systemic risk is left. I think I have sold my risk thanks to my CDS purchase, but so does the guy who sold me the CDS because he purchased another CDS to get rid of his risk. Risk keeps on getting transferred, we know that the total risk to the market as a whole cannot be eliminated or reduced merely by transferring, but each person thinks he's OK because he's sold his risk to some other guy who has sold his risk and on and on. It's hard to tell if the guy I purchased CDS from has too much CDS exposure (too overleveraged) because I don't know how many CDS he's sold or purchased since the time I originally purchased CDS from him.
Some limit has to be set for the amount of CDS exposure a firm has given his capital base. That amounts to a limit on leverage. A clearinghouse would make the market more transparent so I can see that there is way too many CDS out there for the CDS I just purchased to be considered safe. Right now there is no way for the individual actor to see the entire whole and the entire whole has a great impact on the individual actor. That is part of the problem. We need to think about the issues and come up with good solutions, I don't think banning CDS is even remotely close to the best solution.
The theory is to separate risk from investment. What if I just want to take on the risk of GM bonds without having to actually lend GM money, thus tying up my precious capital? With a traditional bond, I need to loan GM X money for a period of years and I will get X money back at the end assuming there is no default. What if I don't want to tie up that capital but still want to take on that risk? Well let someone else lend GM the money, I'll write a CDS on it and sell it to them. There, they just transferred the risk to me and I didn't have to lend GM any money (though I still have to put up collateral usually). Now that the other guy has a risk-free asset, he can then purchase more bonds up to the risk limit set by the risk management team. That's how it's supposed to work in theory. Of course, in reality his insured GM bond isn't risk free, if I go under, his insurance is worthless.
I think the problem lies with leverage and leverage ratios. CDS can help firms manage their risk without making big capital intensive moves. Selling GM bonds from your portfolio means that you have to find a buyer with the money, and then you're left with the problem of what to do with the money you just got. Where to put it? Why not just buy a CDS contract instead? That way, you get rid of the risk and don't have the problem of what to do with the excess cash.
When risk is being pawned off in an endless cycle, it can become hard to tell exactly how much systemic risk is left. I think I have sold my risk thanks to my CDS purchase, but so does the guy who sold me the CDS because he purchased another CDS to get rid of his risk. Risk keeps on getting transferred, we know that the total risk to the market as a whole cannot be eliminated or reduced merely by transferring, but each person thinks he's OK because he's sold his risk to some other guy who has sold his risk and on and on. It's hard to tell if the guy I purchased CDS from has too much CDS exposure (too overleveraged) because I don't know how many CDS he's sold or purchased since the time I originally purchased CDS from him.
Some limit has to be set for the amount of CDS exposure a firm has given his capital base. That amounts to a limit on leverage. A clearinghouse would make the market more transparent so I can see that there is way too many CDS out there for the CDS I just purchased to be considered safe. Right now there is no way for the individual actor to see the entire whole and the entire whole has a great impact on the individual actor. That is part of the problem. We need to think about the issues and come up with good solutions, I don't think banning CDS is even remotely close to the best solution.
Argument Against Modern Monetary Theory and the New Keynesians
Can the FED can print all the money it wants to? Not without bad consequences, the ultimate being a Zimbabwe-like collapse of the monetary system.
What is missing from the discussion that of confidence. For the dollar to be an unit of account and store of value, society needs to have confidence that the numbers aren't being fudged, that whatever savings I've built up, my delayed consumption, isn't being manipulated.
Proponents of MMT and New Keynesian economics have pointed out that the government doesn't even need to issue bonds, it could just give itself dollars and spend up to the point where it can purchase 100% of the goods and services offered in the economy. Actually it can't, the monetary system would collapse well before the 100% and people would stop accepting dollars as money because they would have lost confidence in it as a fair and accurate unit of measurement. If even a dictatorship like Zimbabwe isn't able to compel its citizens to accept and use their worthless unit of account, I doubt the US Govt. would be able to.
The reason the government issues bonds at all (that is borrow) is to provide an open and transparent account and to assure the public that the dollar remains a good and fair measurement of the future consumption that they have saved. People want to know that, if they have saved $5 and that can purchase a sandwich at a fast food chain, they will wake up tomorrow and still have a sandwich "due to them" whenever they want it in the future. If they wake up and the $5 in their bank account can't buy them a sandwich anymore, then they know they've been had. Add expected inflation into the mix if you want a more accurate explanation.
When the government borrows money, the public knows that either future government spending will have to decrease, allowing the public to consume more (purchasing bonds is a way to delay consumption to the future), or the public will give up that future consumption in the form of higher taxes. Taxes are very visible and politicians are reluctant to raise taxes without implied consent from the public.
The FED printing money on the other hand, is a stealth tax that is not transparent and is not accounted for. At least with open market operations we can see how much the FED has printed, but as an independent agency that is not directly elected, the people have limited means to control the actions of the FED. No taxation without representation! That's a notion fundamental to our ethos. There are many reasons why FED printing of money and uncontrolled government money creation should be avoided.
Only under a communist dictatorship with an iron grip over society tighter than even Stalin was able to achieve, could government create money like the MMT/New Keynesians advocate. If I have $30000 in my bank account and the government all of a sudden types in $1,000,000,000,000 and posts it to their own account, I know all I've worked for my entire life amounts to nothing. Perhaps this gives a clue as to why people are so pissed off right now and are electing "extremists" like Rand Paul, who seem to understand better than the MMT folks.
What is missing from the discussion that of confidence. For the dollar to be an unit of account and store of value, society needs to have confidence that the numbers aren't being fudged, that whatever savings I've built up, my delayed consumption, isn't being manipulated.
Proponents of MMT and New Keynesian economics have pointed out that the government doesn't even need to issue bonds, it could just give itself dollars and spend up to the point where it can purchase 100% of the goods and services offered in the economy. Actually it can't, the monetary system would collapse well before the 100% and people would stop accepting dollars as money because they would have lost confidence in it as a fair and accurate unit of measurement. If even a dictatorship like Zimbabwe isn't able to compel its citizens to accept and use their worthless unit of account, I doubt the US Govt. would be able to.
The reason the government issues bonds at all (that is borrow) is to provide an open and transparent account and to assure the public that the dollar remains a good and fair measurement of the future consumption that they have saved. People want to know that, if they have saved $5 and that can purchase a sandwich at a fast food chain, they will wake up tomorrow and still have a sandwich "due to them" whenever they want it in the future. If they wake up and the $5 in their bank account can't buy them a sandwich anymore, then they know they've been had. Add expected inflation into the mix if you want a more accurate explanation.
When the government borrows money, the public knows that either future government spending will have to decrease, allowing the public to consume more (purchasing bonds is a way to delay consumption to the future), or the public will give up that future consumption in the form of higher taxes. Taxes are very visible and politicians are reluctant to raise taxes without implied consent from the public.
The FED printing money on the other hand, is a stealth tax that is not transparent and is not accounted for. At least with open market operations we can see how much the FED has printed, but as an independent agency that is not directly elected, the people have limited means to control the actions of the FED. No taxation without representation! That's a notion fundamental to our ethos. There are many reasons why FED printing of money and uncontrolled government money creation should be avoided.
Only under a communist dictatorship with an iron grip over society tighter than even Stalin was able to achieve, could government create money like the MMT/New Keynesians advocate. If I have $30000 in my bank account and the government all of a sudden types in $1,000,000,000,000 and posts it to their own account, I know all I've worked for my entire life amounts to nothing. Perhaps this gives a clue as to why people are so pissed off right now and are electing "extremists" like Rand Paul, who seem to understand better than the MMT folks.
Wednesday, May 12, 2010
Paulson Deserves Praise
Paulson should be commended for making the right moves to get us out of the crisis. Each time, he was ahead of the curve, he asked Congress for TARP before the crisis actually hit the entire financial system, but Congress took its sweet time debating for a week and then voted no. He asked for a lot of new powers, but did it in many increments because there was just no way Congress would consent to authorize all that he knew he would need, at once.
People criticize him for not rescuing Lehman, but don't take into consideration the political impossibility of bailing out both AIG and Lehman at the time. Only after things got worse and people saw the effects of the crisis were they willing to concede that Paulson needed all that power and money.
I say this with all honesty, it's really too bad that people always have conspiracy theories and look through a political filter. Paulson should be thanked for taking the personal abuse and for putting his ego aside and begging Pelosi on his knees, to authorize TARP because he knew that a failure to authorize would destroy the US financial system and cause another depression.
A less competent would not have come up with TARP and understood that he needed a "bazooka", though it was politically impossible to ask for several trillion all at once. A less competent person would have been frozen in fear and asked too little or waited for the crisis to force a move, rather than try and move ahead of the crisis.
For the critics, I ask what he should have done instead? Let's put impossible demands, like prevent the crisis, aside, since he's isn't God and he didn't arrive at Treasury until the bubble was already in full bloom.
Sometimes it saddens me to see so many people so unreasonable and with such a distorted view. If it's on an event that really doesn't matter, then I just shrug it off, but this was a genuine moment where we could have fallen off of a cliff into disaster. That this man is not getting any credit for saving us from another great depression is simply unfair. Was he perfect, no, but he was about as perfect as you can be without the benefit of hindsight and in a crisis without precedence. Give the man the recognition he deserves.
People criticize him for not rescuing Lehman, but don't take into consideration the political impossibility of bailing out both AIG and Lehman at the time. Only after things got worse and people saw the effects of the crisis were they willing to concede that Paulson needed all that power and money.
I say this with all honesty, it's really too bad that people always have conspiracy theories and look through a political filter. Paulson should be thanked for taking the personal abuse and for putting his ego aside and begging Pelosi on his knees, to authorize TARP because he knew that a failure to authorize would destroy the US financial system and cause another depression.
A less competent would not have come up with TARP and understood that he needed a "bazooka", though it was politically impossible to ask for several trillion all at once. A less competent person would have been frozen in fear and asked too little or waited for the crisis to force a move, rather than try and move ahead of the crisis.
For the critics, I ask what he should have done instead? Let's put impossible demands, like prevent the crisis, aside, since he's isn't God and he didn't arrive at Treasury until the bubble was already in full bloom.
Sometimes it saddens me to see so many people so unreasonable and with such a distorted view. If it's on an event that really doesn't matter, then I just shrug it off, but this was a genuine moment where we could have fallen off of a cliff into disaster. That this man is not getting any credit for saving us from another great depression is simply unfair. Was he perfect, no, but he was about as perfect as you can be without the benefit of hindsight and in a crisis without precedence. Give the man the recognition he deserves.
Wednesday, April 21, 2010
Ratings Agencies: The Monsters Congress Created
It should also be noted that ratings are only important for regulatory reasons. Congress created the game, made these private agencies which are just companies issuing opinions on others, into God-like emperors who pronounce if some debt is worthy of inclusion in a pension fund or not.
Even more important is how AAA securities are treated under Basel and Basel II for capital requirements. AAA securities count 100% towards capital requirements while non-AAA securities start off at 50%. Again, Congress created their own boogeyman through bad regulations. It's important to get regulations right or else very unintended consequences can occur.
People should understand that no large investment or financial management company depends upon ratings to determine risk. Everyone from Fidelity to Paulson with his hedge fund has their own analysts and do their own research. No one except for maybe mom and pop (they probably aren't buying CDOs) use S&P, Moodys, or any agency to determine the risk level of default.
Then why are the agencies important? Because Congress made them so. They're part of the regulatory process thanks solely to Congress. And Congress has frozen out all other competitors, even those who have better track records, only a certain select few ratings agencies can issue ratings that "count" towards regulatory requirements.
Thanks to regulations, it was just too tempting for certain greedy institutions to hold AAA securities that count 100% towards capital requirements and pay a good yield over AAA US Treasuries. The very fact that CDO AAA always yielded more than AAA corporate bonds which in turn always yielded more than AAA US Treasuries shows that the market was aware that not all AAA were created equal. But since regulations treated them equally, we have a little discrepancy that ended up fueling (along with a bunch of other factors) the crisis. Now can people understand why regulations have to be very carefully crafted and the urge to just pass any regulation is probably very stupid?
Even more important is how AAA securities are treated under Basel and Basel II for capital requirements. AAA securities count 100% towards capital requirements while non-AAA securities start off at 50%. Again, Congress created their own boogeyman through bad regulations. It's important to get regulations right or else very unintended consequences can occur.
People should understand that no large investment or financial management company depends upon ratings to determine risk. Everyone from Fidelity to Paulson with his hedge fund has their own analysts and do their own research. No one except for maybe mom and pop (they probably aren't buying CDOs) use S&P, Moodys, or any agency to determine the risk level of default.
Then why are the agencies important? Because Congress made them so. They're part of the regulatory process thanks solely to Congress. And Congress has frozen out all other competitors, even those who have better track records, only a certain select few ratings agencies can issue ratings that "count" towards regulatory requirements.
Thanks to regulations, it was just too tempting for certain greedy institutions to hold AAA securities that count 100% towards capital requirements and pay a good yield over AAA US Treasuries. The very fact that CDO AAA always yielded more than AAA corporate bonds which in turn always yielded more than AAA US Treasuries shows that the market was aware that not all AAA were created equal. But since regulations treated them equally, we have a little discrepancy that ended up fueling (along with a bunch of other factors) the crisis. Now can people understand why regulations have to be very carefully crafted and the urge to just pass any regulation is probably very stupid?
Government Failure: Another Example
Regulations will not work if the regulators refuse to do their jobs. With regards to the massive $8 billion dollar Robert Allen Stanford fraud, the SEC did just that. An internal report released on the same day the Goldman case was filed (of course), revealed that the SEC knew of the fraud as far back as 1997.
It is any wonder why I am so cynical over government control and fixes for our economy?
The OIG investigation found that the SEC’s Fort Worth office was aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme, having come to that conclusion a mere two years after Stanford Group Company (“SGC”), Stanford’s investment adviser, registered with the SEC in 1995. We found that over the next 8 years, the SEC’s Fort Worth Examination group conducted four examinations of Stanford’s operations, finding in each examination that the CDs could not have been “legitimate,” and that it was “highly unlikely” that the returns Stanford claimed to generate could have been achieved with the purported conservative investment approach. Fort Worth examiners dutifully conducted examinations of Stanford in 1997, 1998, 2002 and 2004, concluding in each case that Stanford’s CDs were likely a Ponzi scheme or a similar fraudulent scheme. The only significant difference in the Examination group’s findings over the years was that the potential fraud grew exponentially, from $250 million to $1.5 billion.
While the Fort Worth Examination group made multiple efforts after each examination to convince the Fort Worth Enforcement program (“Enforcement”) to open and conduct an investigation of Stanford, no meaningful effort was made by Enforcement to investigate the potential fraud or to bring an action to attempt to stop it until late 2005. In 1998, Enforcement opened a brief inquiry, but then closed it after only 3 months, when Stanford failed to produce documents evidencing the fraud in response to a voluntary document request from the SEC. In 2002, no investigation was opened even after the examiners specifically identified multiple violations of securities laws by Stanford in an examination report. In 2003, after receiving three separate complaint letters about Stanford’s operations, Enforcement decided not to open an investigation or even an inquiry, and did not follow up to obtain more information about the complaints.
It is any wonder why I am so cynical over government control and fixes for our economy?
Friday, April 16, 2010
More Thoughts on SEC vs. Goldman Sachs
Didn't ACA, IKB, and everyone else have the same information on the RMBS in the CDO as Paulson did? That the great Paulson wanted to bet against this CDO was of supreme importance, why? Because he's an omniscient god?
Goldman acted as a broker/middle-man. It's not their responsibility to advise against trades that they don't think will work out well. Imagine if you entered a market buy order for Goldman stock on Monday and it was canceled because your broker thought that would be a stupid move. I'd be furious.
My take is that Paulson thought the subprime real estate market was going to hell and he needed a way to make a bet. So he asked Goldman to find a manager, ACA, that would structure something he could bet against. Paulson could have been wrong, he had no special information on the RMBS he picked along with ACA correct? He was just smarter and better than everyone else who had the same information. The information included credit scores, loan-to-value, etc., Paulson's opinion of the mortgages and of the real estate market isn't relevant. Is he God?
People are looking at this in retrospect with perfect hindsight. I ask you all to come up with a list of 10 stocks that you want included in some sort of "sure to lose money" index. The point is that Paulson had nothing to do with the low yields the buyers were willing to take or the low payments the CDS issuer was willing to accept for writing insurance. The more I understand the situation, the more I think this is totally BS!
Goldman acted as a broker/middle-man. It's not their responsibility to advise against trades that they don't think will work out well. Imagine if you entered a market buy order for Goldman stock on Monday and it was canceled because your broker thought that would be a stupid move. I'd be furious.
My take is that Paulson thought the subprime real estate market was going to hell and he needed a way to make a bet. So he asked Goldman to find a manager, ACA, that would structure something he could bet against. Paulson could have been wrong, he had no special information on the RMBS he picked along with ACA correct? He was just smarter and better than everyone else who had the same information. The information included credit scores, loan-to-value, etc., Paulson's opinion of the mortgages and of the real estate market isn't relevant. Is he God?
People are looking at this in retrospect with perfect hindsight. I ask you all to come up with a list of 10 stocks that you want included in some sort of "sure to lose money" index. The point is that Paulson had nothing to do with the low yields the buyers were willing to take or the low payments the CDS issuer was willing to accept for writing insurance. The more I understand the situation, the more I think this is totally BS!
SEC vs. Goldman II
I was wrong and Goldman only acted as a middleman/broker in the transactions, they did not directly issue CDS and did not have positions in any of the transactions.
As I read more and more, it seems the SEC is really going to have a hard time proving anything. All Goldman did was find participants, they acted as a market-finder and had no skin in the game. Were they supposed to issue updates on what one of their customers, Paulson, was doing? Or basically say to the CDS issuer, "Hey, don't you know the great Paulson is on the other side of the trade? He's never wrong, and you're going to get taken!".
I think I understand the situation almost completely now. Paulson saw the crisis coming and wanted to bet against housing. But how? There isn't a subprime mortgage index or anything like that so he first had to create a reference index that he could bet against. That was the CDO made up of subprime loans rated Baa2 that he expected would be in trouble. So he asked Goldman to find someone who could act as an asset manager and structure such a CDO so that he could bet against it. Goldman did in ACA. ACA had all the information Paulson did on credit scores and so forth, and subsequent investors would also. After the CDO was structured, Paulson bought CDS on it and he turned out to be correct. Those issuing the CDS had the relevant information, that Paulson wanted to bet against this CDO all along wasn't relevant. It's like if I bought Goldman Sachs tomorrow and I didn't know George Soros was selling me his shares. So what? I'm buying because I see that the SEC has no case, who cares if Soros is selling?
If there is a culprit here, it is Paulson, not Goldman who only acted as broker. Still it is a stretch, Paulson didn't have any information that wasn't available to everyone else. He was just smarter and better.
As I read more and more, it seems the SEC is really going to have a hard time proving anything. All Goldman did was find participants, they acted as a market-finder and had no skin in the game. Were they supposed to issue updates on what one of their customers, Paulson, was doing? Or basically say to the CDS issuer, "Hey, don't you know the great Paulson is on the other side of the trade? He's never wrong, and you're going to get taken!".
I think I understand the situation almost completely now. Paulson saw the crisis coming and wanted to bet against housing. But how? There isn't a subprime mortgage index or anything like that so he first had to create a reference index that he could bet against. That was the CDO made up of subprime loans rated Baa2 that he expected would be in trouble. So he asked Goldman to find someone who could act as an asset manager and structure such a CDO so that he could bet against it. Goldman did in ACA. ACA had all the information Paulson did on credit scores and so forth, and subsequent investors would also. After the CDO was structured, Paulson bought CDS on it and he turned out to be correct. Those issuing the CDS had the relevant information, that Paulson wanted to bet against this CDO all along wasn't relevant. It's like if I bought Goldman Sachs tomorrow and I didn't know George Soros was selling me his shares. So what? I'm buying because I see that the SEC has no case, who cares if Soros is selling?
If there is a culprit here, it is Paulson, not Goldman who only acted as broker. Still it is a stretch, Paulson didn't have any information that wasn't available to everyone else. He was just smarter and better.
Analysis of SEC's Case Against Goldman Sachs
Those who want to read the actual complaint made by the SEC should go here. After reading the complaint, the SEC's case can be split into two parts.
PART 1
Goldman mislead ACA, the third party picked to head selection of securities, that Paulson, a person also involved in the selection of securities to be included, would have skin in the game of the final CDO.
On January 10, 2007, Tourre sent an email to ACA with the subject line, “Transaction Summary.” The text of Tourre’s email began, “we wanted to summarize ACA’s proposed role as ‘Portfolio Selection Agent’ for the transaction that would be sponsored by Paulson (the ‘Transaction Sponsor’).” The email continued in relevant part, “[s]tarting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility aroundthe names.”
then
Considering that what Goldman described was a CONTEMPLATED capital structure, I think this alleged deception will be very hard for the SEC to prove. It's up to ACA to do due diligence as they were hired to do just that, act as a neutral third party analyst for the selection of securities to be included in the CDO.
Later on, ACA's parent company would write insurance on the CDO. The SEC claims that ACA wouldn't have done so if they knew that Paulson had gone short (bet against the CDO since he helped pick the underlying securities. However I think that's a very weak argument as ACA also helped pick and had ultimate say in that they could have refused to put their name on a CDO they didn't like.
Part 2
Goldman did not disclose to investors that the selection process involved Paulson who had a short position against some of the underlying securities or similar securities.
I think this is the only place where the SEC might have a case. But did Goldman have to disclose Paulson's role? After all, Paulson is just another client of the firm and so does it have to keep track of what each and every client is doing? What if Paulson had entered into short positions with another firm instead of Goldman, clearly then Goldman would not have known (but he didn't). It was known that the underlying securities would be based on subprime mortgages rated Baa2, does Goldman have to reveal that Paulson, who played a part in the selection of the particular mortgages, had a negative view of the mortgage market and bet against those securities?
In the end, a stupid German commercial bank, IKB, decided to purchase $150 million of the CDO in two tranches. They lost just about all of the $150 million while Paulson, who had purchased credit default swaps on the underlying securities, profited. The CDS was purchased through Goldman, which means that Goldman "lost" money as they had to pay out on the CDS. That will add complications to the SEC case, but the SEC claims that the money IKB lost went to Paulson which isn't directly true. IKB lost money through purchasing a CDO offered by Goldman. Paulson made a bet on securities that the CDO was based upon or similar securities and collected his insurance money from Goldman. Goldman "won" with IKB and "lost" with Paulson, it doesn't follow that IKB's money went to Paulson. We'll have to see what happens, but this is by no means an open and shut case.
PART 1
Goldman mislead ACA, the third party picked to head selection of securities, that Paulson, a person also involved in the selection of securities to be included, would have skin in the game of the final CDO.
On January 10, 2007, Tourre sent an email to ACA with the subject line, “Transaction Summary.” The text of Tourre’s email began, “we wanted to summarize ACA’s proposed role as ‘Portfolio Selection Agent’ for the transaction that would be sponsored by Paulson (the ‘Transaction Sponsor’).” The email continued in relevant part, “[s]tarting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility aroundthe names.”
then
47.
On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction
Considering that what Goldman described was a CONTEMPLATED capital structure, I think this alleged deception will be very hard for the SEC to prove. It's up to ACA to do due diligence as they were hired to do just that, act as a neutral third party analyst for the selection of securities to be included in the CDO.
Later on, ACA's parent company would write insurance on the CDO. The SEC claims that ACA wouldn't have done so if they knew that Paulson had gone short (bet against the CDO since he helped pick the underlying securities. However I think that's a very weak argument as ACA also helped pick and had ultimate say in that they could have refused to put their name on a CDO they didn't like.
61.
ACA’s parent company, ACA Capital Holdings, Inc. (“ACA Capital”), provided financial guaranty insurance on a variety of structured finance products including RMBS CDOs, through its wholly-owned subsidiary, ACA Financial Guaranty Corporation. On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.
62.
ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1.
63.
The super senior transaction with ACA Capital was intermediated by ABN AMRO Bank N.V. (“ABN”), which was one of the largest banks in Europe during the relevant period. This meant that, through a series of CDS between ABN and Goldman and between ABN and ACA that netted ABN premium payments of approximately 17 basis points per year, ABN assumed the credit risk associated with the super senior portion of ABACUS 2007AC1’s capital structure in the event ACA Capital was unable to pay.
Part 2
Goldman did not disclose to investors that the selection process involved Paulson who had a short position against some of the underlying securities or similar securities.
41.
On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio.
I think this is the only place where the SEC might have a case. But did Goldman have to disclose Paulson's role? After all, Paulson is just another client of the firm and so does it have to keep track of what each and every client is doing? What if Paulson had entered into short positions with another firm instead of Goldman, clearly then Goldman would not have known (but he didn't). It was known that the underlying securities would be based on subprime mortgages rated Baa2, does Goldman have to reveal that Paulson, who played a part in the selection of the particular mortgages, had a negative view of the mortgage market and bet against those securities?
In the end, a stupid German commercial bank, IKB, decided to purchase $150 million of the CDO in two tranches. They lost just about all of the $150 million while Paulson, who had purchased credit default swaps on the underlying securities, profited. The CDS was purchased through Goldman, which means that Goldman "lost" money as they had to pay out on the CDS. That will add complications to the SEC case, but the SEC claims that the money IKB lost went to Paulson which isn't directly true. IKB lost money through purchasing a CDO offered by Goldman. Paulson made a bet on securities that the CDO was based upon or similar securities and collected his insurance money from Goldman. Goldman "won" with IKB and "lost" with Paulson, it doesn't follow that IKB's money went to Paulson. We'll have to see what happens, but this is by no means an open and shut case.
SEC Has Weak Case Against Goldman
Today, the SEC filed civil charges against Goldman, a short summary from the NY Times reads,
After reading more details of this transaction, I'm not sure if the SEC has a case or not. ACA knew that Paulson was involved with picking the securities, they exchanged e-mails with him and both negotiated over which securities would be included in the CDO.
It seems the whole SEC case hinges on the fact that Goldman did not disclose Paulson had purchased Credit Default Swaps (CDS) on some of the underlying securities from Goldman, and was involved with ACA in the initial selection process. However someone else on Felix Salmon's blog raised a really good issue,
This will be a very hard case and is not a clear case of wrongdoing. Goldman was not an underwriter, they were just the broker in the deal. There's no guarantee that anything a broker sells has to be a "good" security in the eyes of the broker or the seller. It's like a yard sale, the buyer knows that the stuff there is junk in the eyes of the seller, but one man's junk is another's treasure. In the financial world, no one is omniscient, Paulson turned out to be right, but ACA had the opportunity to review the proposed list of securities, made revisions, and agreed to the final list. They could have rejected any of the securities on the list, and in fact did reject 21 out of the initial list as well as pick the replacement securities. It was a negotiation and ACA is a big boy who should have done better analysis (actually it's really the willingness of subsequent investors to accept risk for such a low yield). The fact that these were to be based on subprime mortgages at the Baa2 credit level underscores that this wasn't going to be as safe as a government bond.
The only fault I can see is that Goldman didn't correct ACA's false assumptions that Paulson was long in the fund.
All the instant analysis on the mainstream news sites don't do justice to the complexity of the issue. It's a good thing there are blogs out there that will provide real analysis from people who understand the business, but that's bad for the SEC as the deeper you look into the case, the worse it appears for the SEC.
Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.
After reading more details of this transaction, I'm not sure if the SEC has a case or not. ACA knew that Paulson was involved with picking the securities, they exchanged e-mails with him and both negotiated over which securities would be included in the CDO.
On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55.”
It seems the whole SEC case hinges on the fact that Goldman did not disclose Paulson had purchased Credit Default Swaps (CDS) on some of the underlying securities from Goldman, and was involved with ACA in the initial selection process. However someone else on Felix Salmon's blog raised a really good issue,
“After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure.”
In other words Paulson bought insurance for the underlying portfolio from Goldman.
If the underlying portfolio fails–or if it were to fail–Goldman will have to post collateral.
If Goldman knew that these are bad securities (implying that at some point it has to post collateral to Paulson & Co.) then why would GS structure them in a way that Paulson wants?
Even if for some strange reason GS did structure it the way Paulson wanted and got a fee in return, how can GS be held culpable, given the fact it is long on the underlying insurance?"
This will be a very hard case and is not a clear case of wrongdoing. Goldman was not an underwriter, they were just the broker in the deal. There's no guarantee that anything a broker sells has to be a "good" security in the eyes of the broker or the seller. It's like a yard sale, the buyer knows that the stuff there is junk in the eyes of the seller, but one man's junk is another's treasure. In the financial world, no one is omniscient, Paulson turned out to be right, but ACA had the opportunity to review the proposed list of securities, made revisions, and agreed to the final list. They could have rejected any of the securities on the list, and in fact did reject 21 out of the initial list as well as pick the replacement securities. It was a negotiation and ACA is a big boy who should have done better analysis (actually it's really the willingness of subsequent investors to accept risk for such a low yield). The fact that these were to be based on subprime mortgages at the Baa2 credit level underscores that this wasn't going to be as safe as a government bond.
This occurred on February 2, 2007: “Later the same day, ACA emailed Paulson, Tourre, and others at GS&Co a list of 82 RMBS on which Paulson and ACA concurred, plus a list of 21 “replacement” RMBS. ACA sought Paulson’s approval of the revised list, asking, “Let me know if these work for you at the Baa2 level.”
The only fault I can see is that Goldman didn't correct ACA's false assumptions that Paulson was long in the fund.
On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction…
On February 12, 2007, ACA’s Commitments Committee approved the firm’s participation in ABACUS as portfolio selection agent. The written approval memorandum described Paulson’s role as follows: “the hedge fund equity investor wanted to invest in the 0- 9% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities.”
All the instant analysis on the mainstream news sites don't do justice to the complexity of the issue. It's a good thing there are blogs out there that will provide real analysis from people who understand the business, but that's bad for the SEC as the deeper you look into the case, the worse it appears for the SEC.
Monday, January 4, 2010
Monday, December 28, 2009
Fixing Corporate America
What we need are interests of owners (shareholders) and managers to be aligned, and a mechanism for owners to enforce discipline on mangers. With alignment, fraud and taking huge risks would not happen, Enron and the housing mortgage bubble would not have happened. All government needs to do is to legally empower owners to have control over what they own.
Why have we not employed this solution yet? Because it benefits neither government nor the managers who donate money to government. There is huge opposition by managers who are able to game the current system, and government has no incentive to make the changes needed so only inferior reforms are proposed.
All the reforms so far being discussed focus on empowering the government to act on behalf of owners to discipline managers. However that solution is far inferior to giving owners direct power to discipline. With government, interests are still not aligned. Government has its own agenda, some of which do not match that of owners. Owners would trade one master for another, and with government, an even more powerful master.
Those who are truly interested in stopping the abuse and ending what John Bogle calls Manager's Capitalism, need only to increase the power and ease by which owners can set manager pay and replace bad managers. Right now managers set their own pay by stacking compensation committees with other managers, and by staggering board nominations and preventing alternative proposals from appearing on the official, company paid, voting documents sent to each and every shareholder. This sets a high bar for shareholders to organize and inform other shareholders of an alternate slate of management. It also makes it difficult to set pay, the very best that can be done is to reject a compensation proposal, but shareholders can never actually make their own proposal without using their own money to mail and inform other shareholders that such a proposal exists.
The current abuse of the corporate structure can be solved, but there has to be enough will to make the right choices, for government officials and politicians to actually want to solve the problem rather than just increasing their own power and importance. That is the high bar to jump, it won't be easy, which is why there are no proposals being seriously discussed that will actually solve what ails corporate America.
Thursday, October 29, 2009
Observations on Bubbles
Bubbles are only obvious after the fact. I thought there was a housing bubble, but I also thought we had a bond bubble too when 30-year Treasury bonds were near 5%. It could be that the bond bubble is still ongoing and will pop soon, or next year, or not at all. Gold is another case. I don't think there is a bubble in gold, the heightened attention paid to it reflects the unease people feel towards the ballooning balance sheets of central banks and the unsupportable budget deficits of certain nations. Yet there are others who think gold is pretty much worthless outside its value for industrial purposes. Is gold in a bubble right now? Too hard to say. Should gold drop to $450 then it becomes obvious and we can look back at the gold bubble and blast the idiots who couldn't see something so obvious. Stock market P/E has been higher than average and in bubble mode since the early 90's, yet even after this meltdown we're way higher.
What I think we need to focus on are the types of events or bubbles that can bring down the financial system. This has to do with leverage and allowable risks to our banks. The dot com bubble hurt, but wasn't as damaging as this crisis because banks didn't stand a chance of going under, they were not exposed enough to the bubble to cause a financial system meltdown. However banks are tied to real estate in a much great fashion, here is where a bubble can do great harm.
In the future, we have to make sure leveraged firms don't have their eggs in one basket and that not all firms that are leveraged are exposed to the same risks. Should all banks start lending out cheap money for margin accounts tied to gold, then the price of gold would have a great impact and could cause a crisis like this one. It's the banks and the leverage that is the problem. If we can eliminate the risk of many banks going under at the same time, then we've solved the problem, crises will no longer be as severe as this one.
Large banks should have higher capital requirements, and lower leverage allowances. Smaller banks will have looser requirements, but the regulator needs to see if they are all betting on the same thing and if that poses a danger to the entire system should the bet turn out badly.
Almost forgot, bubbles are almost always the result of easy credit. Bubbles can't form without credit, in every case I can think of, credit was the hidden accomplice, perhaps even the mastermind that causes bubbles. No credit, not enough "fuel" for a bubble to develop. I think we're seeing a lot more bubbles recently because the FED just will not allow credit to contract, they keep on trying to reinflate the bubble, even now there are calls for more loans and credit to be made available. I think the FED's monetary policy is severely flawed, the default rate in normal times is too low and they refuse to tighten until its too late due to pressure to allow good economic times to continue (the economy is always referred to as bad, no matter what, even when we had below 5% unemployment in order to create pressure for more rate cuts). The FED has to break the cycle or we'll have another bubble shortly, the aftermath of reflating the housing bubble.
Friday, April 10, 2009
Securitization and Conspiracies
What the financial system does is match savers with borrowers, that's all in the grand scheme of things. That simple task is actually quite hard, just as matching two people in search of love is very hard.
The point is that there is no conspiracy or Illuminati behind the scenes pulling strings. All the credit derivatives and other tools are there to help money from savers flow to borrowers. Of course each saver has his own risk tolerance and most people don't have the time to check out every potential borrower for credit worthiness. That's why we pool savings together into banks, who vet the borrowers, or purchase bonds through mutual funds who also do research.
Securitization splits risk into different sections so that money from low risk savers can still find its way to high risk borrowers. It is a tool and is incredibly useful. Before, a high risk borrower like GM needed to find a high risk saver willing to lend at appropriate yields. Now, GM's debt is bundled, maybe with other companies, and then chopped up so that grandma's savings can be used to purchase senior tranches which are much less risky than whole GM bonds.
The problem wasn't securitization or chopping up debt. It was that the tranches were mis-priced and mis-allocated. Turns out that not as much of the bundle can be treated as relatively safe. Instead of 92% of a bundle being AAA, more like 88% is or something like that. Once more data is collected, the system will work better, but one thing is for sure, we'll never go back to life without these tools. That would be stupid. Just because a madman like OJ Simpson used a knife to kill two people doesn't mean the rest of society will stop using knives. Securitization is here to stay and it's not a conspiracy or some trick. It's just a tool to allow savers to lend to borrowersSaturday, February 7, 2009
The Road Ahead
The more I dig into this, the more I realize that there is no easy way out. Recapitalizing a worthless bank pretty much guarantees a loss for the taxpayer. The taxpayer will have to eat the losses first just to get the bank back up to $0 book value, then pump more money in to move equity into positive territory. Now the taxpayer could make that money back in the future, but that's far from assured, what's clear is that the taxpayer is "overpaying", which is why private equity doesn't step in right now.
We have to figure out a way for taxpayers to be able to make money through future profits or a future sale. However, we also don't want government to run the bank because government is terrible at running things and politics would enter into the daily operations of the bank. If only we could trust that politicians wouldn't interfere but we know they will by demanding loans to "low income" borrowers (translation: ultra-high risk subprime borrowers) and to forgive outstanding mortgages in default. That means more bad loans will be made and the nationalized bank will face insolvency again a few years down the road, the crisis will be prolonged.
That's why we have very little choice but to use taxpayer money to recapitalize the banks while still making sure they are in private hands. The government can and SHOULD demand changes to the Board, but only qualified bankers should replace those ousted, please no more political hacks like Daschle, maybe someone competent like Warren Buffet would take the job as a service to the country. The Board would decide on a new CEO, again with the sole focus on competency and profitability. That might mean financial sector employees further down the ranks would be promoted or given the CEO job. Again, there will be the usual cries of enriching Wall Street, but only people with banking experience can be expected to run a bank. Those calls will have to be ignored and Obama will have to use his golden voice to explain that to the public. Obama will lose favor with the leftist extremists who are out of touch with reality, and be called just another Bush. He will have to take the criticism for the sake of doing what's best and hopefully he will be able to articulate why only Wall Street people are being given CEO jobs. A tough task lies ahead.
Friday, January 2, 2009
Obama Offers Conservatives Hope
Does it seem disquieting to anyone that Obama seems to be "staying the course" with respect to overall foreign and domestic policy? I commend Obama for using his brain and continuing the policies that make sense and are best for America.
Look at Obama's choices on the economic front. Romer, Summers, Geithner, and Bernanke to continue in his current role. These are incredibly sensible and wise choices that have to make any liberal angry. If Republicans had to choose among Democrats, they would not be able to come up with a better slate. Volker is also well liked among Republicans and he will continue to advise Obama. This is the sort of change that will make Obama into a good president, changing the Democrats into a party that focuses on efficiency and regulations that work without imposing massive burdens.
On the foreign policy front, Clinton is a hawk within the Democratic party and Obama even more hawkish. I can't distinguish Obama's foreign policy from that of McCain, other than Obama seems willing to invade and bomb Pakistan while McCain is more dovish.
Again, it seems that the image Democrats have of Obama is different than the one I'm seeing. There hasn't been any indication that Obama would be the radical that destroys America as we know it. He seems smart enough to pursue wise policies and has done a great job in recruiting smart, experienced Cabinet members that will continue the good policies of the past.
Bush was an incompetent manager. It wasn't that all his policies were bad, especially on the foreign policy frong, it was that they were all badly executed. With a competent person behind it all, we could see great gains. We needed a change in quarterbacks, not gameplans. The gameplan remains solid as ever, but the right quarterback can make the difference between a pitiful looking team and a Superbowl winning team.
So when Krugman looks out and sees a radical change, he's imaging things again. Yes the outcome can be very different when incompetence is replaced; a football play can look ugly if executed badly, yet be a thing of beauty when executed as planned. Obama could be the perfect quarterback for our Run N' Shoot offense.
Look at Obama's choices on the economic front. Romer, Summers, Geithner, and Bernanke to continue in his current role. These are incredibly sensible and wise choices that have to make any liberal angry. If Republicans had to choose among Democrats, they would not be able to come up with a better slate. Volker is also well liked among Republicans and he will continue to advise Obama. This is the sort of change that will make Obama into a good president, changing the Democrats into a party that focuses on efficiency and regulations that work without imposing massive burdens.
On the foreign policy front, Clinton is a hawk within the Democratic party and Obama even more hawkish. I can't distinguish Obama's foreign policy from that of McCain, other than Obama seems willing to invade and bomb Pakistan while McCain is more dovish.
Again, it seems that the image Democrats have of Obama is different than the one I'm seeing. There hasn't been any indication that Obama would be the radical that destroys America as we know it. He seems smart enough to pursue wise policies and has done a great job in recruiting smart, experienced Cabinet members that will continue the good policies of the past.
Bush was an incompetent manager. It wasn't that all his policies were bad, especially on the foreign policy frong, it was that they were all badly executed. With a competent person behind it all, we could see great gains. We needed a change in quarterbacks, not gameplans. The gameplan remains solid as ever, but the right quarterback can make the difference between a pitiful looking team and a Superbowl winning team.
So when Krugman looks out and sees a radical change, he's imaging things again. Yes the outcome can be very different when incompetence is replaced; a football play can look ugly if executed badly, yet be a thing of beauty when executed as planned. Obama could be the perfect quarterback for our Run N' Shoot offense.
Wednesday, December 24, 2008
Regulations Caused This Crisis
If there is one thing we should learn from this crisis it is the danger of bad regulations and the unseen danger of unintended consequences. The Basel II regulations put a lot of power in the hands of the ratings agencies. These agencies are the only ones allowed "in the game" by law, I'm talking about S&P, Moody's, etc. Go to the link below for the full list of ten.
A Nationally Recognized Statistical Rating Organization (or "NRSRO") is a credit rating agency which issues credit ratings that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes.
http://en.wikipedia.org/wiki/Nationally_Recognized_Statistical_Rating_Organizations
Thanks to the REGULATIONS we ALREADY HAD, financial institutions were eager to separate their subprime debt into AAA securities and left over toxic waste. Unfortunately, those AAA securities weren't as safe as the ratings agencies said they were and became toxic themselves.
Regulations made a protected cabal of agencies free from other competition. Regulations allowed these agencies to affect the capital requirements of large financial institutions. AAA securities count toward capital more than BBB securities under Basel II.
Regulations caused this financial mess, they set the stage and regulators who were supposed to watch over the system failed to do their jobs.
Let's not pretend there were no regulations. The regulations we had didn't work. Government plans and wise thinking failed and turned out to be very stupid instead of wise. This is just another example of government failure and why we should not put our faith in government. Anyone who looks at the facts and past history can see that the government's record is incredibly poor, the government is incredibly incompetent no matter what party is in power. And for those who believe in the superiority of international regulators, Basel II was push upon us by "the international community". Below is an article with links to other articles.
http://www.allbusiness.com/government/government-procedure-lawmaking/7503196-1.html
The long-awaited implementation of the Basel II capital adequacy accord has been further threatened by US concerns over the results of the recently completed quantitative impact study (QIS4). The four US federal banking agencies (OCC, Federal Reserve, FDIC and OTS) have called for a delay in publishing an important notice of proposed rulemaking (NPR), from the summer to the autumn this year, to allow for further study.
Sunday, December 21, 2008
Defending the TARP's Execution
Below is my response to Alan Blinder's Op-Ed in the New York Times.
The original plan was abandoned because 1) there isn't enough money to buy all the toxic securities out there 2) Since these securities are non-standard and have various structures and terms, buying them through an auction would be a difficult and time consuming process 3) buying securities at market value would expose many banks as being insolvent or below regulatory capital requirements 4) it would be hard to limit purchases to US banks, we would in effect, have to buy all the toxic stuff in the world, how do you prevent foreign banks from selling toxic assets to US banks so that they can be sold to the Treasury? 5) Now you know why there isn't enough money.
The author is indeed dazed and confused. The terms of the capital infusions were favorable because the banks are in trouble. Predatory terms, as with the initial AIG deal, would have been too onerous. Banks need to make money so that they can use the earnings to write off their bad loans, if Treasury takes all of the earnings or even most, then it will take more time for the banks to get better. The whole point of a "bailout" is to HELP, not put banks out of business, thus the 5% preferred shares. And as for non-voting shares, it allows room for private equity investment as it leaves control to the private sector and minimizes government interference on the Board. Furthermore, preferred shares eliminate the need for the government to find people to run the companies they invest in. There are too many companies, and Treasury or FED are ill-equipped to run dozens of companies. Who are the heads to report to? Who will call the shots? Paulson has enough on his hands and even he can't run dozens of separate companies.
Forget about stopping foreclosures, it's a foolish idea and would only prolong the crisis. Real estate prices have fallen so much that it's not possible anymore to pretend that they are anywhere near what someone in foreclosure paid for them. Thanks to that fact, there's very little incentive for a person to continue paying on a mortgage when he'll never see a penny from the eventual sale. Remodify the mortgage and he still has no incentive other than it allows him to rent the property. If rent is cheaper elsewhere, then he'll default again, why should a person pay extra for rent? And that house is, by all accounts, being rented since the mortgage defaulter will never see a penny of profit.
I'm glad Paulson wisely saw the above and chose the best course of action left to him. It's ridiculous to expect a quick or painless end to this crisis. Else it wouldn't be a crisis. There are no easy solutions. Whatever the criticism, the downturn will take its course and NOTHING can change the fact that the losses are real and have to be borne by someone. Nationalizing the banks would just transfer the losses to the taxpayer and cause panic in the stock markets. When government seizes private equity, then appetite for that equity disappears.
Friday, October 24, 2008
Lack of Regulation?
I don't know, we have dozens of government regulatory agencies with thousands of rules and regulations, yet somehow the entire financial sector was unregulated!
Face it folks, the regulations didn't work! The regulators were asleep! This is the problem with regulations and regulators, they often don't work and fail us!
What gave the ratings agencies the power to determine what securities are safe enough to hold in some portfolios?
Oh, regulations!
What made certain institutions purchase only assets that were deemed good enough by the ratings agencies?
Oh, regulations!
What gave these agencies monopoly power and prevented any other company or agency from entering into their business and offering better analysis?
Oh, regulations!!!!
And yet somehow there were no regulations and no regulators?
We have Greenspan's testimony, and somehow the government isn't involved in this crisis? It was a LACK of government? Gee, I guess Greenspan was never appointed by a government official or confirmed by Congress. He was never a part of the Federal government right?
Perhaps a better suggestion would be to craft regulations that work, cut the ones that don't, and be sensible instead of just screaming for more bad regulations.
Face it folks, the regulations didn't work! The regulators were asleep! This is the problem with regulations and regulators, they often don't work and fail us!
What gave the ratings agencies the power to determine what securities are safe enough to hold in some portfolios?
Oh, regulations!
What made certain institutions purchase only assets that were deemed good enough by the ratings agencies?
Oh, regulations!
What gave these agencies monopoly power and prevented any other company or agency from entering into their business and offering better analysis?
Oh, regulations!!!!
And yet somehow there were no regulations and no regulators?
We have Greenspan's testimony, and somehow the government isn't involved in this crisis? It was a LACK of government? Gee, I guess Greenspan was never appointed by a government official or confirmed by Congress. He was never a part of the Federal government right?
Perhaps a better suggestion would be to craft regulations that work, cut the ones that don't, and be sensible instead of just screaming for more bad regulations.
Thursday, October 16, 2008
Bad Regulations Caused This Crisis
Political Calculations provides a great case in point for my skepticism over regulations and regulators. The greatest problem with regulations is their unintended consequences.
And the greatest problem with regulators is that they often do not act until it is too late. Regulators do not respond well to new technologies and new innovations because they are entrenched in a bureaucracy with a well-worn mode of operation. Going outside the box will put a regulator's job in jeopardy if he is wrong or at the very least, cause his actions to be examined. And if you have a cushy job, why rock the boat and put your generous benefits in danger? If all goes to hell, regulators can always just use the age old excuse that they don't have enough resources or that they need new powers and new regulations to do their job correctly.
I've heard too many people expressing a wish for more regulations recently, without any regard as to how these regulations will work and how they will be structured. We need more good regulations, but that's easier said than done. It's crucial we do not make more bad regulations and most of all, we cannot expect regulators to do a better job than they've done in the past. You can't expect a lifelong C student to become an A student. We have to factor in incompetence. Only then can we determine if the regulation is likely to do more good than harm. So far, only the good part is being examined, with nothing on the harm that regulations routinely inflict.
An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.
And the greatest problem with regulators is that they often do not act until it is too late. Regulators do not respond well to new technologies and new innovations because they are entrenched in a bureaucracy with a well-worn mode of operation. Going outside the box will put a regulator's job in jeopardy if he is wrong or at the very least, cause his actions to be examined. And if you have a cushy job, why rock the boat and put your generous benefits in danger? If all goes to hell, regulators can always just use the age old excuse that they don't have enough resources or that they need new powers and new regulations to do their job correctly.
I've heard too many people expressing a wish for more regulations recently, without any regard as to how these regulations will work and how they will be structured. We need more good regulations, but that's easier said than done. It's crucial we do not make more bad regulations and most of all, we cannot expect regulators to do a better job than they've done in the past. You can't expect a lifelong C student to become an A student. We have to factor in incompetence. Only then can we determine if the regulation is likely to do more good than harm. So far, only the good part is being examined, with nothing on the harm that regulations routinely inflict.
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As I've learned recently, capital requirements (as in Tier I capital, etc.) are the only limit to lending by banks. But the use of SIVs and off balance sheet subsidiaries allowed banks to escape the capital requirements imposed on them. Even without the SIVs, a "well-capitalized" bank only needs a tier 1 ratio of around 8%!
The capital requirement for Fannie, and other GSEs were even lower at around 3%. Back in 2002-4 when Fannie had an accounting scandal, Congress had a chance to reform and limit the outrageous size of the GSEs, but of course this was defeated. Meanwhile Bush pushed for lower down payment requirements and government subsidies to make housing "affordable for all".
The crisis is almost totally due to bad loans, or loans that are underwater. Had the standard 20% down payment been in place, it would have been hard for the majority of the populace to engage in the bubble. Bubbles can only happen when the mainstream populace participates. The 20% equity would have also cushioned the banks from the majority of losses in my opinion as the peak would have been lower to begin with.
Interestingly enough, we're not the only ones with a housing induced crisis. Australia and Spain are only some of the many other nations that similarly experienced a housing bubble. This leads me to the belief that there is a systematic problem within the global financial network. The problem is that bank lending is not constrained adequately. Furthermore, the low interest rate environment does NOT translate into commodity or consumer good inflation thanks to what the modern financial system has developed into, which is a credit based system.
In this new system, firms or agents first identify an investment opportunity (it can be to build a factory or buy an income producing asset that will generate a greater return than the cost of the loan). Banks then lend to the firm or agent. Notice that the identification of the investment opportunity is step number one, not the lending. With a low interest rate environment, the hurdle to clear for a profitable investment is much lower. Borrowers then borrow to acquire assets. I believe this is why we saw asset and commodity inflation but no inflation in goods and services tracked by the CPI. Firms and agents aren't borrowing to consume, they are borrowing to acquire income assets or building a factory (or store) that produces consumer goods and services to sell at a profit. The new production that comes online keeps prices for consumer goods and services down, but the means of production get bid up. The lower the interest rate, the lower the threshold yield needed for a firm or agent to borrow to acquire or build.
I don't think people understand this new system of finance. This is why people are constantly looking for inflation (as measured by CPI) but finding none except in asset prices (which aren't included in CPI) and can't see the connection between the FED's loose monetary policy and the various bubbles (all asset bubbles) that have popped up. In sum, I identify lax leverage limits and the low interest rate environment established by the various central banks as the underlying causes of the crisis.