Goldman Sachs

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News Round-Up

So far the news this week has been very ordinary. Nothing suggests we need to change our expectations about next year that much. That is if we accept the likelihood of a very slow recovery with continuing downside risk. The point being that we have not yet begun to see data that foretells a strong upswing. Things remain tepid to say the least.

Leading Indicators:

Take yesterday’s leading indicators for instance: they rose for the seventh straight month, which is obviously a good thing, but the increase was much weaker than the previous month – the index rose 0.3% in October and 1.0% in September. In fact October’s rise was the weakest in six months. So any headline proclaiming that the recovery remains firmly on track is technically correct, but it misses the crucial aspect of much recent data: there is no momentum. We have forward motion, but is appears to be either fitful or weakening. Our language now is reverting to the inverse of that we used earlier in the year. Back then we spoke of things getting worse ‘less slowly’. Now we speak of things getting better, only less slowly.

I call it sputtering. That’s a technical economics word reserved for dubious and unpredictable growth.

We are definitely sputtering.

Unemployment:

The other data yesterday reinforced this general view. The weekly report for new claims for unemployment assistance showed that we remain stuck just around the weekly loss of 500,000 jobs. Remember that this is not a count of actual net jobs lost because it does not include any reference to new jobs being made, and even in this economy there are new jobs being created all the time. Just nowhere near enough. The good news within the claims data is that the trend is still down: the four week moving average dropped very slightly once more to 514,000. The bad news is that the number of people making long term claims is still climbing and has now reached 4.23 million. Obviously, and this is no news at all at this point, the job market is a very long way from being healthy.

TARP:

It may have slipped your memory but last year we, the taxpayers, provided a ton of money to the banks so that they could pay themselves fat bonuses this year survive. This week’s report by the person installed to take a look at the way TARP was managed – an ex-Goldman guy, who knew there were so many of them? – criticized the Fed’s handling of the way in which the AIG bail-out ended up being a back door bail out of other Wall Street firms.

Surprise.

The issue back then came down to the extremely weak leadership the Fed displayed as they sought to push back against the counter parties who had purchased those infamous Credit Default Swaps we all read about – and contributed to – late last September.

The story goes this way:

AIG sells a ton of totally insane CVDS contracts. The contracts are insane because AIG has nowhere near enough money to pay up on those contracts were they to come due in a cluster. No matter: the geniuses earning those massive bonuses at banks like Goldman and Citi all decide that the risk of a cluster default is so small no one needs to care – and these folks are still employed? – so they not only buy covered contracts they buy ‘naked contracts as well. Lots of them. A ‘naked contract being one where I buy insurance against something I don’t own … like me buying life insurance on your death. These naked contracts are tons of fun and make lots of money for the gamblers traders who get away with it. The problem is that by piling up lots of naked contracts the system is now awash with insurance against a much smaller number of possible events. So instead of stabilizing the market by offering sensible insurance against a default, they destabilize it because single event can cascade across the balance sheets of banks who weren’t even involved in the original deal being covered.

Back to the story …

When the economy soured last year it turns out that the geniuses had been dumb as all hell – are these people still employed? Apparently none had noticed that AIG was way too small to pay up if a cluster of defaults swept through the economy. It’s actually more technical than that: the terms of these contracts includes the posting of collateral. The clever people at Goldman etc realize that it might take time for AIG to get the money together to pay off on the contract so they ask for front money. You know just in case something really insane happens like we need to call in the contract. No that will never happen. But horrors it did. As the credit market tanked the geniuses started to get itchy and asked AIG to ante up more front money. AIG looked in its piggy bank, realized it was empty, and ran to the Fed for help.

Basically the cry from AIG was: bail us out or watch the banking system melt before your eyes.

The Fed, being full of ex-bankers and bank sycophants, jumped right in. They decided to pour in the money needed for AIG to make good on all the calls being made against it.

The big question became how much money is needed?

That’s where the Fed failed. And we ended up getting gouged. Royally gouged.

The big criticism is this: the counter-parties were trying to enforce contracts that, in the absence of the taxpayers, were worth either nothing or, at best, a few cents on the dollar. But AIG was not in bankruptcy, it was being bailed out. So the Fed decided it had, legally, to abide by those contracts. It tried to get the counter-parties to agree to take a hair cut – take less than the 100% they were owed. Only Credit Suisse agreed. All the others, including Goldman, JP Morgan, Citi, Wells Fargo, Bank of America and all the other rogues gallery of taxpayer beneficiaries told the Fed to get lost. They guessed – or knew – that the Fed would have to keep AIG afloat and so the cards were in the bank’s hands. Naturally the Fed, being a Wall Street groupie, caved in and we ended up larding the banks with cash that they most likely would never have seen otherwise.

It appears that the Fed held out on our behalf for all of a nanosecond.

The lawyers will all cry that the Fed have no option: those contracts had to be honored.

To which I reply: balderdash. We had the money. They wanted it. The question is now how much. I would have let them sweat over a weekend. Let the geniuses contemplate their potential losses. then force them to take a decent haircut. Not enough to sink them, although they surely deserved to sink given their stupidity, but enough to make them feel the pain. And enough to reduce the taxpayer bill from the stratospheric levels it late became.

All this has a happy ending of course.

Goldman is back to paying egregious bonuses. AIG complains daily about the invasive nature of its government overseers who – gasp – dare to suggest that the dimwits who nearly sank the Western world should collect merely sensible bonuses this year rather than the normal insane ones they are used to.

The Fed chugs on happily cow-towing to Wall Street. And Tim Geithner, who master minded the cave in, has been promoted.

So all is well.

At least that’s what they all say.

I say we’re headed into another finance inflamed crisis – watch those emerging market asset prices as they streak skyward aided and abetted by our neighborly geniuses.

Are they still employed?

Unfortunately, yes.

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Goldman Sachs Largesse

Ah the holiday spirit.

Overcome, no doubt, by images of Scrooge dancing in their heads, the leaders of Goldman Sachs have come forward and boldly admitted they helped in the great banking screw up. Yes, you heard it: the banks trashed the economy and Goldman was right there at the center of the foul up.

The remedy?

A generous dollop of cash for small businesses. Those would be the little people. You know the ones who don’t inhabit Wall Street.

These poor unwashed will get to benefit from a whopping $500 million being set aside by the generous folks at Goldman. Warren Buffett has been brought on board to lend his sage advice and, I imagine, some legitimacy to the whole deal.

Let me see now … Goldman sets aside $500 million for small business. And $16.71 billion for compensation for its poor employees. A quick calculation reveals that the little people are worth about 3% of the big people’s salaries and bonuses.

Oh the generosity.

Now I am all for rewarding excellence. And I am sure that the lovely folks over at Goldman are truly amazingly clever.

But.

They are only still in business because we bailed them out. That makes them somewhat less clever then they think they are. And probably not $16.71 billion clever.

However I also think they’re smart enough to make sure that the $500 million will be tax deductible. In which case their generosity is being subsidized by … the very little people the program is meant to help.

Ouch.

And these guys wonder why finance has such rotten reputation.

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Contingent Convertible Debt? A Quick Primer For Finance Jocks.

Just a quick addition to my comments so far this week:

Just when you thought it was safe, out pops another miserable acronym. Finance is awash with silly names and jargon – those lawyers must be paid huge fees to think this stuff up.

Today’s hot new acronym is ‘Co-Co’, as in contingent convertible bonds, is becoming all the rage in banking discussion circles.

Just what are these ‘co-co’s’?

They are a new breed of bond a bank can issue that acts like a true bond during normal economic times, but which can be triggered into pure equity when a bank’s capital is under stress. This may seem arcane, but I think the idea has some merit, and may even help reduce the need for future bail out cash from taxpayers when were we to experience another banking implosion.

There have always been convertible bonds: they are structured such that an investor can convert an investment from debt to equity under certain favorable conditions. This mechanism is biased to favor the investors and induce them to participate in a company’s stock growth by allowing them to covert debt into stock at a predetermined price. This gives a bond investor a share in the equity gain a growing company may experience, yet protects them from any downside risk: if the company’s stock price drops the bondholder simply doesn’t convert and thus protects the investment. If the stock price rises the bondholder converts into equity and shares in the gains. This structure is why many start-up companies find themselves funded through convertible bonds rather than straight equity.

So traditional convertibles have been designed to favor the bondholders. Not so with ‘co-co’s’.

Essentially a co-co bond acts as if it were a form of regular long term debt until the terms of its trigger mechanism move it from one slot on the balance sheet to another. This move is a key one: creditors, like normal bondholders, do not anticipate losing their investment when a bank’s capital is stressed by things like loan losses. Those losses are absorbed first by the shareholders through their loss of the capital they have invested in the bank. When that capital is exhausted the bank is insolvent and goes into bankruptcy – unless it is too big to fail of course, in which case taxpayers bail it out. Notice that in this process the bond holders are treated as if they were ‘normal’ creditors. Their investment is at risk and may be subject to a ‘haircut’, but they have legally accepted rights in bankruptcy that they can enforce in court and thus have the ability to gum up the works and prevent a quick resolution of the bank’s problems.

This legal standing appears benign, and in non-financial companies it usually is dealt with in bankruptcy court, but in a bank the option of a lengthy legal battle flies in the face of the public interest which is to protect the banking system from a knock-on run on healthy banks. So regulators are often forced to protect bondholders as well as depositors in a bank insolvency through the need for expeditious action. This is nonsense since the purpose of the public safety net is to protect depositors not large scale and sophisticated investors. More to the point, bondholders are often negligent in taking preemptive action when they see a bank entering into profit difficulties: they know their debt is protected so they tend to avoid getting involved in pressuring bank management to act more forcibly. Plus many big banks are bondholders in other financial institutions so they are reluctant to boss around their fellow bankers. Even worse: some large banks, Goldman Sachs is particularly prone to this, hedge their bond positions by taking out credit default swaps. This means that they will be paid back their investment via the CDS insurance regardless of whether the bank has the resources to pay them or not. Following this thought further: if a bank like Goldman holds a CDS for the full value of its investment it will more than likely receive more money back were it to allow the bank to cave in, than were it to renegotiate the terms of its loan in an attempt to keep the bank afloat. Clearly this creates a huge conflict of interest and potentially a motive for anti-social behavior.

So bondholders often represent a roadblock to keeping a bank afloat because they have no economic interest in renegotiating its debts – those CDS’s may cover them anyway. Then, after the bank goes under, they are often swept up in the warm embrace of the public safety net even though theat safety net was never designed to protect them. This is a classic case of the ‘rent seeking’ I have been going on about lately.

This new concept of a co-co ends this ability to rent seek by forcing the bondholders to confront the looming loss of their investment. They will have the option to force management’s earlier action, and thereby try to rescue the bank and their investment, or they will see their bondholder status converted into pure equity where the bankruptcy process is harsh. Either way the public gains: the bondholders are forced to be active investors, or they stand to lose their privileged position in the winding up process and are no longer able to be scooped up in protective net the taxpayers provide to depositors. This makes for cheaper bail outs in future.

The bank benefits also by having an emergency cushion of equity that will kick in just at the moment when it is highly unlikely the bank can raise fresh equity from new investors.

The idea of a co-co style bond is still very new, and is subject to much debate. But if it acts in the way I have just described, it will be another brick in the wall as we rebuild a better regulatory system and safer banks.

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Finance Reform

Well things are heating up. Senator Dodd released his much awaited – by people like me that is – proposed legislation for the reform of our broken down financial regulatory structure. The legislation weighs in at 1,136 pages of text, so I doubt whether anyone has read it yet unless they received a copy ahead of time. I certainly won’t be wading through it all. I will use the executive summary as my source for the major proposals.

Here are the highlights, or ‘lowlights’ if you’re at the Federal Reserve Board:

  1. Dodd proposes to establish a single large new regulatory agency[the Financial Institutions Regulatory Administration or ‘FIRA’], similar to the FSA in the UK, that will take over many if not all the regulatory powers now vested in the warren of agencies in Washington. The idea behind this centralization is to prevent banks from getting themselves regulated by the most lenient overseer. This ability to shift the regulator with oversight over your bank – an ability known as ‘regulatory arbitrage’ – undermines the current system and allows banks to cherry pick the regulations they want to be governed by. Ending this ability is key to future enforcement. I have doubts whether Dodd will get his way with this proposal, the current agencies all have cheering sections in Congress and the massive inertia within the American system will most likely kill the initiative off. Plus centralization in the US is simply a first step: international regulation needs to be tightly synchronized as well is we are to eliminate global regulatory arbitrage.
  2. Once FIRA is set up the current Offices of Thrift Supervision and Comptroller of the Currency would both be abolished and their functions absorbed into FIRA. Likewise the bank regulatory aspects of the FDIC would be rolled into FIRA as would those of the Federal Reserve Board.
  3. The proposal also gives the SEC an ability to fund itself by keeping the fees it levies on the financial industry.
  4. A controversial aspect of the Dood reform is that it establishes a Consumer Financial Protection Agency [‘CFPA’], which is designed to monitor and control the products that banks create and sell to consumers. This is obviously a reaction to the sub-prime mess when lenders ran amok with fancy, and often incomprehensible, loan types, and then sold them to people who were not credit worthy if the fine print in the loan ever kicked in. Naturally the fine print always kicked in and precipitated the mass of delinquencies and foreclosures we are now cleaning up. I like this idea. The so-called innovation in banking is not innovative at all. It is simply an endless permutation of the same old products wrapped in ever more obtuse legal language. Innovation is supposed to drive higher value to the customer, but most bank ‘innovation’ is designed simply to open new sources of fee income for the banks. This proposal is vehemently opposed by the Republicans – they object to anything that seems to limit the good deeds of the market place – and the various bank lobby groups are pouring money into a fight to stop its successful passage. Given that both the House bill and the Obama administration endorse a similar concept, the odds are that we will get some form of CFPA. Good.
  5. Dodd also proposes setting up a new agency to govern financial stability. This agency is the lynchpin of the new Dodd style system of limiting the damage ‘too-big-to-fail’ banks can do to us all. The idea behind this agency is that it would monitor and manage the systemically important organizations – think Citicorp or Goldman Sachs – and suggest rules and limits on their activities to prevent their gambling taking us all down the way they did in 2008. The need for such an authority is an open acknowledgement of the total failure of the current system to account for the risk embodied in all the interconnections between the biggest banks. Remember it was our complete failure to understand systemic risk that led us to have to bail out AIG and bail out pay off Goldman Sachs et al through the back door by honoring those counter-party positions they had all foolishly entered into. The overall notion in this initiative is to limit the extent of the socialization of losses needed in future – Dodd’s fine print even has this agency given the power to recommend breaking up banks that are deemed too large for the safe operation of the entire system. Also good.
  6. The proposal also includes a raft of measures designed to discourage banks from becoming to big. In this respect Dodd’s legislation fits right in with all the other proposals floating about. This is also a welcome change, although I remain skeptical about its impact: we have capital regulations now. The question is getting them enforced.
  7. Small banks would find themselves subject to federal regulation if Dodd gets his way. This will annoy all those country bankers who have a cozy relationship with their local state regulator. It is about time we abolished the state level regulatory structure – not only does in encourage regulatory arbitrage, it helps maintain a fragmented industry. The proliferation of small banks prevents the emergence of new medium and larger banks that could compete with, and therefore limit the growth of, the existing mega banks. If we believe in a market system then we need to ensure that system is full of competitors and is not dominated – as it now is – by an oligopoly who can impose rents on the rest of us. {Rent seeking is the word economists use to describe activities where one person or organization can extort wealth from others by employing legal, but non-competitive, methods. Enforcing a patent is an example. Lobbying and getting preferential legislation is another}. One way to limit the damage of the pervasive rent seeking now current in finance is to encourage the emergence of healthy and innovative competitors. Getting all our small banks onto one regulatory playing field would be a step in this direction because it would probably encourage consolidation across state lines, where asnow the various State regulators discourage such activity.
  8. The last big change Dodd proposes is to bring all hedge funds under a strict regulatory framework. They would be required to register with the SEC. Further: hedge funds and private equity firms would be subject to capital requirements for the first time and may even be broken up if deemed systemically too large. This is a major step towards bringing the so-called ‘shadow banking system’ into the daylight and set up under the same controls as the normal system. This is a very good move.

That’s about it.

Predictably the Fed and the FDIC have already mounted the barricades in defense of their entrenched positions. The Fed’s big criticism of the Dodd proposal is that it strips away their ability to use their regulatory control of big banks as a way to take the pulse of the economy – they regard this ‘touchpoint’ as an important source of information as they manage the money supply. They also reject the measures the proposal includes to open up their activities to wider scrutiny – by making appointments more subject to public input for instance. They are wheeling out the dreaded ‘the Fed must be politically independent’ defense tactic, which is sure to energize the financial market and right wing analysts to become allies of the Fed.

I agree the Fed should be independent of direct political control. Its Board should have a mandate unfettered by political agendas. But, just as important, the Board should not be dominated by the banking industry – the Chairman of the New York Fed is an ex-Goldman executive who was trading his Goldman stock at the same time as sitting in on meetings to determine who should, or should not, be bailed out. It is this clear conflict of interest that Dodd is taking aim at, not political independence.

In any case the recent record of the Fed just doesn’t stand up: they are so embedded with Wall Street that they are incapable of executing a regulatory mandate effectively. They have swallowed the same free market ideology that misled the banks and even now don’t seem willing to admit much by way of error during that 2002-2007 period when the current bubble was being inflated largely as a result of Fed policy and inept oversight.

I will end with this latter point: defenders of the Fed loudly proclaim its need for independence. But in a broader sense the Fed, under Greenspan in particular, was anything but apolitical: it was a vehement advocate of the same theory and ideology that was the foundation of Reagan/Bush style Republicanism. Greenspan, more than once, intervened to prevent regulation of things like derivatives, and openly supported the modern Republican view that government is a problem and not a source of solutions. While I admit the entire political world has been infected with this worldview – Rubin and Summers in the Clinton years were just as culpable – the Fed under Greenspan became more than usually tainted by a particular political point of view.

So the question becomes: can the Fed ever be ‘independent’? Or is the search for independence simply a cover for its adoption of free market ideology?

This is not academic.

The big discussion at the Fed currently is when and whether to raise interest rates. Those that want higher rates advocate a raise because they want to defend price stability – they are afraid of inflation – which is one of the Fed’s two legal mandates. They are by and large are the free market folks. Those that push back are driven by the other mandate the Fed has: to support employment. During recent years the first of these two mandates, the fight against inflation, has dominated the other. This is a political choice that favors business and banks over workers. It gets interesting this year if unemployment keeps rising even while the economy starts to grow. The pressure to raise rates will increase as GDP ticks up. But such a move would damage the prospects for a fall in unemployment. Left wing politicians will want lower unemployment. Right wing politicians will want to limit inflation.

Whichever course the Fed chooses is thus political.

So just how independent can the Fed truthfully be?

Not so much.

Which is why opponents of opening up the Fed with a more transparent management style need to find a better defense than its purported independence.

Meanwhile … back at the regulatory ranch.

The Dodd legislation conforms fairly well with the House and administration proposals. I hear the the administration is even willing to support the establishment of FIRA, which they initially opposed.

Given the total opposition coming from the Republicans, I don’t see to much time being invested in a fruitless search for ‘bipartisan’ support for reform. Having been burned in the health care pseudo- debate, where bipartisanship was mocked by the actual discussions, I hope the administration and the Democratic leadership plunge onward without distraction.

This is not to say I wouldn’t support debate. Clearly on something this important we need healthy discussion. But I emphasize that word ‘healthy’. Name calling and obduracy are not healthy and don’t constitute debate. They are merely obstructionism and should be ignored.

Given the recent crisis and the evident failure of our laissez-faire system, we need to re-regulate finance. With the Dodd proposal now on the table the process has begun in earnest. I would like the Republicans to play a constructive role in getting the nation’s banking system safe again. If they join in the debate, then good. If not, well that’s just fine.

Either way we will get reform.

Good.

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Oh How They Are Mistaken!

In today’s Financial Times is an op-ed by Frederic Mishkin, a former Federal reserve Board governor advocating a benign attitude towards the current asset price run up that has all the worrying aspects of a bubble in the making. He urges us not to confuse what he sees as two kinds of bubble: the first, such as the hi-tech stock boom of the 1990’s leaves the banking sector largely untouched because it was concentrated in the equity values of the notorious ‘no-hope’ companies that popped up every day back then. The people who were burned were the folks who fell for the hype – they deserved to be taken for a ride, and many fell flat as a result of their gullibility. It is the second kind of bubble Mishkin describes that he argues calls for policy level push back. These second bubbles are dangerous because they are fueled by and feed back into a parallel credit boom. It is this feedback that creates the danger since it implies the accumulation of vastly overvalued assets within the financial system.

To me this is just too nuanced to make sense.

The second type of bubble is indeed the one we just suffered through. Or rather was the kind foisted upon us by the incompetence and greed on the big banks. For those of you who want to dig deeper into the instability of finance I suggest a reading of Minsky’s Financial Instability Hypothesis. He articulates what, I think at least, Mishkin is trying to say. Finance is inherently unstable and therefore needs constant and vigilant regulation. bankers cannot be trusted to make socially sound investments or judgements because they are prone to waves of speculation. Unless a particular wave crashes and deflates asset values it is amplified by the next. Each larger subsequent wave attracts more bonus driven short term investing by bankers who starve the real economy of capital and divert cash into the creation of what ends up being a monstrous asset bubble. Eventually, as we all know, the bubble burst and the bankers come hat in hand to the taxpayers for help. We clean it all up, and the bankers start all over again.

The problem I have is that there is no way to tell whether a run up in asset prices is a type ‘A’ or a type ‘B’ bubble. And given the ability of banks to manufacture ‘synthetic’ assets in the conference rooms of their lawyers and accountants, I am not sure there is a difference anyway. The credit and asset markets are so intertwined nowadays I don’t think a policy maker should regard any sudden escalation of asset prices as benign: I suspect the banks will find a way to lose money somehow.

Then again there is always the fact that Mishkin himself is tainted by his own inability to understand banking. Take this quote from one of his speeches:

‰ÛÏMore recently, developments in the subprime mortgage market have raised some additional concern about near-term prospects for the housing sector‰Û?. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal.

Variable-interest-rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely.

Banks and thrift institutions that hold mortgages are well-capitalized, and exposures of individual banks to possible subprime losses do not appear to be large. On the whole, some borrowers may find credit more difficult to obtain, but most borrowers are not likely to face a serious credit constraint.‰Û?

Fed speech Aril 10, 2007

Not to pick on him too much, but that’s horrible forecasting.

This leads me to another point: the really big problem we all have at the moment is that the folks being quoted and sought out by the press are, by and large, the same folks who missed the problems of 2005 through 2007. They are wedded to the theories that brought the economy to its knees. While I am all for giving people a second chance, they need to prove their competence. Too many of them are maintaining a high profile at a time when they ought to be beavering away correcting the errors in their theories.

I would throw Geithner, Bernanke, and Summers into this bucket also. None has a stellar record and all are far too close to the old ways of Wall Street to be able to sense what truly went awry.

That’s why I am a fan of paul Volcker at the moment. He seems to ‘get it’.

Bankers are perennially ‘rent seeking’. They rig the game to their own advantage. They cannot be trusted. They reward themselves for playing in a game where the odds are stacked in their favor and then claim to be ‘smart’ and thus worthy of those rewards. They seem to forget the trillions of losses they impose upon the rest of us.

I am afraid that people like Mishkin provide cover for the antics of bankers by trying to be too clever.

There may be a ton of different kinds of bubbles.

I don’t care.

Bankers should be prevented from playing in any of them.

Letting a bank get involved in an asset bubble is like giving matches to a pyromaniac and then wondering why there’s a fire.

Bankers just can’t help themselves. Take Citibank for example: all of the asset bubbles of the past thirty odd years – most have been explosions of Third World debt – have a common theme. Lax regulation in the epicenter of the trouble and an over eager credit provider trying to cash in on the ‘opportunity’. Citi has managed to impale itself on at least three of these bubbles, and has been bailed out each time. The cost to the taxpayer has been enormous. And the bank has never learned.

Bankers like those at Citi [or Goldman etc] just aren’t grown up enough.

Someone has to take the matches away.

That would be us.

Re-regulate the banks.

Now.

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