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Speaking to the American Enterprise Institute, Treasury Secretary Tim Geithner had some good lines yesterday:
"The magnitude of the financial shock [in fall 2008] was in some ways greater than that which caused the Great Depression. The damage has been catastrophic, causing more damage to the livelihoods and economic security of Americans and, in particular, the middle class, than any financial crisis in three generations."
Like Ben Bernanke, Mr. Geithner also finally grasps at least the broad contours of the doom loop:
"For three decades, the American financial system produced a significant financial crisis every three to five years. Each major financial shock forced policy actions mostly by the Fed to lower interest rates and to provide liquidity to contain the resulting damage. The apparent success of those actions in limiting the depth and duration of recessions led to greater confidence and greater risk taking."
But then he falters. In part, the Secretary of the Treasury seems hung up on the final cost of the Troubled Asset Relief Program (TARP):
"Reasonably conservative estimates suggest that the direct fiscal costs of this crisis will ultimately be less than 1 percent of GDP, a fraction of the over half a trillion dollars estimated by [the Congressional Budget Office] CBO and [the Office of Management and Budget] OMB just a year ago."
But everyone agrees that the true fiscal cost of the crisis (and bailout) of 2008–09 is the increase in net government debt held by the private sector—closer to 40 percent of GDP (i.e., nowhere near 1 percent of GDP).
This matters because, by lowballing the true fiscal cost, Treasury plays down the need for the toughest safeguards in the future.
If the cost were 1 percent of GDP, then perhaps the measures they have in mind would be enough. But if the cost is a doubling of our national debt—pushing us close to the danger level on that dimension—then we should think about what we need quite differently.
We agree completely with the administration's approach—actually, with Elizabeth Warren's approach—to consumer protection. (We make this clear in 13 Bankers.)
But the sticking point is "too big to fail." Mr. Geithner's Treasury (and Senator Dodd's bill) continues to rely on the complete illusion that a resolution authority (i.e., an augmented bankruptcy process for banks) based on US law will do anything to help manage the failure of a large cross-border financial institution. It simply will not.
I've discussed this specific point with top technical people from G-20 countries, as well as with our most experienced international bankers and leading lawyers who specialize on this very issue. They agree that a US resolution authority would be a complete illusion—at least with regard to the big cross-border banks.
Mr. Geithner gave a good speech yesterday. But someone needs to give another speech, walking us through—step by step—how exactly this resolution authority would have prevented the cross-border chaos that followed the collapse of Lehman in September 2008. Break it down into pieces and expand on every legal nicety.
Then tell us how the resolution authority will work for Citigroup in 5 or 7 years, when that bank will likely be twice its current size.
And the next speech might also explain why Mr. Geithner no longer mentions the Volcker Rules—there was nothing about proprietary trading and nothing about even prospective caps on bank size. Have they been withdrawn? What exactly happened on the way to the Senate?
Mr. Geithner wanted to sound tough yesterday. But is he really coming out to fight? Or did he and his colleagues already throw in the towel?
Volcker and Bernanke: so Close and Yet so Far
March 22, 2010
In case you were wondering, Paul Volcker is still pressing hard for the Senate (and Congress, at the end of the day) to adopt some version of both "Volcker Rules." It's an uphill struggle—the proposed ban on proprietary trading (i.e., excessive risk taking by government-backed banks) is holding on by its fingernails in the Dodd bill and the prospective cap on bank size is completely missing. But Mr. Volcker does not give up so easily—expect a firm yet polite diplomatic offensive from his side (although the extent of White House support remains unclear), including some hallmark tough public statements. It's all or nothing now for both Volcker and the rest of us.
But at the same time as the legislative prospects look bleak (although not impossible), we should recognize that Paul Volcker has already won important adherents to his general philosophy on big banks, including—most amazingly of late—Ben Bernanke, at least in part. In a speech Saturday, Bernanke was blunt:
"It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation [like fall 2008]."
You may dismiss this as empty rhetoric, but there is a definite shift in emphasis here for Bernanke—months of pressure from the outside, the clear drop in prestige of the Fed on Capitol Hill, and the pressure from Paul Volcker is definitely having an impact.
Bernanke finally understands the "doom loop"—in fact, he provides a nice succinct summary:
"The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too big to fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks."
He also expands on an important, related point—that the presence of "too big to fail" (TBTF) is simply unfair and really should be opposed by all clear thinking businesspeople who don't run massive banks (aside: someone kindly point this out to the Chamber of Commerce—they are undermining their people):
"Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses…. In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too big to fail problem once and for all."
Bernanke now endorses the first Volcker Rule, "Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities."
But he is still hampered by the illusion that there is any evidence we need megabanks in their current form—let alone in their likely much larger future form. Let me be blunt here, as the legislative agenda presses itself upon us.
I've discussed this issue—in public where possible and in private when there was no other option—with top finance experts, leading lawyers, preeminent bankers (including from TBTF institutions), and our country's most prominent policymakers. And I have testified on this question before Congress, including to the Joint Economic Committee, the House Financial Services Committee, and—most recently—the Senate Banking Committee, where leading spokesmen for big banks were also present.
Mr. Bernanke, with all due respect: there is simply no evidence to support the assertion that, "our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope," at least if this implies—as it appeared to on Saturday—we need banks at or close to their current size.
We can settle this in a simple and professional manner. Ask your staff to contact me with the evidence—or, if you prefer, simply have a Fed governor provide the compelling facts in a speech and/or have a staff member put out the technical details in a working paper.
There is no compelling case for today's massive banks, yet the downside to having institutions with their current incentives and beliefs is clear and awful. Think hard: what has so far changed for the better in the system that brought us to the brink of global collapse in September 2008? In this context, Mr. Bernanke's three part proposal for dealing with these huge banks should leave us all quite queasy:
- He wants tighter regulation. Fine, but what happens next time there is a "let it all go free" president again—a Reagan or a Bush? Regulation cannot be the answer; there must be legislation.
- Improving the clearing and settlement of derivatives is also fine. But why not also make the banks involved smaller—given that a bankruptcy of a future megabank could easily involve millions of open derivative positions? This would also make complete sense as a complementary measure—unless you think society would lose greatly from the absence of megabanks. Again, show us the evidence.
- A resolution authority is not a bad idea. But everyone involved in rescuing the big banks with unconditional guarantees in spring 2009 insists on one point—if they had run any kind of Federal Deposit Insurance Corporation (FDIC)-type resolution process, this would have been prohibitively expensive to the taxpayer. You simply cannot have this both ways—either resolution/bankruptcy was a real option in early 2009 (as we argued) or it was not (as Mr. Geithner argues), but in that case the resolution authority (and also living wills, by the way) would change precisely nothing.
Mr. Bernanke needs to face some unpleasant realities. Because of the various actions—some unavoidable and some not—it took in saving too big to fail financial institutions during 2008–09, the Federal Reserve is now looked upon with grave suspicion by a growing number of people on Capitol Hill.
The cherished independence of the Fed is now called into question—and losing this could end up being a huge consequence of the irresponsible behavior and effective blackmail exercised by megabanks—who still say, implicitly, "bail us all out, personally and generously, or the world economy will suffer."
Mr. Volcker sees all this and wants to move preemptively to cap the size of our largest banks. Mr. Bernanke has one last window in which to follow suit (e.g., lobbying Barney Frank could still be effective). In a month it could be too late—the legislative cards are now being dealt.
Mr. Bernanke is a brilliant academic and, at this stage, a most experienced policymaker. What is holding him back?
Metternich with a BlackBerry: the Drama in Greece
March 20, 2010
If watching the twists and turns in European politics—"Should we bail out Greece?", "Should we bring in the IMF?", "Should the Greeks go directly to the IMF, cutting out the European Union?", etc. has your head spinning and reminds you of overly complicated and opaque episodes from the history books, then you have actually caught the main point. European power structures and alliances webs are being remade before your eyes.
Is this all random—just the collision of disparate national interests with no coherent plans on any side? Or are there some strong, deliberate, and very personal hands at work guiding key pieces into place?
Prince Metternich worked long and hard to maneuver countries and people before and after 1815, cynically and cleverly building a system of interlocking interests that suited him—and his employer, the Austrian/Habsburg Emperor. Is there a modern Metternich now at work? Most definitely: Yes.
If you've followed the twists and turns of the global dimensions that emerged from the financial crisis of 2008–09, you'll know that the IMF was transformed from an organization that was being euthanized by the G-7 to an important element in the G-20's backup financing for emerging markets (with the most dramatic turn of events in the run-up to the London summit in April 2009)—and definitely part of what helped stabilize confidence around the world.
This sequence of events created a great opportunity for the IMF's managing director, Dominique Strauss-Kahn (known to friends and foes alike as DSK), to relaunch his political career in France—he previously ran for the presidency but could not secure the socialist nomination, and taking the IMF job seemed to everyone (including President Sarkozy, who lined it up) as akin to being marooned on a desert island. But DSK is—like Metternich—a master of the opportunity, a man who knows when to move and when to stand still, and someone always working a network of long-cultivated European political contacts (including socialists in Greece).
DSK's objective is to cast himself as the savior of Europe—undoubtedly this would play well with the French electorate—and of course he is greatly aided by the serious underlying problems within the eurozone in general and for Greece in particular (back story is here). As he controls the IMF absolutely and completely, he has access to the best global economic intelligence as well as the means to make large loans to countries at low interest rates. He must of course bring others with him, but this is not hard—the White House, for example, could not care less about who ends up running Europe and at what growth rate, as long as it does not blow up.
President Sarkozy's aim at this point is naturally to keep DSK and the IMF as far from the action as possible. But Sarkozy has three problems.
- The Greeks have learned fast how to play international economic diplomacy—threatening to bring in the IMF in a way that would embarrass the European leadership. Without question, they are being coached by people close to DSK. Watch the masters at work.
- German voters really do not want to be involved in anything that looks or feels like a bailout. A low interest rate loan to Greece would really upset them. The Germans could do something off–balance sheet (i.e., get their banks to provide cheap credit to Greece), but the German banking system is already so ridden with governance problems and hidden bailouts that this is not appealing to the elite.
- If you provide financing to Greece at anything other than low interest rates, the numbers simply do not make sense (we take you through this here.) Merrill Lynch pushed back against us this week with a report arguing that if Greece can borrow again at the level of German interest rates, everything would be fine—this is, of course, a legitimate point, but a cursory look at Merrill's relatively sanguine research reports on Greece prior to the crisis (and also at their assessments of global credit markets prior to fall 2008) does not suggest that the "don't worry, be happy" scenario is of high probability.
Sarkozy is also an expert tactician and he is not finished yet—entering the weekend, the ball is definitely in his court. Expect further "let's do it without the IMF" options to surface now—in particular, Sarkozy will try to scare the Germans regarding how the European Central Bank (ECB) would be undermined if the IMF enters the arena. Sarkozy can also commit, behind the scenes, to support Axel Weber for the ECB presidency—something top Germans want more than they want almost anything else in the world.
And what if Strauss-Kahn prevails and the IMF makes a loan to Greece, would this save the day? Not necessarily—remember that DSK's goal is to just to look good until he leaves the Fund to run more openly for the presidency, which is probably no more than 12 months from now. His incentive would be to put in place a relatively small program of funding that does not ask Greece to do too much up front; if this explodes later (as seems likely), that would not be his problem.
Sensible program design and dealing with the core underlying issues in a reasonable manner—including confronting the looming issue of "debt restructuring"—is not likely. This is French electoral politics after all.
Senator Kaufman: Fraud Still at the Heart of Wall Street
March 15, 2010
Last week, Senator Ted Kaufman (D-DE) gave a devastating speech in the Senate on "too big to fail" and all it entails. A long public silence from our political class was broken—and to great effect. Today's Dodd reform proposals stand in pale comparison to the principles outlined by Senator Kaufman. And yes, DE stands for Delaware—corporate America has finally decided that its largest financial offspring are way out of line and must be reined in.
Today, the senator has gone one better, putting many private criticisms of the financial sector—the kind you hear whispered with conviction on the Upper East Side and in Midtown—firmly and articulately on the public record in a Senate floor speech to be delivered (this link is to the press release; the speech is in a pdf attached to that—update: direct link to speech, which will be given tomorrow). He pulls no punches:
"fraud and potential criminal conduct were at the heart of the financial crisis."
He goes after Lehman—with its infamous Repo 105—as well as the other entities potentially implicated in those transactions, including Ernst and Young (Lehman's auditors). This is the low-hanging fruit—but have you heard even a squeak from the White House or anyone else in the country's putative leadership on this issue?
And then he goes for the twin jugulars of Wall Street as it still stands: the idea that we saved something, at great expense in 2008–09, that was actually worth saving—and Goldman Sachs.
"[T]his is not about retribution. This is about addressing the continuum of behavior that took place—some of it fraudulent and illegal—and in the process addressing what Wall Street and the legal and regulatory system underlying its behavior have become."
Our system has long been imperfect, but it used to work much better:
"When crimes happened in the past (as in the case of Enron, when aided and abetted by, among others, Merrill Lynch, and not prevented by the supposed gatekeepers at Arthur Andersen), there were criminal convictions."
Here's the most intriguing bit—he challenges the moral authority of those who think they are doing "God's work" in finance.
"If we uncover bad behavior that was nonetheless lawful, or that we cannot prove to be unlawful (as may be exemplified by the recent reports of actions by Goldman Sachs with respect to the debt of Greece), then we should review our legal rules in the [United States] and perhaps change them so that certain misleading behavior cannot go unpunished again."
But that's not all—he actually lays out the parameters of what should be, if our legal institutions still functioned, a compelling case against Goldman.
"Following these transactions, Goldman Sachs and other investment banks underwrote billions of [euros] in bonds for Greece. The questions being raised include whether some of these bond offering documents disclosed the true nature of these swaps to investors, and, if not, whether the failure to do so was material."
"These bonds were issued under Greek law, and there is nothing necessarily illegal about not disclosing this information to bond investors in Europe. At least some of these bonds, however, were likely sold to American investors, so they may therefore still be subject to applicable US securities law. While ‘qualified institutional buyers' (QIBs) in the [United States] are able to purchase bonds (like the ones issued by Greece) and other securities not registered with the [Securities and Exchange Commission] SEC under Securities Act of 1933, the sale of these bonds would still be governed by other requirements of US law. Specifically, they presumably would be subject to the prohibition against the sale of securities to US investors while deliberately withholding material adverse information."
This sounds like a potential violation of Rule 10b-5—you are simply not allowed to sell securities in the United States while withholding material adverse information, i.e., what any reasonable investor would want to know (like the true indebtedness of a government) when you are being pitched on a sovereign debt issue. In fact, such actions are frequently considered serious fraud—at least when the people involved aren't as powerful as Goldman Sachs.
And after having just spent a considerable amount of time with Hank Paulson's memoir, On the Brink, I have to ask: What did Hank Paulson know (as CEO of Goldman at the time), and when did he know it—regarding the potential misleading sale of Greek government securities to US entities? Goldman reportedly netted $300 million from its Greek "swaps" and presumably more from managing subsequent Greek debt issues; this is the same order of magnitude as Mr. Paulson's payout when he left Goldman (around $500 million, tax free).
Who is Senator Kaufman and what power does he have in this situation? He is not a member of the Senate Banking Committee, and if you think this is a regulatory issue—that reduces the weight of his voice.
But he is a member of the Senate Judiciary Committee and we are discussing here potential crimes—or what should be crimes if the legal system still functioned. He was also a cosponsor of the Fraud Enforcement and Recovery Act (FERA)—which was right on topic—and is an experienced Capitol Hill insider who has studied these issues long and hard. He has also worked closely, over many years, with Vice President Biden.
The tide is turning, but not primarily through the actions of Senator Dodd and his banking colleagues. Rather the biggest and most unruly players in our financial system have behaved in such an egregious manner that they will be brought down by the law—either that, or they will further bring down the law.
The German Finance Minister Needs to Confront Investment Banks
March 12, 2010
Wolfgang Schäuble, German finance minister, has a surprisingly sensible op-ed in today's Financial Times. As we suggested yesterday, first the relevant Europeans should decide if they want to keep the euro—more precisely, who stays in and who leaves the currency union—then policy must be adjusted accordingly.
Mr Schäuble is obviously correct that existing economic self-policing mechanisms are badly broken; the eurozone can only survive if there are effective monitors and appropriate penalties for fiscal and financial transgression. He is also right to fear that involving the IMF in Greece would necessarily give the Fund greater rights to kibbitz on European Central Bank monetary policy. Given the fear and loathing expressed for the IMF's "4 percent inflation solution" (or is it 6 percent?) in eurozone policy circles, you can see why this gives the Greek prime minister some bargaining power—the Germans will do whatever it takes to keep him away from the IMF in the short term.
But Schäuble misses (or holds back for now) on a potentially important point vis-à-vis investment banks.
He is tough, toward the end of his piece, on countries that "intentionally breached European economic and monetary law." But what about banks that aid and abet countries that are trying to break the rules?
Of course, governments can always massage their statistics unassisted. But when international banks help countries to disguise their true debt levels through off–balance sheet transactions, what is the difference between that and what Merrill Lynch did for Enron regarding "Nigerian oil barges" (and more)?
Technically, Greece's (and potentially other countries') debt deals may not have broken any laws—because the international space for these transactions is so anarchic.
But Mr. Schäuble would be well within his rights to call for rogue investment banks—i.e., those that help break European rules in any fashion—to be banned from the highly lucrative market for European government new issues.
Of course, if he is afraid to do this because the banks in question have great market power and a fearsome reputation for sharp elbows and exacting revenge, perhaps Mr. Schäuble should consider referring the broader investment banking market (including over-the-counter derivatives) to the relevant antimonopoly authorities within the European Commission.
