Tag: financial crisis

Tim Geithner: The Forrest Gump of World Finance

One almost feels sorry for Treasury Secretary Tim Geithner.

He’s a punchline in his own country because he oversees the IRS even though he conveniently forgot to declare $80,000 of income (and managed to get away with punishment that wouldn’t even qualify as a slap on the wrist).

Now he’s becoming a a bit of a joke in Europe. Earlier this month, a wide range of European policy makers basically told the Treasury Secretary to take a long walk off a short pier when he tried to offer advice on Europe’s fiscal crisis.

And the latest development is that the German Finance Minister basically said Geithner was “stupid” for a new bailout scheme. Here’s an excerpt from the UK-based Daily Telegraph.

Germany and America were on a collision course on Tuesday night over the handling of Europe’s debt crisis after Berlin savaged plans to boost the EU rescue fund as a “stupid idea” and told the White House to sort out its own mess before giving gratuitous advice to others.German finance minister Wolfgang Schauble said it would be a folly to boost the EU’s bail-out machinery (EFSF) beyond its €440bn lending limit by deploying leverage to up to €2 trillion, perhaps by raising funds from the European Central Bank.”I don’t understand how anyone in the European Commission can have such a stupid idea. The result would be to endanger the AAA sovereign debt ratings of other member states. It makes no sense,” he said.

All that’s missing in the story is Geithner channeling his inner Forrest Gump and responding that “Stupid is as stupid does.”

…at birth?
Separated…

This little spat reminds me of the old saying that there is no honor among thieves. Geithner wants to do the wrong thing. The German government wants to do the wrong thing. And every other European government wants to do the wrong thing. They’re merely squabbling over the best way of picking German pockets to subsidize the collapsing welfare states of Southern Europe.

But that’s actually not accurate. German politicians don’t really want to give money to the Greeks and Portuguese.

The real story of the bailouts is that politicians from rich nations are trying to indirectly protect their banks, which - as shown in this chart - are in financial trouble because they foolishly thought lending money to reckless welfare states was a risk-free exercise.

Europe’s political class claims that bailouts are necessary to prevent a repeat of the 2008 financial crisis, but this is nonsense - much as American politicians were lying (or bamboozled) when they supported TARP.

It is a relatively simple matter for a government to put a bank in receivership, hold all depositors harmless, and then sell off the assets. Or to subsidize the takeover of an insolvent institution. This is what America did during the savings & loan bailouts 20 years ago. Heck, it’s also what happened with IndyMac and WaMu during the recent financial crisis. And it’s what the Swedish government basically did in the early 1990s when that nation had a financial crisis.

But politicians don’t like this “FDIC-resolution” approach because it means wiping out shareholders, bondholders, and senior management of institutions that made bad economic choices. And that would mean reducing moral hazard rather than increasing it. And it would mean stiff-arming campaign contributors and protecting the interests of taxpayers.

Heaven forbid those things happen. After all, as Bastiat told us, “Government is the great fiction, through which everybody endeavors to live at the expense of everybody else.”

What to Read on the Financial Crisis, Part II: Popular

Last week I offered my suggestion on the one book you should read, if you really want to understand the financial crisis. In this Part II, I offer a list of popular books, mostly written by journalists, along with very brief thoughts.  Part III, to come, will focus on more “scholarly” books.

As general rule, these popular books lack a theoretical framework of the crisis. They often have the feel of a “bad people did bad things” narrative. These are only books I’ve actually read (and remember), so its a selective list. Some are insider stories of only a single firm, and hence, somewhat limited in their usefulness. I will also give little evidence behind my judgments, so if you don’t value my opinion, stop reading now. 

1. All the Devils Are Here, by Bethany McLean and Joe Nocera. (2 stars) There’s only one reason to read this: it is the model of the establishment Left version of the crisis. This is the book that future Harvard professors will force their students to read to “understand” the evil Bush years. Otherwise, skip it. Wildly off both in terms of fact and interpretation.  Read any of their columns and you know what the book is like.

2. Reckless Endangerment, by Gretchen Morgenson and Joshua Rosner. (4 stars) See Part I. Despite many flaws, probably the best of the “popular” books.

3. After the Fall, by Nicole Gelinas. (3 stars) I usually love Nicole’s stuff, and the story here on “too-big-to-fail’ is dead-on, but I think she’s off on Glass-Steagall and doesn’t make that case. Still, a relatively short and worthwhile read.

4. Fool’s Gold, by Gillan Tett. (4 stars) Exclusively about JP Morgan, but great background on credit default swaps. So despite its narrow focus on one firm, still a worthwhile read.

5. Chain of Blame, by Paul Muolo and Mathew Padilla. (3 stars) A narrow, but interesting, focus on subprime mortgage lending. Muolo is a long time reporter for National Mortgage News, so this has an almost insider’s feel of the mortgage industry, for that reason a worthwhile read.

6. Senseless Panic, by William Isacc. (4 stars) Author is the former FDIC Chair during the S&L crisis, and applies insights learned there to the current crisis. He misses a lot, but it’s breezy and short, and what is there is very worth reading. I wouldn’t put this at the top of your list, but if you’re going to read several, then add this one.

7. House of Cards, by William Cohen. (3 stars) Focused exclusively on Bear Stearns.  Again, a narrow focus, but generally fast moving and an interesting story line.

8. The Sellout, by Charles Gasparino. (4 stars) Despite a few minor factual errors, this was one of the better books.  He’s tough on Washington and Wall Street, and accurately so. 

9. A Colossal Failure of Common Sense, by Larry McDonald. (3 stars) Focused only on the failure of Lehman. Maybe too much useless personal detail, but otherwise an interesting story.

10. In Fed We Trust, by David Wessel. (3 stars).  Despite reading like a love letter to Bernanke, it is probably the best inside story of the Fed’s behavior during the crisis, which is also its weakness as the book offers little insight into happens outside the Fed.

Again, Part III will focus on more scholarly books, and in my opinion, generally more insightful reading.  That said, they don’t often make fun beach reading, which the above should be safe for.

Who Wants To Be ‘Too-Big-To-Fail’?

I’ve argued that the Dodd-Frank financial reform bill does not end “too-big-to-fail”, that is the belief that certain companies are implicitly backed by the government because policy-makers are unlikely to let said institutions actually fail. By naming some companies as ”systemically important” – as required by Dodd-Frank – the government is actually sending a signal as to who is likely to be bailed out.

As evidenced by regulators’ behavior during the financial crisis, the prime beneficiaries would be the creditors of these companies, as even when shareholders and management suffered, creditors generally did not. This should allow such firms to borrow at a cost lower than firms not deemed systemically important.

Given this funding advantage, it would seem natural that firms would want to be included as systemically important. Sure they might be examined by bank regulators more often, but that’s hardly a large cost compared to the funding advantage.

Congressman Frank has attempted to refute that there are any benefits from being deemed “systemically important” by the fact that ”so many financial institutions have lobbied against being designated in this way.” What his argument misses, or chooses to ignore, is that these benefits are not the same for all institutions. It is companies that rely heavily on debt market financing, such as banks, that have the most to gain. And under Dodd-Frank, the largest banks are automatically included. They have no opportunity to lobby to be in or out. The firms that are not automatically in, the most important of which are insurance companies, do not fund themselves primarily via the debt markets. Insurance companies get most of their funding from the premiums paid by their policyholders. And those premiums must be sufficient to cover expected losses, which have little to do with funding costs in the debt markets. Other non-bank financial companies, such as hedge funds and private equity, do not gain to the same extent that banks do because they have traditionally been a lot less leveraged than banks.

So the answer to Mr. Frank’s point is that those who have the most to gain from being ”systemically important” are already included, those with the least the gain are the very ones lobbying against being included. The real perversity is that once they are included, they will have a strong incentive to shift their business models toward more debt funding, making them riskier and more likely to fail (debt markets are far more fickle than insurance policy-holders). We are left relying solely on the judgment of the regulators to avoid this outcome, the same regulators who were asleep at the wheel as the housing bubble expanded.

The Banking Deregulation that Mattered (and Actually Happened)

One commonly heard refrain is that the deregulation of banking caused the financial crisis.  To those of us that have actually spent years working on banking policy, such a claim is met with surprise.  What banking deregulation?  The usual response, with generally an absolute lack of detail or argument, is the repeal of Glass-Steagall by the Gramm-Leach-Bliley Act (GLB).  When the proponents of this claim bother to offer any explanation (in some circles simply invoking the name “Phil Gramm” substitutes for any analysis), it usually goes like this:

With Glass-Steagall dead and gone, financial institutions were now free to grow large.

That’s taken from the recent book Reckless Endangerment.  What it misses that is that Glass-Steagall placed zero constraints on the size of banks.    

The following graph shows the share of total commercial bank assets held by banks over $10 billion in assets.  Its been quite a change, and obviously one toward growing concentration.  But was this caused by GLB?  Recall GLB was not signed into law until 1999.  By 1999 the share of assets held by the largest banks was already 65%, at the height of the bubble in 2005 it had risen to 73%.  

What could have contributed to this increase? Perhaps, just maybe, the removal of branch banking restrictions in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Prior to the passage of Riegle-Neal many states had substantial restrictions on the number of branches a bank could have, which severelylimited the size of banks. In Texas for instance, banks were limited to a single location.

Before the passage of Riegle-Neal, the large bank share of assets stood at 38%.  In the few years, between its passage and that of GLB, this 38% shot up to 65%.   Far more than GLB, Riegle-Neal was the legislative driver of commercial bank consolidation.  But then a banking deregulation passed by a Democratic Congress and signed by a Democratic president just doesn’t garner the blind emotion of blaming everything on Phil Gramm.

It should, of course, be said that  the removal of branching banks restrictions was a great thing.  There is a substantial body of academic work supporting the notion that such restrictions increased the risk of the banking system.  Because of Riegle-Neal we had a safer banking system than we would have had otherwise.  It was indeed a deregulation — one that matter and one that vastly improved our financial system.

The CAP-AEI Fannie Mae Food Fight

It’s probably never wise to inject oneself into the middle of a food fight, but since I think both sides actually have something right and something wrong, its been a worthwhile debate to follow.  That is the ongoing debate between Peter Wallison at the American Enterprise Institute and David Min at the Center for American Progress (at least we can all agree we love America) on the role of Fannie Mae (and Freddie Mac) in the financial crisis.  If you can’t guess, Peter says Fannie/Freddie caused the crisis, David says they didn’t.

David makes an interesting point, one I’ve actually argued, in his latest retort.  That is, this wasn’t exclusively a housing crisis/bubble.  Other sectors, like commercial real estate, boomed and then went bust; other countries, with different housing policies, also had bubbles.  True from what I can tell.  I will also add that the U.S. office market actually peaked and fell before the housing market, so we can safely say there wasn’t contagion from housing to other parts of the real estate market. 

But the problem with this argument, at least for David, is that it undercuts the Dodd-Frank Act, which he has regularly defended.  The implicit premise of Dodd-Frank is that predatory mortgage lending caused the crisis, so now we need Elizabeth Warren to save us from evil lenders.  But how does predatory lending explain the office market bubble?  Do we really believe that deals between sophisticated parties, poured over by lawyers, were driven by predatory lending practices?  Do we also believe that other countries were also plagued by bad mortgage brokers?  Again, I think David is right about the problem being beyond housing, but he can’t have it both ways.

What is the common factor driving bubbles in commercial real estate, housing, and foreign real estate markets?  Maybe interest rates.  This was a credit bubble after all.  Especially since the Fed basically sets interest rate policy for the world.  It is hard for me to believe that three years (2002–2004) of a negative real federal funds rate isn’t going to end badly.  This is what I think Peter misses, the critical role of the Federal Reserve in helping blow the bubble.  But Dodd-Frank does nothing to change this. 

Now there are a ton of things I think both still miss.  We could argue all day about what a subprime mortgage is.  I think the definitions used by Wallison (and Pinto) are reasonable.  There is also a degree, a large one, to which David and Peter are just talking past each other.  For instance, there is something special about the U.S. housing market that transfers much of the risk to the taxpayer.  In contrast, the bust in the office market didn’t leave the taxpayer to pick up the tab.  That has to count for something, unless one just doesn’t care about the taxpayer. 

There are a few other issues that make Fannie/Freddie uniquely important in the crisis, but I lack the space to go into them here. Instead, I’ll wrap up by saying that their role in the overnight repurchase (re-po) market is under-appreciated and their ability to essentially neuter the Fed was critical in keeping the bubble going.  What’s for dessert?

Financial Crises as Information Problems

If you haven’t seen it already, be sure to give a read to Friedman Prize winner Hernando de Soto’s recent piece in Business Week, “The Destruction of Economic Facts.” It’s a fascinating perspective on the economic and financial turmoil that is wracking the United States and the world.

As de Soto perceives more easily from working in developing economies, an important input into functioning markets is good information—about property, ownership, debts, and so on. The “destruction of economic facts” is one of the roots of instability and uncertainty in Europe and the United States: “In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.”

The law and markets are information systems, says de Soto:

The rule of law is much more than a dull body of norms: It is a huge, thriving information and management system that filters and processes local data until it is transformed into facts organized in a way that allows us to infer if they hang together and make sense.

If you’re interested in information and transparency, it’s worth a read.

Ben Bernanke: Central Planner

There’s a great piece in the spring issue of The Independent Review on Federal Reserve Chairman Ben Bernanke by San Jose State Professor Jeffrey Rogers Hummel.  Although a bit long, its well worth the read for anyone wanting to understand both Bernanke’s thinking and his actions during and since the financial crisis.

First, Prof. Hummel discusses the differences between Bernanke’s and Milton Friedman’s explanations for the Great Depression.  Those that debate whether Bernanke’s actions, especially the quantitative easings, would be approved of by Friedman will get a lot out of this discussion.  From this comparison, you get the point that Friedman was concerned about overall credit conditions and liquidity, whereas Bernanke is less focused on the monetary factors than on the impairment of credit intermediation, which explains his support of selective bailouts.

Hummel’s comparison of Greenspan and Bernanke is also insightful, particularly since many (myself included) often lump the two’s policies together.  From the analysis, it is clear that Greenspan falls into the Friedman camp, his “rescues” were of the financial system in general, and not of specific firms.

One might say a bailout is a bailout, so what’s the difference between rescuing the system and rescuing individual firms within the system?  Certainly that’s a view I have some sympathy for.  The “Greenspan put” was as much a contributor to reckless risk-taking as anything else.  Hummel, however, discuses why this difference ultimately matters, and why it shows Bernanke to fit the role of economic central planner.  In short, the facts are presented that during the financial crisis, Bernanke did not actually increase overall liquidity by much, he re-directed it to those firms he deemed most important.  This process of reducing liquidity to some sectors while re-directing it to others, arguably less efficient sectors, goes a considerable distance in explaining some of the decline in both aggregate demand and consumption in 2008.

Again, the piece is one of the more accessible and insightful I’ve read on Bernanke in quite a while.