Who was asleep while financial markets ran amok? On Freddie and Fannie, the Bush Administration says, not us. Read the whole timeline. Greg Mankiw, who is mentioned in the statement, provided the pointer.
Is Henry Paulson a hero? Not to Luigi Zingales. Zingales articulates a concern that has been near the surface of some of my own recent posts, which is that the government officials making these decisions are seeing things from the perspective of Wall Street, which is kind of like seeing the auto industry from a Detroit viewpoint or seeing the movie industry from a Hollywood viewpoint or seeing elections from a Washington viewpoint. Tyler Cowen found this one.
Tyler also dug up an old blog post from an investment banker who used the pseudonym Mindles H. Drek. He points out that the expanded use of derivatives was largely a response to regulation. He points out, en passant, that the credit rating agencies’ role in financial markets is driven by regulators, as well. I’ve talked about the credit rating agencies in recent posts. I’ll talk about the role of derivatives in another post, soon.
Brad DeLong has a long post. It is worth reading to understand his point of view. Basically, he throws the kitchen sink of market imperfections at financial markets–moral hazard, adverse selection, multiple equilibria, and so on, and then says that we should never again allow private decisions to be made without wise technocrats like himself overseeing things. He and I could have a long, long debate. Thanks to Mark Thoma for the pointer.
Sep 20 2008 at 11:54am
Combining an auction and a cram down might be possible. For example, “to participate in the auction, this is the cram down price you will pay”. For example, the government would have rights to an equity cram down, if returns were not greater than x on the assets bought at auction. The seller gets cash, but remains significantly on the hook for asset quality. This aligns incentives. Letting bankers get away with fully transfering risk destroys the incentives for the behavior you want. The risk of cram down would be discounted in the auction price. The banks get cash but remain on the hook.
Sep 20 2008 at 2:06pm
I agree that the problem must seem more significant and structural to a former Wall Streeter like Paulson. In fact it looks so much like a negotiation between Wall Street and the FED that one wonders if some collusion is going on (Leahman bankruptcy responded to by a bear run on the rest of the IB banks, ending up with the announcement that the Govt will buy the toxic debt after all). It is no secret that Detroit has collusion between the car companies when it comes to bail outs, so perhaps this is what is happening now with Wall Street, I mean with the FEDs credit facility, no one should be worried by the IB banks abilities to get credit.
Another thought, re the fact that the hedge funds are reportedly doing OK, perhaps hedge funds have denuded the IBs of all the good talent, and also created a base of well capitalised investors with good knowledge of IB banks weaknesses. In other words this is part of the creative destruction that happens in all other industries.
The change to mark to market rules must surely be a cause of part of this, If I was a bank, I don’t really want to buy your debt, even if I think it is a good deal, because if someone else sells the same debt for a lower price (perhaps because of a need for liquidity), I have to report an immediate loss, despite my belief that eventually I will make money. Mark to market only really works when the market is liquid and well capitalised. Perhaps all that is needed is a market maker in this debt, once the FED says that they will buy the stuff, this puts a floor on the debt so that no-one needs to worry about being marked to market down to zero anymore. People will then start to look at the intrinsic value again, so on the optimistic side of things, perhaps just the existence of the new entity will be enough, and the Govt won’t actually have to buy very much.
On intrinsic value, if the toxic debt is really worth nothing and can’t be valued, then the assets underlying them are worth nothing and can’t be valued, but houses prices haven’t fallen by that much (22 cents on the dollar, implies houses selling for 1/5 the 2007 prices, there can’t be many examples of this can there?). So, why not as part of the bailout, when the debt is bought by the government, have the mortgage simply lowered to the new value of the debt, this should deal with any concerns about a bailout to Wall Street, it would be a clear bailout of Main Street instead. It would also greatly lower the interest payments increasing the probability of a reasonably payback for the Govt.
Sep 20 2008 at 2:48pm
Let’s change the concern from the markets running amok to the markets getting so “interconnected” that we can’t allow companies to fail. We’re all believers in Creative Destruction, and now we want to swear it off?
We put in place mechanisms like FDIC insurance to prevent runs on banks. For a small price, banks get to smile while they tell depositors “your money is as safe as the United States.” This worked damn well until a shadow banking system, without any backstop, grew up around the banking system, and its high profits thru leverage and unregulated activities set the bar for the regulated institutions.
The failure of the regulators is NOT that iBanks and insurers took excessive risks; companies’ responsibility to their shareholders and the economy is to find innovative ways of making money and that REQUIRES the risk of pushing the envelope too far. Equity capital demands risk, and as long as shareholders aren’t heavily margined, wiping out equity is a good buffer for society to absorb those risks.
The failure is that we have had a couple of decades in which we completely re-designed the financial system of the United States but did not put in place protections that would have provided some cushion after equity was wiped out. I give special credit to the ideologues in the current administration who insisted markets were far superior to government oversight, but it’s been decades. AFAIK, nobody has challenged the notion that FDIC insurance is necessary to prevent bank runs (see Dybvig & Diamond from 25 years ago); why did we think shadow banks could survive crunches without something like it?
A second failure is that the SEC dropped the ball on its charter to require full and open accounting to let investors know how much risk Citicorp et al were hiding in SIVs, and how the entire system was levered up so high that an ordinary business shock — and the housing debacle is of itself just a bigger shock of the type that economies just plain have now and again — would eat thru companies’ capital.
Who was in control, and what principles they followed are important. But it’s also important to know what functions they needed to provide, and how perhaps they consciously ran away from their actual charters.
Sep 20 2008 at 3:50pm
Using the term “en passant” is a blatant violation of George Orwell’s “pretentious diction” rule, which says that if a native English version is available (in this case, “in passing” is the literal translation from the French), you ought to use it and not use a more “pretentious” foreign phrase.
Sep 20 2008 at 5:03pm
“we should never again allow private decisions to be made without wise technocrats like himself overseeing things.”
Many systems or public constructs require regulations and guidelines, e.g. building codes. Saying that technocrats should not oversee things is like saying we shouldn’t have building codes.
It’s a completely indefensible position. It’s the reason buildings fall down in places without building codes. And people dropping their kids off at day care, for example, should not be required to evaluate the blueprints and record of the builder.
Hence, regulations are a necessary part of life and the question is not whether technocrats are going to be writing them, just when they should. And they should when something can collapse on top of everyone, as we are currently watching with the financial system.
Sep 20 2008 at 5:37pm
Banks should not be allowed to create massive negative externalities (i.e, systemic risk) that they are not forced to internalize. For example, people like Jimmy Cayne should not be able to year after year double down on a risk with a small probability of happening but a massive downside for society and taxpayers. SIVs should never have been permitted. 30:1 leverage by these investment banks?
What is wrong with the current system that banks can give the government collateral and get cash against that collateral with the risk that if collateral falls apart the banks have a problem not the government? No above market price paid by the government and hence no subsidy? No transfer of risk from the banks to the government?
There is no requirement in any scheme that all risk move to the government– the banks should continue to have plenty of risk for anything transferred and the government should see the upside of any risk it takes. The way to make sure that the banks behave themselves is with equity warrants that kick in if the debt deteriorates in quality.
Sep 21 2008 at 10:27am
Here is the bottom line: bankruptcy has eliminated “fear” from the greed/fear equation. We have detached cause from effect.
Traders on Wall Street can gamble with other people’s money, collecting fat salaries and bonuses for years, and then simply walk away rich beyond your wildest dreams when the house of cards comes crashing down. If they had to make good on those loses out of their personal funds, with no forgiveness whatsoever, they would be *much* more careful in their actions.
This is the inevitable consequence of the corporate veil. It is a false construct that detaches people’s liabilities from their actions.
And now the federal government has just told Wall Street “Please, be as reckless as you’d like. We’ll stick the taxpayers with the bill for all the bad decisions you’ve made over the years while amassing personal fortunes.”
Sep 21 2008 at 11:24am
There has to be a downside, a big downside, for the banks in any bailout.
So for we have not heard much about this bailout but, if there is no downside, it will only serve to encourage bad, and short term greedy, management in the future. The management of large investment firms and banks have not had to consider the downside. They could make enough in a very short time to provide for a comfortable future even if they got fired.
How do you think senior management would feel if the feds required that all senior officers of bailed out banks repay all bonuses earned in the previous 4 years? If they didn’t repay (less taxes paid) the bank wouldn’t get bailed out. That would get their attention.
Possibly any bailed out bank, or other entity, could be forced to agree that the company will pay no bonuses whatsoever to any employees for a period of 5 to 10 years. If they don’t agree to that they don’t get help. That would certainly raise eyebrows.
Every single day, regular people in all walks of life, have to consider the downside of their decisions. They learn not to repeat the mistakes. The above mentioned “punishments” are only off the top of my head, and I don’t hold that they’re the only answer. However, the Wall Street types have to face downsides, BIG downsides, it we are to avoid repeats of this disaster.
Sep 21 2008 at 12:02pm
Here’s some info on Mindles. I thought I recognized the name from “Jane Galt’s” old blog. She is now currently blogging at Atlantic Monthly as Megan McArdle. Mindles was her co-blogger from years ago.
Sep 21 2008 at 4:55pm
Is this your way of challenging Brad DeLong to a long long debate? Maybe via bloggingheads? That would be spectacular.
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