Cry wolf

There is the story of the boy who cried wolf.  One day the wolf came and no one did anything because they boy had cried wolf too often.  The wolf is finally here, and after hearing politician after politician talk about the end of the world, when you finally have a crisis that can cause the end of the world, no one believes them.

What happens next depends on how quickly things unravel versus how quickly people just get over their anger and realize how bad the situation is.  One reason that I think Paulson’s bill failed was that there really hasn’t been a bad impact to the economy, and I think that things will have to get a little worse before people really realize that the wolf is out there.  I think the challenge now is to have things fall apart slowly so that as people realize that this isn’t the usual politics, things don’t get so bad that they are unfixable.

Reports of the death of Wall Street have been greatly exaggerated

I really do think that people are being much too premature about the death of Wall Street.  Sure a lot of the stupid craziness is going to end, but that isn’t necessarily a bad thing.  Yes the new institutions that are going to be running Wall Street may be much less highly leveraged, but you can make up for lack of leverage with volume and as long as the underlying economy is more or less sound, you can find volume.

This might sound odd.  Two days ago, I was saying “Oh my God, we are doomed!!” and now I’m talking about the economy being fundamentally sound.  It’s there a contradiction, here?  Not really.  Think of it as flying on an airplane.  There isn’t that much difference between a smooth comfortable ride, and a life threatening situation in which you end up dying in a huge fireball.  The sense that I had a few days ago, was that of a passenger strapped into an airplane seat, entering a massive thunderstorm heading toward a mountain, and then suddenly seeing the pilot with this crazed look that suggests that he might be drunk or suicidal.  Once it becomes clear that the pilot isn’t drunk or suicidal, and once the airplane suddenly swerves and misses the mountain, then I can finish vomiting and try to relax.

The fact that there is no contradiction between “the economy is fundamental sound” and “oh my God, we are all doing to die” is what makes things like the Great Depression rather tragic.  In the United States in 1929 (or Japan in 1988), there was a lot of craziness, but you had an economy with factories, jobs and employment, and the fact that things spiraled out of control shows how a financial crisis can turn into an economic crisis if that crisis isn’t handled very carefully.  To use another metaphor, if you cut off someone’s oxygen, they are going to die.  It’s true that if you are unhealthy, you are more likely to have your oxygen cut off, but if someone dies from lack of oxygen, that doesn’t mean that they were basically unhealthy to being with.

Hedge funds not going boom

One thing that is interesting about the mess on Wall Street is how hedge funds didn’t go boom like they did in 1987.  There are reasons for this, the main reason of which is that hedge funds are nowhere near as leveraged as they were in 1987, and without leverage, it’s less likely that you will end up with a financial crisis, and much, much less likely that you will end up with a financial crisis quickly.

The interesting thing is why hedge funds are less leveraged, and a lot of that has to do with prime brokers that lend hedge funds money.  Prime brokers are a lot less willing to lend hedge funds large amounts of money sight unseen than they were when Long Term Capital Management blew up, and the main reason for this is that the prime brokers are overseen by government regulators such as the Federal Reserve and the SEC.

Now the world seems to be saved for the moment, and we start turning over to what worked and what didn’t, and what sort of regulatory scheme that we need, and I think one thing we need to look at is how hedge funds generally didn’t manage to blow up.

Whew

Had a bad evening last night when it seemed that the bailout bill was falling apart.  Fortunately it looks to be like your standard political mess.  Once thing that is somewhat both refreshing and scary about the bailout bill is that this is the first time in a long time “real politics” has made it to the front pages of newspapers.  Usually what ends up in newspaper is just “show” in professional wrestling terminology, where the only thing presented is very carefully tweaked image.  But this week because time was short, we actually got to see the real legislative process in action in all of its messy detail.

One of the more bizarre things was that Charles Krauthammer actually wrote an editorial which I thought was very well thought out and which I agreed with.  I can feel hell freezing over.

Anyway, the big boss where I work came in for a “let’s celebrate that we made it through the week” gathering and ordered everyone to relax for the weekend, which I can do since it appears that the world will not end next week.  Since the world will not end next week, I’ve been trying to think what this means for the months and years later.

One cool thing is that no one knows.  No one knows since everything is still a work in progress.  Things are going to be massive torn down over the next few months and built up.  It’s going to be interesting to see what gets created and to be a part of that creation.  One thing that I consider pretty amazing is that given how close we came to total financial meltdown, how little this disruption has spread to the rest of the economy.   But I’m pretty sure that New York City will come out well from this.

And then there were none…..

The American investment bank is no more.  Goldman and Morgan Stanley look like they are going to no longer be independent banks but rather commercial banks with investment branches.

One thing that is interesting is to look at the consequences of the Gramm-Leach-Billey Act which removed the wall between investment banking and commercial banking.  At the time, the belief was that by removing the walls, it would allow financial conglomerates to offer integrated financial services at the retail level.  You go to one bank, and have your checking account, stockbroker, and insurance all handled via one stop shopping.  This actually didn’t happen because the difficulties in integrating different financial services into one integrated firm turned out to be more than the amount of useful that integration would provide.

However, the one thing that has happened, and this is almost unintended is that by attaching an investment bank to a commercial bank one allows the investment bank to survive economic storms that would kill the investment bank if it was on its own.  Also it allowed investment banks to take advantage of the stability and safety that comes with stricter government regulation of commercial banks.  So it turns out that systems integration wasn’t that useful, but balance sheet integration was.

What I think may end up happening is that banks are going to start looking and acting like public utilities.  Huge and somewhat boring corporations that are very highly government regulated designed to bring cash in the same why that the power company brings power.

This I suppose will bring in some big cultural changes to Wall Street.  You really don’t think of the people that run the power company as brash, larger than life, cowboys.  But on the other hand, you really hope that the people that run the power company *aren’t* cowboys.

Thoughts about the Paulson plan

It’s actually quite simple really.  Congress gives the Secretary of Treasury a $700 billion blank check to do whatever he thinks he should do to fix the problem.  One reason I think that he is trying to get this done now is that it’s not clear who exactly is going to be using that power, and it’s going to be much harder to get people to support something once they realize that their guy isn’t going get to use the power.

The thing that bothers me is the term “Gulf of Tonkin Resolution.”  I’m quite worried that this transfers a huge amount of power to the Secretary of the Treasury without much oversight.  The powers are theoretically limited to two years, but the bill lets the Treasury Secretary write contracts that may likely bind the United States for quite a bit longer than that.  I’m especially worried that the powers in the bill will be used before the new President takes office. Part of what I’m trying to figure out is what the conspiracy theorists will say in about a year (hi Naomi Klein) and set things up so that they will have less ammunition.

If the mortgage assets get auctioned off to banks and private equity firms that make a large amount of money on this, then I don’t want there to be a “well Paulson and those evil banks planned this all along” mantra.  One thing is that it is likely that banks and private equity firms will make a large amount of money on this.

Right now people are willing to get rid of anything they can.  It’s called a “fire sale.”  It’s likely that they are going to end up selling some very good assets at very cheap prices because they just want out.  In crisis, people want cash right now, so have a house on fire, you can make a lot of money by paying for the assets, putting out the fire, and then reselling the house, which is what I think is going to happen.  The thing about a lot of these assets is that they are actually worth reasonable amounts of money if you are willing to hold them for 30 years or so, but they are almost worthless if you want cash now.

Personally, I think that there ought to be some changes that the next administration puts in:

1) soak the rich – This is a taxpayer supported bailout so we need to hit the right taxpayers.  A surtax on salaries over $1 million/year, capital gains surtaxes on profits over some large number (say $300,000/year) would help put the pain where it should be put.  Also a large tax on golden parachutes would be useful.  If a company has to pay an executive $15 million to leave then fine….  It would be good to take say $2 million and put it into a fund to clean up that executive’s messes.

2) easier personal bankruptcies – first there is this issue of social fairness.  Why can’t ordinary people wipe out their debts if the big banks can.  There is also a more important reason.  If the big banks had been hit by a huge wave of early bankruptcies and foreclosures, this would have given them a much early signal that maybe they were doing things that were stupid.  As it is the lack of bankruptcies meant that you can people stuck paying loans that they the couldn’t pay and it was going to end up in tears.

3) higher capital requirements – People are talking about “more regulation” but the question now should be “what types of regulation.”  The big one I think are higher capital requirements.  The problem with bans on things like complex derivatives is that they are easy to get around.  Statements that you must not do something cause people to find all sorts of clever ways to do it.  However, if you say that you must have X% of capital reserve and then define things careful so that when people cleverly try to get around the regulation they end up doing useful things, then when things go bad you have an insurance fund that you can go to.

Getting rid of zombies

One might point out that if let banks transfer bad assets to the government, the banks will find the worst assets that they have, give those to the government, and the keep the best assets that they have.

That’s part of the point.

If you don’t do the transfer then the banks have an incentive to make the bad stuff look good.  They will be afraid of doing anything that makes their situation worse, and will try their best to as one common expression goes, “put lipstick on a pig.”  This is bad because you then have zombies within the bank, things are not quite dead, but not quite alive eating up precious energy and money.  Once you have zombies in a bank, then start wanting to eat healthy flesh, and you end up with a situation like Japan.

So to get rid of the zombies, you need to change the incentives so that people will tell you where the bad stuff is rather than covering them up.  So you go to a bank and say, we are going to give you $10 billion dollars for anything that you have, and the bank instead of covering things up, will start throwing the zombies out.  Once you have them all somewhere else, you can see how bad the problem really is, and then decide what to do about it, and who ends up paying for the getting rid of the bad loans.

Global impact

http://blogs.cfr.org/setser/2008/09/18/morgan-stanley-cic/

The world has changed forever…..

1) The belief that governments should not intervene in the markets and can and should remain completely apolitical and detached is dead.

2) The belief that the Chinese banks and financial industry are worse run than American ones and that the US should serve as a financial model for the rest of the world is dead.

3) The belief that concerns about Chinese human rights and the one-party state should cause Western nations to limit the ability of China to play an integral role in the world economy is dead. Now that the world no longer looks to the United States as an economic model, whether the world should look at the United States as a political, social, or legal model is going to be challenged in ways that were impossible last week.

(added this after I thought about it)

4) The curious thing is that while this episode reveals how unimportant the United States is as far as ideological leader, it reveals how important it is as far as the source of economic power.  The events of the last week show the United States actively intervening in the world economy in the way that no other country can.

Two big misconceptions about the financial crisis

One misconception that I’ve seen a lot is the idea that letting the banks fail would hurt only rich fat cats while having a government bailout will hurt “good honest working class taxpayers.”  In fact the situation is quite the opposite.  All of the rich fat cat corporate executives have already jumped out of the flaming wreckage of these financial companies, and if you let them fall, they’ve already taken their money and their bonuses and left.  The people will be hurt if you just let the banks fail are the creditors of the bank (i.e. people with checking accounts in them).

Now once you have the government assume the debts, then you can have Congress decide who pays for it.  The everytime a I hear about “we taxpayers” I think “I, super rich person that wants to hide behind poor people.”  Congress can decide to pay for the bailout by “soaking the rich” and I think you’d end up with a fairer answer to “who pays” than you do if you set let the banks fail.  In any case, you end up with a discussion of “who pays” that you don’t if you let things happen.

The second misconception that I’ve heard is “I’m save because my bank accounts are insured.”  This is false.  You are indeed *safer* if your bank accounts are insured, but FDIC only has about $50 billion of cash to cover $5 trillion of deposits, so if banks start failing, the government would have to fund anything anyway.  Checking accounts in insured banks are the last domino to fall, but they *will* fall if people didn’t do something about it, and the fact that we are looking at a situation were you could have mass bank failures and closures is why this is a scary situation.

And bank deposit insurance isn’t really going to help you that much if everything does fall apart.  Most people just don’t have that much money in their bank accounts.  They have enough to pay the bills and get them to the next paycheck, and most people rely on a job for their wealth.  Your checking account may be fully covered by depositor insurance, but I doubt that the account that the company that you work for uses to write your payroll check is.  This poses another problem which is time.  If FDIC runs out of money, then you will need Congress to approve a bailout package, and who knows how long that could take.  Getting your checking account money is bad if it takes a month to get the cash, and if you don’t have the cash on hand to buy groceries that is going to be a problem both for you and the supermarket.  Even using your credit card may not work, since you will have problems if the bank that runs your credit card is closed, and even if it is open, it doesn’t have much cash.

The fear of cascading failures is also why Treasuries put a guarantee on money market funds.  Money market funds are based on commercial paper which companies use to borrow working capital.  You take steel, make cars, but you need some way of buying the steel in the first place, so you borrow money with the promise that you will pay it back once you’ve made a car.  Commercial paper and money market funds are used for this, and if you don’t have this market, then no steel, no cars, no jobs.

If you want to imagine the worst case scenario just imagine yourself in front of an ATM with the it telling you that it is out of money, and having the bank tell you that your credit cards have all been cancelled because the bank is out of business, and then your employer telling you that he can’t pay you because his cash and his credit is frozen.  Once this happens then the system unravels very quickly, and the last time this happened, it took 15 years to get out of the mess.

The good news is that ATM machines and credit card systems are working now.  I can go to the corner store to get a slice of pizza.  The system is still functioning, but it took a lot of effort this week to keep it working.

Money talks – Constitutional implications of the financial crisis

One interesting thing about this crisis was how powerful the Secretary of the Treasury, the Federal Reserve have been and how weak and passive the President of the United States and the Securities and Exchange Commission.  There is a quick reason for this.  Money talks.  Treasury and the Federal Reserve have money.  The President and the SEC don’t.  When you have a financial crisis, people care how much money you have, and if you don’t have money, then people don’t care what you think.

This has some interesting implications for the role of Congress in relation to the President.  Congress has the power of the purse, and the President has the power of the sword.  During most of the twentieth century, power has moved from Congress to the Imperial Presidency, and even for much of this decade, Congress has been very passive in challenging the President even when the President was from an opposition party.  I think the financial crisis may change this, because we now are in a realm in which Congress must make certain decisions which are out of the realm of power for the President.

The government has assumed massive liabilities and now the question has to be what to do with them.  We have a taxpayer sponsored bailout, but now people are increasingly going to realize that we having quite decided “which taxpayers” pay the bill.  These questions are Congressional questions and not Presidential ones, and so I think we may see a massive shift in power from the Presidency to Congress as these questions are debated.