Dynamic Duo or Just a Couple of Jokers?
Wednesday, 06/17/2009 - 12:29 pm by Robert Johnson | Post a Comment
Does Wall Street rule the government or does the Administration govern the financial sector?
Treasury Secretary Geithner and economic architect Summers have presented us with a window into their thinking on financial sector reform via a Washington Post editorial. This regulatory reform effort, combined with mortgage relief, stimulus, and bailout policies constitutes the complete vision of Administration response to the financial crisis they inherited from 2008.
The United States has lost a great deal of reputation internationally because the failures of regulation and the costs of the financial crisis that propagated to the far reaches of the globe. No longer are the wizards of American financial engineering called the best and the brightest. No longer do people talk with reverence about the wonders of “innovation” or the virtues of intentional capital flows. Geithner and Summers have a tall task in leading the USA to a place of restored confidence on the domestic and international stage, all the while wrestling with the executives of the large financial firms that Simon Johnson has dubbed, “the oligarchs”.
President Obama has recast the notion of strength as the ability to resist vengeance against the oligarchs because we need them to make the financial system function. Others suspect that a courageous course of action would entail investigations, firing of executives, and criminal prosecutions of those who have cost society and the world trillions of dollars, quickly followed by a substantial and convincing set of regulatory reforms whatever, the consequences for campaign finance coffers.
Taxpayers have something in common with our foreign creditors. This process will be watched ever -so-closely and confidence in the international role of the dollar, and in the integrity of our capital markets hang in the balance. So does a sense of fair play in the economic realm. When auto companies are restructured in a downturn caused by financial shenanigans and the banks are bailed out, something is amiss that everyone can smell. I am not suggesting to do things different in Detroit. Even so, the difference is dramatic and Wall Street has gotten away with way too much. It feels as if “systemic risk” is now a banner trumpeted by financiers and is translated by the public as “getting away with murder”.
On to the particulars.
The Geithner/Summers Op Ed piece presents 5 problems that they seek to address with reform:
1. Insufficient capital held by financial institutions when systemic stress can arise.
2. Securitization led to a deterioration in lending standards.
3. Inadequate protection for consumers and investors.
4. Inadequate financial sector management tools.
5. Need for adequate global standards of financial regulation.
The proposed solutions to these 5 problems in turn are:
1. Increased capital and liquidity standards and more stringent capital standards for large and deeply intertwined firms. Also consolidated supervision by the Federal Reserve.
2. Issuers of asset backed securities will have to retain financial interest in the securities they originate, submit to greater reporting and diminish reliance on credit rating agencies. Also call for more robust regulation of futures and OTC instruments. Derivatives will all be subject to regulation and derivatives dealers subject to supervision.
3. A stronger framework for consumer protection and investor protection.
4. Financial Services Holding Company resolution mechanism to be established.
5. Promise to lead effort to improve regulation and supervision around the world.
So what is to be made from this foreshadowing of financial regulatory reform? Do they touch the right bases? Are there any glaring omissions?
As I look at the menu I sense that much of what needs to be there can be there for the most part. It is also important to remember that an Op Ed piece has word limits, so there may be more in the details of the White Paper to come. Overall tone and program appears to be a bit timid, though again we must await the details. As they say, the devil is in the details.
We have had a colossal failure in finance and as a social system. The bailouts employed by the Paulson, and now Geithner Treasuries have exacted a colossal toll in opportunity cost. Just ask the deficit hawks who claim we cannot afford roads, bridges, schools, healthcare, and other public investments because we bailed out unsecured bank bondholders who had nothing in their covenants suggesting they were entitled to such gifts. Wonder where those hawks were between October and March when the bailout bills were accrued?
Leverage, complexity, executive incentives and moral hazard are at the core of what caused our financial system to explode. Unfortunately the bailouts we have done have reinforced the moral hazard. Too Big to Fail banks stock and wholesale liabilities are both distorted and overpriced. Given the scale and pace of de-leveraging that may be necessary for a bit of time, but not for long. As a precedent the bailouts we have just seen sow the seeds of more excess. Anesthetizing creditors does not enhance prudence. Quite the contrary.
Does the Geithner/Summers outline suggest they will get to the core of these problem?
First the positives. Capital increases directly diminish leverage. A little more on the question of off balance sheet vehicles being forced back onto balance sheets had better be in the details, and I suspect it will. Lower leverage implies we will fall, when shocked, from a lower rung on the ladder than we did when our large firms were leveraged at 33 to 50 times capital. At 11 to 1 there is a lot more financial distance between these financial firms and the taxpayers wallet.
Second, resolution powers are a big help on the moral hazard front if done right. Financial executives at the helm have to look over the horizon in the future and see that the government is not afraid to zero out their stock, and restructure their balance sheets in the event they become insolvent. The greater the cost to them of becoming insolvent, the more they will be deterred from approaching the frontier near dipping into Uncle Sam’s pocket. If they know they will not be bailed out — that management will be fired, but the firm will continue — then they have little to gain by gambling on their political power. The bailout policies elected by both Bush and Obama Administrations to date have had the effect of preserving the value of unsecured bank debt and maintaining the out of the money option called equity for existing owners of insolvent firms that are taking a bite out of the taxpayers. That cannot continue. It is demoralizing. Especially when so many people and sectors are being forced into reorganization. Finance made the mess. They are the last group you want to see get off easy.
Government managers of social risk have to be able to promptly minimize the consequences of the decision to take a mega firm into receivership. The more flexibility they have, the lower the damages and the greater are the probabilities that future Treasury Secretaries can step forward to protect the taxpayers with the equivalent of prompt corrective action practiced by the FDIC with regard to banks. Forbearance may be easier day to day, and if this were a one-shot deal, it might even sometimes be of value. But our official actions are setting precedents for future action, and there are incentives embedded in those expectations. Clear credible resolution powers not only minimize the cost in the event of the disruption, but they also make the likelihood of a disruptive event smaller through their deterrent effect. Geithner and Summers appear to be addressing this based on the bill that the Treasury introduced in March and the declaration in their Op Ed. This ability to maneuver and avoid forbearance is particularly vital for a large country like the USA that cannot resolve a crisis by dropping the exchange rate by 25 percent to export our way out of the ditch. There are no tugboats big enough to tow us back to health elsewhere on this planet — particularly when our large financial institutions that represent 70 percent of our market are impaired and limping.
The big political task is to reduce complexity of assets that hover, in and around, government guarantees. Complex derivatives that are OTC priced and traded can have mark to model administered prices which serve to minimize capital set aside and maximize profit margins. Complexity defies imitation and protects profit margins. It also pollutes the system. Mark to model are not real prices and the discontinuous changes of asset values have proven to be extreme. Intractable valuation problems turbocharge suspicion when the system is shocked. No one knows what these assets are really worth or whether any of their counter parties are solvent. Fear of counter party risk freezes credit markets and sends the system on an amplified spiral downward. In this realm, the private profitability of OTC discretion is pitched against systemic integrity.
Close observers who know what role Summers and Gary Gensler played in defeating derivatives regulation in the late 1990s will watch this dimension of the regulatory debate closely. Here, the social system and the oligarchs will want different outcomes. And the oligarchs are a bit desperate given that their net worth is far too close to the zero line for comfort in many cases. Geithner and Summers are compelled to address this issue. Earlier Treasury discussions and proposals on how to handle OTC derivatives have caused alarm as expressed by Frank Portnoy in the New York Times. Portnoy smelled loopholes. Watch this one very closely. High stakes here. Big bank profits, huge national amounts outstanding and systemic fault lines of the future all hang in the balance. This is the core of the wound, the essence of how money was made as we created a crisis. It is where we must return to heal our wounds. When you hear the word ‘intertwined,’ think OTC derivatives. When you hear the word ’standardized,’ ask what that will mean and who will determine it. It would be great to see a clear statement that all OTC derivatives will pay a higher margin set aside than standardized derivatives. They should pay a premium to internalize the externalities they impose on the system.
Closely related to complexity is the commingling of well-known speculative activities with traditional banking services. Proprietary trading, market making, investment banking services and all the inherent conflicts of interest of mixing these with banking are not explicitly mentioned. A glaring omission in the Geithner/Summers Op-Ed is any mention of executive compensation at the firms who fall under the government guarantee umbrella. Their incentives are surely fair game for public policy, given that their results stand so close to taxpayer dollars. I would just plain not allow such commingling. But one can achieve the same results with with constraints on executive compensation incentives as well. As George Soros says in the Financial Times today,
“They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs”.
Is the world really better off if JPM/Chase, Goldman Sachs, or Morgan Stanley have proprietary trading departments within firms that can go to the discount window? It is hard for me to see why. Price discovery can, as Soros suggests, be located elsewhere. If they cannot retain their traders, why should society care? Better from a social point of view if they do not have any access to anything that looks like downside mitigation from the government.
On the international front, it is interesting to see the U.S. officials pledging to lead a process to strengthen the weakest links in the international regulatory chain. Perhaps the Icelandic and Swiss situations (neither of these countries have enough GDP to bail out credibly all of the bank liabilities in their national system. Iceland is an aberration. Switzerland is downright scary, as their largest firms are heavily intertwined with those in Europe, the UK and North America. In this global world, your crisis can quickly become my crisis. Yet what is curious is how upset the Europeans appear to be with U.S. foot-dragging on regulatory reform in the G-20 process. Time will tell.
Financial Product safety is described here and we must see the details and await the reaction of Elizabeth Warren to determine if this is a real structure or a fig leaf.
Then there is the skin-in-the-game section on securitization and originate to distribute incentives. Some attention is good, but one can look at the recent crisis and wonder why so many of the institutions that got into trouble did continue to originate when their inventory backed up and became a major proprietary holding albatross. I sense this is a valuable dimension, but not the essence of why we are in trouble or what we have to correct.
Let us hope, once again, that Op Ed length forced Geithner and Summers to omit very important consideration of two themes. First is the separation between banking and commerce. I shudder to think of the discount window being connected to Carlyle, Blackstone, Flowers, or more to the point, Goldman Sachs hedge funds and private equity. The private equity industry seems bent on getting their liquidity pipeline built-in and we should be wary of the private equity firms bearing gifts of bank capital that are offered to entice the Fed to relax the boundaries and let them in. Talk about sowing the seeds of future crisis.
As I mentioned above, executive compensation is a huge area where power meets politics. As long as these wild asymmetric payoff mega contracts entice top management to employ legions to find ways around the constraints and the rules to allow them to strap on more risk, these financial institutions will spare no effort to reemerge in their Midsummer Night’s Dream as a bank where the wild time grows.
I have no love for government meddling in compensation. Yet when abutted up against the taxpayer, who is largely defenseless against the mega donors from large financial institutions, the only protection can be to remove the temptation of raiding the public fisc as a means to augment already extraordinary wealth. Obama’s strength will surely be tested here and the whole world is watching to see if he can protect the nation. At core is the question, does Wall Street rule the government or does the Administration govern the financial sector? The integrity of our economic system depends upon how the Obama Administration leads this process.
These are very trying times. Most Americans know we should have single payer health insurance like so many other countries offer to their citizens at a fraction of the cost of U.S. medical care, but cannot because of lobbying power in Washington. Even a public option is in jeopardy. And Cap and Trade without auctions of the caps can become, in these budget anxious times, “the greatest corporate welfare program enacted in the history of the United States”, according to Peter Orzag, the Director of OMB. Similarly, a financial system that safely channels savings to investment and distributes risk to the place where it is best borne is a dreamlike vision of a simple system that serves commerce in a market economy that serves our social goals. Finance today appears more like a Dark Knight that haunts our economy. The servant’s servant has become the master’s master. To change that, Geithner and Summers will have to be the Dynamic Duo rather than just a couple of jokers in the deck that has been Wall Street’s House of Cards. Their Op Ed has some promising elements. Let’s watch closely as those devilish details unfold to see whether in the realm of finance, this Administration has the strength to face down the Oligarchs and enact change we can believe in.
Braintruster and economist Robert Johnson is former managing director of Soros Fund Management. Dr. Johnson served as Chief Economist of the U.S. Senate Banking Committee under the leadership of Chairman William Proxmire and before that, as Senior Economist of the U.S. Senate Budget Committee, under the leadership of Chairman Pete Domenici.
