Interesting article on financial reform

[donheff]

After discussing "what would real reform look like," I found the following article by Paul Krugman quite interesting. I hesitate to post because I know Krugman is viewed as a liberal economist and thus may provoke flames but I like his take on the issues confronting reform and am interested in what others think of it.

Six Doctrines In Search Of A Policy Regime - Paul Krugman Blog - NYTimes.com

He breaks the causes of the current crisis into six possibilities and discusses each of them in turn. Here is a quick take on it from the article but it is worth reading the details. It isn't very long:

Now, I have a personal opinion: basically, I believe in view #2, with some allowance for #3 and #4 too. But before I defend my version, let me lay out the list of candidates for explaining the mess we’re in. Later on, I’ll also describe three visions of financial reform, again along with my personal preference.
So: what’s the problem? Here are the views I see out there.
- Size: Our largest financial institutions have just gotten too big
- Shadows: The rise of shadow banking, institutions that fulfill banking functions but evade the regulatory regime, has undermined stability
- Opacity: We’ve come to rely on complex financial instruments that neither regulators nor the private sector
- Predation: Financial firms deliberately misled consumers and investors
- Government intervention: Public policy pushed lenders into making bad loans, especially to the poor
- Monetary mismanagement: The Fed did it by keeping interest rates too low for too long, and/or policymakers panicked in 2008 and spooked the markets
​

 

[IndependentlyPoor]

P.K. sure has a way with words:

with limits on the interest banks could pay, coupled with barriers to entry, banks had a large franchise value – and this made bankers reluctant to take risks that could kill the cash cow that kept laying golden eggs, or something like that.

 

[youbet]

- Government intervention: Public policy pushed lenders into making bad loans, especially to the poor

Krugman making this statement has elevated him somewhat in my eyes..... I think he's right on here. If our omnipotent politicians wanted folks who couldn't afford houses to have houses, they should have given them grants to buy them, not pushed lenders to make loans unlikely to be repaid.

 

[donheff]

Krugman making this statement has elevated him somewhat in my eyes..... I think he's right on here. If our omnipotent politicians wanted folks who couldn't afford houses to have houses, they should have given them grants to buy them, not pushed lenders to make loans unlikely to be repaid.

Sorry, Youbet, you are not going to like Krugman based on this article. He lists that as a cause to explore but doesn't adopt it as one of the three culprits he believes were germane. Here is how he fleshes that item out:

Government intervention: A large part of America’s political spectrum believes, as an article of faith, that do-gooding politicians caused the crisis – that the Community Reinvestment Act forced banks to lend to minority groups, and that Fannie/Freddie were responsible for the bubble.
I won’t spend much time on this, since it’s easy to refute. The CRA was around for almost 30 years before the problems in subprime began to develop; anyway, most subprime lenders weren’t even covered by the act. And the worst of the housing bubble developed at a time when Fannie and Freddie, under pressure over accounting scandals, were actually withdrawing from the market.
Nonetheless, it’s important to know that a lot of people believe that Barney Frank did it – and nothing will convince them otherwise.
​

 

[youbet]

Sorry, Youbet, you are not going to like Krugman based on this article. He lists that as a cause to explore but doesn't adopt it as one of the three culprits he believes were germane.

I shoulda known!

Like Krugman, I don't believe that gov't pressure and programs to lend to low income folks to enable home purchases was "the prime cause" of our recent financial meltdown. OTOH, I still don't believe gov't should intervene in that arena via private lenders. If they want to get more low income folks into houses, they need to either (1) improve the economy so that low income folks can afford homes conventionally or (2) just transfer the money to buy the houses from higher income folks to lower income folks via taxes and grants and be honest and transparent in doing so.

 

[Gone4Good]

Thanks Donheff,
Krugman's article and conclusions mirror pretty closely the path of the conversation on the other "Would you support real financial reform?" thread.

One thing I hadn't heard before was the contribution of bank's "franchise value" to financial stability for the past 80 years. It's an interesting idea. I'd have to see some evidence supporting it. But I sure hope it wasn't a big factor because it is something that is unlikely to be reproduced.

 

[LARS]

Krugman making this statement has elevated him somewhat in my eyes..... I think he's right on here. If our omnipotent politicians wanted folks who couldn't afford houses to have houses, they should have given them grants to buy them, not pushed lenders to make loans unlikely to be repaid.

Sorry, Krugman is off base on this to a large extent. His point is valid, but not significantly relevant to the financial bust. Wall Street through the alchemy of Securitization is what allowed banks to make crappy loans, which they were happy to do as they pocketed fees for origination, all the while knowing they could then pawn the "crap" loans off their books to "investors". Which we now know meant the US taxpayer.

 

[Gone4Good]

The "six views" listed by Donheff are Krugman's summary of the various arguments people are advancing for what went wrong. He doesn't support all of them . . . #5 least so.

 

[youbet]

LARS - We can just agree to disagree then. My own belief is that the gov't should not attempt to acheive social agenda goals by pressuring lending institutions to make loans they otherwise wouldn't. Lending institutions should follow strictly enforced standards of non-discrimination and fairness, but shouldn't be pressured to take risks they otherwise wouldn't. If gov't wants to put lower income or bad credit folks into homes, they should collect taxes and issue grants to do so openly, transparently and in the full light of day so the costs to the tax payers are understood.

 

[LARS]

LARS - We can just agree to disagree then. My own belief is that the gov't should not attempt to acheive social agenda goals by pressuring lending institutions to make loans they otherwise wouldn't. Lending institutions should follow strictly enforced standards of non-discrimination and fairness, but shouldn't be pressured to take risks they otherwise wouldn't. If gov't wants to put lower income or bad credit folks into homes, they should collect taxes and issue grants to do so openly, transparently and in the full light of day so the costs to the tax payers are understood.

Youbet,

I wasn't arguing one way or the other on government policy as it relates to the "ownership society". Actually, I agree that it is not the place of the government to "push" home ownership with unsound financial practices (i.e. zero down tax payer backed lending).

The point I was making is that while the "ownership society" government initiative (unwise use of Fannie/Freddie/FHA) contributed to the housing bust, the real problem was the government's utter failure in regulating securitization. This one act alone would have significantly reduced the likelihood of the "credit bubble crash".

 

[samclem]

For a very good encapsulation of the problems with the present reform proposal, it's hard to beat this short CNBC interview with Rep Paul Ryan.
News Headlines

 

[Gone4Good]

For a very good encapsulation of the problems with the present reform proposal, it's hard to beat this short CNBC interview with Rep Paul Ryan.
News Headlines

Except his argument is a bad one (as more fully discussed here and here). It is really an argument, at its core, for doing nothing with respect to setting up any kind of system to unwinde large financial institutions. Because whatever system you set up "institutionalizes to big to fail" in his view. The alternative is to have nothing in place so that "firms know they will fail". But that isn't a credible position, or expectation, because we'll never allow our financial system to fail. We'll always bail it out whenever necessary. Saying we won't when the future looks bright won't change the fact that we will when we're staring into another financial collapse. And the market will not be chastened by these obviously false promises. The only thing that will happen is we'll be caught unprepared . . . again!

And his idea to put in place a CDS trigger to cause an unwind is total lunacy. You might as well call the trigger level a "short seller target price". Because as soon as any firm has even a whiff of uncertainty, short sellers will keep lifting protection until they hit the "target". The closer they push the price to the target, the less willing anyone will be to take the other side of that trade . . . making the path of least resistance lower, toward a bear-run insolvency. It's a really, really, dumb idea.

 

[samclem]

Except his argument is a bad one (as more fully discussed here and here). It is really an argument, at its core, for doing nothing with respect to setting up any kind of system to unwinde large financial institutions. Because whatever system you set up "institutionalizes to big to fail" in his view. The alternative is to have nothing in place so that "firms know they will fail". But that isn't a credible position, or expectation, because we'll never allow our financial system to fail. We'll always bail it out whenever necessary. Saying we won't when the future looks bright won't change the fact that we will when we're staring into another financial collapse. And the market will not be chastened by these obviously false promises. The only thing that will happen is we'll be caught unprepared . . . again!

And his idea to put in place a CDS trigger to cause an unwind is total lunacy. You might as well call the trigger level a "short seller target price". Because as soon as any firm has even a whiff of uncertainty, short sellers will keep lifting protection until they hit the "target". The closer they push the price tot the target, the less willing any speculators will be willing to take the other side of that trade . . . making the path of least resistance lower, toward a bear-run insolvency. It's a really, really, dumb idea.

So, is it your position that government panels can more effectively gauge market risk than the market can? Well, then where were all these geniuses when we needed them last time? And how effective has this de facto government guarantee been in the case of Freddie and Fannie?
Regarding short sales driving down prices--during the most recent "crisis" the government banned certain short sales. It's hard to simultaneously argue that we must now resign ourselves to unlimited future bailouts because we made the mistake once before, but also ignore the idea that we could again prohibit short selling (like we've done before). No, it's not the preferred solution, but it's better than making every financial company a GSE (which is what this bill, in effect, does). The government should be distancing itself from any hint of future guarantees for firms that make bad decisions. We should absolutely not be enacting legislation that codifies even more promises, guarantees, and bailouts. And the $50 Billion fund--is that a joke? What did the last bailout cost? The $50B would obviously just be a token "tripwire" for the coming Uncle Sam Money Truck.

 

[IndependentlyPoor]

Well, then where were all these geniuses when we needed them last time? And how effective has this de facto government guarantee been in the case of Freddie and Fannie?

This is snarkier than I generally like to be but...

Perhaps those regulatory agencies would have done a better job had we not spend the last 20 some-odd years eviscerating them: repealing laws, and installing political appointees to head them who believed that the government could do no right and that corporations and the market could do no wrong.

It really is the height of something to support a long-term, concerted policy of deregulation and then complain that regulation has failed.

Rant off. Sorry. IP remains in a grouchy mood.

 

[samclem]

Perhaps those regulatory agencies would have done a better job had we not spend the last 20 some-odd years eviscerating them: repealing laws, and installing political appointees to head them who believed that the government could do no right and that corporations and the market could do no wrong.

If this is true, then it's a good argument against entrusting government panels to look for impending crises and pre-emptively wind down problem companies. After all, we're sure to elect leaders again who don't trust government, and they'll put the same people and executive policies in place that you cite as being the problem last time.
The market, on the other hand, is not subject to political "fashion." It needs an overseer (to assure transparency), but can be trusted to be the best means of assessing risk and relative value. Bar none.

 

[IndependentlyPoor]

The market, on the other hand, is not subject to political "fashion." It needs an overseer (to assure transparency), but can be trusted to be the best means of assessing risk and relative value. Bar none.

Guardedly yes, but you omit the possibility, nay the history, of fraud. Goldman Sachs certainly had an accurate estimation of the risks behind their Abacus product, but it seems now that they deliberately mislead their retail clients. Sure, the market will eventually figure it out, but it might take global catastrophe (indeed it has) to wake the market up. The market cares not who gets hurt along the way.

Granted, some regulations are intrusive, and even stupid. Let's fix them.

But what rationalization could possible exist for the Gramm-Leitch-Bilely act?

Perhaps worse, the Commodities Futures Modernization Act that opened the Enron Loophole. Thank you again Mr. Gramm. Why should anybody be allowed to take out a billion dollar bet that a bond that they don't even own would default. Why would a rule against that be any problem at all? Why is it resisted so?
Aside: his wife Wendy was the commissioner who actually administered the rules. She became an Enron board member after leaving government. That last little bit of snark is from memory. I'm sure somebody will correct me if I am wrong on that.

Why should anybody be allowed to take out a billion dollar bet that a bond that they don't even own would default? Why would a rule against that be any problem at all? Why is it resisted so?

At the risk of repeating myself:
Pre 1929 - financial chaos, bank runs, and panics.
Post New Deal regulation - 50 years of regulation and orderly prosperity
Post neo-deregulation - financial chaos, bank runs, and panics.

Your main point,

If this is true, then it's a good argument against entrusting government panels to look for an impending crises and preemptively wind down problem companies. After all, we're sure to elect leaders again who don't trust government, and they'll put the same people and policies in place that you cite as being the problem last time.

doesn't seem much of a problem to me. Just vote against politicians who campaign on the platform that anything with "Inc." in its name is good and any and every regulation is bad.

Some regulation was very effective and did not require geniuses to foresee crisis. Good regulations don't even have to be particularly intrusive.

Until the SEC changed the Net Capital Rule, independent brokerage houses were required to keep at least some capital in reserve. Now that seems like a good idea, easy to enforce, and not particularly intrusive. But no. Wall Street lobbied hard and succeeded in getting the rules changed. The change exempted Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley (and only them) from reserve requirements and look what happened to them.

Insurance companies have long been required to maintain significant capital reserves, but somehow the operations AIG's London Financial Products ended up endangering those reserves, even though they remained completely unregulated. That doesn't seem hard to fix either.

Just giving up and declaring total Darwinian market rule seems to me to be the sure route to global financial disaster. That markets self correct is merely a belief. As far as I know, it has never been proved.

Gosh I am cranky today!

BTW, I completely agree that the market is the only way to asses relative value... provided it has accurate info and is not being lied to.

 

[Gone4Good]

It's hard to simultaneously argue that we must now resign ourselves to unlimited future bailouts because we made the mistake once before,

I'd argue with the word "mistake". GDP is expected to grow 3% this year and unemployment looks to have already peaked and should start to head lower. By comparison, we avoided a bailout of the financial system in the 1930's and things were much, much worse. I think with this bill it would be possible to take down individual firms, like AIG, Citi, Lehman etc. without risking the contagion that would have wiped out the entire financial system. That's an improvement, in my view.

No, it's not the preferred solution, but it's better than making every financial company a GSE (which is what this bill, in effect, does) . . . we should absolutely not be enacting legislation that codifies even more promises.

This bill does not turn every financial institution into a GSE. Where in the legislation does it denote any implicit or explicit guarantee of anything? There are nearly 200 pages within the bill that detail the bank resolution and liquidation process. This is pretty typical stuff for bank failures. And no one claims these are bailouts. It's not clear to me why handling the shadow banking system the same way you handle normal banks is all that contentious. (It actually is clear to me, but I'll leave that alone for now). Describing this legislation as a "bail out bill" or effectively guaranteeing bank liabilities is a gross distortion. I guess the large banks are lining up against this bill because they don't want the government guarantee? I recall Fannie and Freddie fighting aggressively to keep their coveted position. Why don't all the large banks see this legislation the way you do?

And with respect to the $50B fund, I could take it or leave it. It will probably get dropped from the legislation anyway. But its existence or absence doesn't change anything. Not even market expectations. Because when confronted with the complete collapse of the financial system (as opposed to individual firms), we absolute will bail it out . . . and we should.

 

[samclem]

Guardedly yes, but you omit the possibility, nay the history, of fraud.

Fraud is already illegal. Let's enforce the existing laws before we decide to add more laws that won't be properly enforced..

Thank you again Mr. Gramm.

Let's be sure to spread that credit around. It was signed into law by President Clinton.

 

[IndependentlyPoor]

but it's better than making every financial company a GSE (which is what this bill, in effect, does). .

This is the current GOP strategy, to claim that the reform bill codifies bailouts. I admit to not reading the bill (who has?) but can you supply some support for this assertion?

 

[samclem]

This is the current GOP strategy, to claim that the reform bill codifies bailouts. I admit to not reading the bill (who has?) but can you supply some support for this assertion?

It's not just the GOP saying this. In a quick search I found this article in The Atlantic, (hardly a friend of conservatives) which cites similar problems with the bill and the associated $50B fund bailout fund. In part:

But quickly and cleanly liquidating giant failed firms won't be easy. So merely providing this authority to a government regulator isn't enough. What happens if losses to creditors and counterparties threaten to further weaken the financial system? To alleviate this pitfall, Dodd has included a $50 billion liquidation fund to cover those costs, which will be paid for through proactive assessments on the very firms that the fund could be used to wind down.
And therein lies the problem: the liquidation fund would likely provide those firms a distinct advantage. The American Enterprise Institute Financial Policy Scholar Peter Wallison explains this objection in a blog post today. What are these "costs" that the $50 billion fund will be used to cover? He believes it will serve to pay off creditors, "so that the market's fear of a general collapse will be allayed." Even if creditors don't benefit, other vendors or counterparties who do would provide an advantage to firms that are covered by the fund in a failure event.
Wallison has a fair complaint. Even though the resolution authority may, ultimately, wind down these big failed institutions, it may still bail out creditors -- and that's a problem.

And the $50B is just the nose of the camel. It reinforces the perception that the government is there to bail out firms, and the $50B isn't even a down payment on what the actual costs would be. But the money would have to continue to flow.

Far better to have well enforced laws that prevent the need for a bailout in the first place (capital requirements, transparency, rules that assure those making money from a transaction are the ones bearing the risks, attention to the bizarre incentives in place for rating agencies [including the enforced government monopoly they have], sentencing guidelines that help assure white-collar criminals get punishments comparable to other thieves, etc). When that is done, the final step is make sure these sophisticated investors know that US taxpayers won't be giving them any money if they make dumb bets and lose. There's no better way to assure they perform their own due diligence research. Any legislation should be making these players less certain of a government bailout, and the present proposed legislation takes us in exactly the wrong direction in that important area.

 

[Gone4Good]

Regarding short sales driving down prices--during the most recent "crisis" the government banned certain short sales.

But they never banned buying protection, which is the transaction at issue. And even if they tried, they couldn't ban buying protection without also banning selling protection (two sides of the same coin). And without any buying & selling of protection, there is no CDS market, thus no CDS market price, and therefore no "market trigger".

It won't work. It's a dumb idea that is designed to sound smart so that people have a reason to reject real reform.

 

[IndependentlyPoor]

Far better to have well enforced laws that prevent the need for a bailout in the first place (capital requirements, transparency, rules that assure those making money from a transaction are the ones bearing the risks, attention to the bizarre incentives in place for rating agencies [including the enforced government monopoly they have], sentencing guidelines that help assure white-collar criminals get punishments comparable to other thieves, etc).

Sounds good to me!

 

[Gone4Good]

Far better to have well enforced laws that prevent the need for a bailout in the first place (capital requirements, transparency, rules that assure those making money from a transaction are the ones bearing the risks, attention to the bizarre incentives in place for rating agencies [including the enforced government monopoly they have], sentencing guidelines that help assure white-collar criminals get punishments comparable to other thieves, etc).

All of which (except sentencing guidelines) are in the Dodd bill.

 

[Gone4Good]

It seems to me that people are confusing bailing out the financial system (a.k.a. preventing a complete financial collapse of healthy and unhealthy companies alike) with bailing out individual companies. In 2008-2009 we needed to bailout individual companies to prevent a financial collapse because we had no alternative. The Dodd bill gives us that alternative.

One of the problems we're trying to address is how to prevent a run on the financial system. That is how do you prevent short-term creditors from fleeing the system and causing a wide spread liquidity crisis. In the banking system depositors have FDIC insurance. That has prevented bank runs on healthy firms for 80 years. There is no such insurance in the "shadow" banking system. And as we've found out recently, the shadow banking system is prone to runs just like the normal banking system.

During the recent crisis, the only solution available to prevent these runs from spreading was to stop entire firms from failing, bailing out the entire capital structure to stop the financial panic. That seems to have lead to this false premise that bailing out the financial system is the same thing as bailing out individual companies. But bailing out whole companies is overkill. In a panic you can allow an insolvent firm to fail. But you do have to protect its short-term creditors so that those creditors don't start pulling their money from every other company. In an AIG or Citigroup situation, you let the firm collapse and begin liquidation proceedings but make short-term creditors whole (possibly with taxpayer dollars if needed). But you allow the rest of the capital structure to absorb the losses. In normal times (absent a wide-spread financial panic) you can let short-term creditors take losses too.

This is almost exactly what happens in a bank failure. It's been proven to work. It's a system that created financial stability for 80 years. And it's what the Dodd bill tries to replicate.

When seen this way, the charge that the Dodd legislation is a "bailout bill" is shown to be the distortion that it is. A system that allows losses for long-term investors in every instance and short-term investors in all cases except during panics does not create a bunch of GSE. Its not even close. It does not extend implicit guarantees to anyone, accept to short-term investors and even then only on a contingent basis. It's hard to see how this perpetuates "moral hazard". In fact the opposite is true. Because without resolution authority, the only alternative to stopping future financial panics is to bailout entire companies, like we did last year. So in reality, it is those who oppose resolution authority that are perpetuating moral hazard and making future company bailouts more likely.

I guess the other alternative is to simply let the entire financial system collapse. We did that in the 1930's and the result was depression. That was also the status quo throughout the 1800's and the result was a financial panic and a depression nearly every decade. That is not a good alternative. But if people really want to go that route, they should step up and defend that system and explain how it could possibly be an improvement to government resolution authority.

I eagerly await the answer.

 

[samclem]

All of which (except sentencing guidelines) are in the Dodd bill.

Good, then take out the "naughty bits" about bailing out creditors and pass the rest of it. It should be easy.