Day: January 23, 2010

Too Much Leverage Precedes Many Disasters

Too Much Leverage Precedes Many Disasters

There seems to be some confusion over what threatened to cause major banks to fail.? Let me go over my list of the risks:

  • Many relied on AIG to insure their subprime and other structured lending risks.? Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”? After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!? Alas for risk control, and the illusion of the strength of companies merely because they are big.
  • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.? Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.? When the tide goes out — oh well,? GE Capital might not have survived without the TLGP program.? Another reason why I sold all my GE Capital debt when I was a bond manager.? Big companies can make big mistakes.? Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
  • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.
  • Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
  • In general, banks ran with leverage ratios that were too high.? Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.? Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
  • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.? The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.? Guess who survived?
  • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
  • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
  • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
  • State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading.? These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.? By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened.? I don’t care if it means that lending diminishes for a few years.? Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.? (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains.? In the long run, what makes economic sense will prevail, not what scores political points.

Blaming Bonuses is Politically Easy but Wrong

Blaming Bonuses is Politically Easy but Wrong

A senior aide to a Congressman emailed me regarding the debate on Capitol Hill.? I responded:

Nell Minow knows what she is talking about, but this paragraph on page 5 is the money shot:

But the key is the board. It is unfathomable to me that many of the very same directors who approved the outrageous pay packages that led to the financial crisis continue to serve on boards. We speak of this company or that company paying the executives but it is really the boards and especially their compensation committees and until we change the way they are selected, informed, paid, and replaced we will continue to have the same result. Until we remove the impediments to shareholder oversight of the board, we cannot hope for an efficient, market-based system of executive compensation.

Pay can’t be reformed unless corporate governance is reformed.? Her suggestions above that are “mom-and-apple pie,” but they never get implented because boards are captured by their executives.? What she says on board reform after the aforementioned paragraph is crucial.

Away from that, anyone structuring incentives quickly learns:

  1. Short-term incentives motivate more.
  2. Incentives based on what the employee can control motivate more than those he can’t.
  3. Cash now is preferred to anything else — it motivates more, unless there is tax deferral as a goal, or, inflation of apparent corporate profits, because the issuance of stock does not hit the income statement as a cost.
  4. Some incentives are near-guaranteed because there are goals of not destroying the firm through taking too much risk — those should disappear during a crisis.? In this case, they didn’t but they should have disappeared.

That’s why Wall Street’s incentives were designed the way they were — they motivate to a high degree; that is the culture of Wall Street.? They should have cancelled bonuses because of the crisis — they would have if they had not been bailed out, which the Government stupidly did, and even then did it stupidly.

If the government had merely backstopped the derivatives counterparties, while sending losses to the holding companies until they were insolvent, and running an RTC 2, rather than just handing cash to holding companies, this all could have been avoided.? The systemic risk would have passed — most firms on Wall Street would be in insolvency, and bonuses would not have been paid.

The fault belongs mainly to the Fed and Treasury; they botched their jobs.

Back to incentives — the four points above work best for companies when revenues and expenses of the business are short term in nature.? But when the results of business take a while to develop, like selling a life insurance policy, the accounting gets complex.? So do the incentives.? Life insurance companies typically pay agents most of their compensation in a lump at the sale.? There are limited clawbacks.? Other methods of compensating agents more gradually have been tried, and generally, they don’t work so well with making sales.

But management aren’t salesmen — they should be bright and motivated on their own, or they shouldn’t have their jobs at all.? They shouldn’t need the “immediate gratification” incentives, and should be able to live with the eight reforms that Nell Minow suggests.? This is particularly true for financial companies, the the true results of activity will not be known for years.? Creating longer-term incentive structures will aid stability and improve managment of the firms.? The firms will be less aggressive, and that is good.? Aggressive financials almost always blow up.

To close, if you want to see this happen, corporate governance should be changed, where boards cannot so easily be captured by their managements.? Otherwise, this issue will return.

David

Why Bernanke Doesn’t Matter, So Vote Him Down If You Want

Why Bernanke Doesn’t Matter, So Vote Him Down If You Want

I am no fan of Ben Bernanke, longtime readers know.? There are many reasons to find fault with him:

  • His actions on the Fed while Greenspan was Chairman provided the intellectual support for over-providing liquidity to the market.? Dropping the Fed funds rate below 2% was indefensible.? All the economy needs is a small positive slope to the yield curve, and after a few years, the economy will normalize.? Steep yield curves work faster, but they encourage bad investments because when the yield curve is steep, many people will try to clip free income.
  • Rather than encouraging liquidation of broken financial institutions, he gave money to holding companies in exchange for ownership, with few strings attached.? The Fed should not have power to bail out any financial institutions; that power should belong to Congress or the Treasury directly, so that we can hold them accountable.
  • He resisted giving information regarding the bailouts by denying FOIA requests.? There is no good reason to avoid those requests.? The insurance industry has to reveal every asset, and material liabilities in aggregate.? The is no reason why the banks could not do the some thing.
  • He has been intellectually certain that the Great Depression occurred because monetary and fiscal policies were too tight, and a trade war disrupted commerce, rather than the more likely hypothesis that loose monetary policy led to an increase? in debts financing an asset bubble, and the Depression only ended when enough of the debts were extinguished (around 1941).

To any Senator that might be listening (I dream), I would simply say this — it doesn’t matter whether Bernanke is reappointed or not because the greater question is reforming the Fed.? The Fed has a self-perpetuating nature, and resists real change.? The faces change, but it remains business as usual.? Would Congress consider:

  • adding Governors that are not neoclassical economists?? Bring real diversity of thought to the Fed?
  • slimming down the Fed so that it does not dominate research on monetary policy?? Employment of economists at the Fed is too big, and not justified by their output.? You could fire half of the people at the Fed, and there would be no effect on its effectiveness.
  • making the Fed solely responsible for all depositary institutions?? Note: I don’t like the Fed, but I do like accountability.? Let there be one institution responsible for credit, and one institution responsible for creating bubbles.? The Fed has created bubbles, and denies it.? No.? Let the Fed take care of credit, and when they blow it, hold them accountable.? Either fire those that made the bad decisions, or, move back to a commodity/gold standard.? It would constrain our government that attempts to mandate prosperity with out the power to do so and fails.

Senators, if you need to vote down Bernanke for political reasons, there is no reason not to do so.? The American people will not think the worse of you for doing so, and while the markets may blip down, they will recover once a new Chairman is appointed.? Among conventional candidates, I would favor John Taylor, who formulated the Taylor Rule of monetary policy, which Greenspan and Bernanke violated.? Unconventional candidates?? Elizabeth Warren, Sheila Barr, Ron Paul, Barry Ritholtz, jck at Alea, and I could name many more people who understand our crisis better than Bernanke.

PS — the same logic applies to Timothy Geithner; he is dispensable as well.? We think that the institution will change if we change the person at the top, but structural change is needed, refocusing or reducing the institution as a whole.? I could generate another list of complaints against Mr. Geithner, but truly, if he were gone. without structural reform, the Treasury would not change.

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