I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here.  One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.

It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant.  The moment you put money into a holding company, it goes everywhere.  Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.

Also, few fingered the Fed’s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough.  Unlike William McChesney Martin, who joked that the Fed’s job is “to take away the punch bowl just as the party gets going,” Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.

Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced.  Why invite any neoclassical economists at all to the conference?  The few economists that were ahead of the asset bubbles were ignoring neoclassical economics.  Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding.  The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology.  And, no, applying math to ecology doesn’t help that much.

Preventing Too Big to Fail

There are three main ideas as I see it, in preventing “Too Big to Fail.”  The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions.  Use RBC to discourage banks from getting too large.

The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions.  Do you want to limit contagion?  Well, if you do, you must limit the amount that regulated banks own of/lend to other financials.  That even applies to subsidiaries with the same ownership group.  Keep it clean.  If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking.  Ban cross-guarantees among subsidiaries.

The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out.  Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.

On Detecting Fraud

I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.  In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.

This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made.  Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.

When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.

Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble.  Financial companies are in a mature industry, so beware companies that grow fast.  Also beware of long dated accruals.  Accrual quality declines with length of time until payment and likelihood of payment.

Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already.  But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring.  Where debt is increasing the most is usually the area where there will be the most financing problems in the future.

One more note for regulators: look at the high short interest.  The shorts are doing you a favor.  They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line.  I would tell regulators to use the shorts as a guide.  Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.

More Tomorrow — until then.

Carl Felsenfeld: Do we know what the problem is?  What are we trying to solve?  Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.  But it didn’t deal with those bank acquisitions.  The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.  (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.  The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.  Perhaps a more rigorous application of the Sherman Act would be more effective.  Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.  Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.  RBC as well.  Difficult to detect Control Fraud.  Originating bad loans allows a bank to grow rapidly.  Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.  – Worked ten years at a major bank that went through  a ton of mergers.  The self-regulations with each bank having its own risk model doesn’t work.  The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.  Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.  Bonuses to executives skew incentives.  (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.  Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).  (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?  The market is good at absorbing single failures.  (DM: but not multiple failures.)  b) who should do the regulation?  Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.  No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.  Analyze management culture for short-termism.  Remember you can never get pricing, volume and quality at the same time.  Financial companies are in a mature industry, so beware sompanies that grow fast.  Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.  I’ll write more about that tonight in a piece that articulates my views on banking reform.

Simon Johnson’s lunch talk was pretty standard: there is no social benefit to banks being larger than $100 billion in assets.  Major banks are too politically powerful, but they should be fought the same way Teddy Roosevelt did with JP Morgan and trustbusting.  Simon thinks that political opinion is shifting on this issue.  He calls for a size cap based off of a 4% percent of GDP for commercial bank assets, and 2% for investment banks.  This would only affect 6 banks, and would put the banking system sizewise where it was in 1990.

A frequent comment is that Canadian banking is concentrated, and they haven’t been hurt.  But other nations have concentrated banking and have gotten into trouble, notably Switzerland and the UK.

One commenter noted that reliance on wholesale funding drove much more of the panic than deposit funding.

Now the third panel starts:

Rob Johnson spoke about creating a credible resolution authority.  He asked why we can’t send Large Complex Financial Institutions [LFCI] through Chapter 11?  Derivatives must be simplified and brought into clarity.  Contagion, complexity, etc.  No real solution offered.

Jane D’Arista — Financials cannot insure other financials.  Leverage must be scaled back.  Various types of short term funding must be scaled back.  Margin standards must be extended to all financial instruments.

Richard Neiman — Banks are risk-takers, that provide a social service, thus taxpayer guarantees via the FDIC.  Volcker rule may not have prevented the last crisis, but it might prevent the next.  Need a group to try to be proactive on future risks — war-gaming.  Attempt to predict black swans.

(DM: most of this can be done by following increases in leverage.)

Arthur Wilmart: no magic bullet.  Fed overstimulated housing market after dot-com crash.  Reduce implied subsidy to banks.  How to internalize the costs?  Three problems on deposit limits: failing banks, intra-state acquisitions and thrifts aren’t counted.  Narrow banking would contain the subsidy.  Systemic risk insurance fund — at least $300 billion, pre-funded.  FDIC would manage it — most competent of the regulators.

Frank Pasquale — Talks about information asymmetries, need more disclosure.  Financial privacy — banks that are big would have to reveal a lot more.  Records of everything would have to be kept for a long time 10-15 years.

A discussant: choosing the lax regulator (DM solution: government assigns the regulator)

DM: banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula.

One panelist suggests that all financial instruments be traded on exchanges.  (Ridiculous, because only common instruments can can trade on exchanges.  Unique things don’t trade on exchanges.  That’s why IBM equity trades on an exchange, but most IBM bonds don’t.)

Discussant: banks cannot self regulate, not even as a group.

Cheapest source of funds are FDIC-backed deposits.  That’s the big subsidy.  (DM: Charge a much larger FDIC fee.)

Discussant: won’t narrow banking create more risk outside the banks?  Where things are less regulated?  Those losing money outside of the banks would end up taking a haircut.

Discussant: GS or MS failing would still shake the system.

Discussant: a new insurance fund would be difficult to make work.  Also,a new regulator might not be better than existing regulators

Discussant: Regulating money market funds as banks.  (DM:  money market funds lost so little, and banks lost so much… why is this an issue.)

Cornelius Hurley argues that banks are implicitly and explicitly subsidized, and that they need to return the subsidy.

Dean Baker argues for a transfer tax, and weakening the political power of financial institutions.  Really tangential to the point of the conference.  I’m not sure it would help or hurt too much.  It would drop trading volumes.

Dana Chasin argues for more centralized information analysis to deal with opacity and interconnectedness.

Ron Feldman argues that plans should be made in advance for how to wind up firms, based on what is special about the firms aka “living wills.”  Suggests that resolution regimes are too vague.

Tamar Frankel argues that banks should bail out each other, but pay differential guaranty fees based on the riskiness of each bank.  I think that would be difficult to pull off, such a strategy hasn’t worked that well for the PBGC (not equally funded), State Insurance Guaranty funds (post-funding), or the FDIC (pre-funded but equal contributions).  There are moral hazard and agency problems with this idea.

Personally, I would make the Risk based capital [RBC] percentage rise with the amount of risk-based capital.  Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

One questioner suggested unlimited liability for bank shareholders.  That sounds like requiring the investment banks to be partnerships.

Another mentioned the trouble with state guaranty funds in the ’80s.

Also, more capital needs to be held against securitized assets versus non-securitized assets.

One commenter suggested making repo funding unsecured.  Oh my.

Another guy commented that having subordinated debt as a warning sign did not work in the past.

Another commenter said that liquidity always dries up when you need it most.

There are always a few loonies at conferences, who know nothing about the topic at hand.  It keeps things colorful.

At the end of this panel, Heather McGhee of Demos came to talk about Financial Reform in DC.  Snapshot:

• Non-compromise Dodd bill coming Monday — no systemic risk regulator, but a systemic risk council.
• Standardization of derivatives trading, clearing, etc.  There will likely be end-user exemptions.
• Prudential regulation ~20 big financial companies will be regulated by the Fed.
• New special bankruptcy court — a check to determine illiquidity or insolvency.
• Possible Prop trading amendment — the Volcker Rule, with regulatory exceptions.
• Possible amendment: Size cap on assets, unlikely to get made into law.
• Possible new resolution authority.

Difficult to see how proactive financial services regulation gets enacted… politicians and regulators tend not to be forward looking.

First panel deals with

James Kwak: Funding costs were overly low at the major banks.  Alleges too big to fail, but big banks were highly rated.  My experience is that small banks equally good as large banks have much higher fundung costs.

Richard Carnell: hits the nail on the head — Regulators had the power to act and did not.  No political constituency for tight capital standards and higher capital levels.  So bankers argue from a concentrated political interest, and there is no political interest for solvency in good times.

F.M. Scherer — argues that too many mergers were allowed to occur, and that there were too much profits in the financial sector.  Not sure why this guy was invited.  Very long-winded, but with little new thought.

Jennifer Taub: focuses on the repo market and other short-term financing markets.  Why do banks get to finance long assets short?  Really seems to be a failure of basic Asset Liability Management.

Elizabeth Nowicki: Directors and Officers need liability and personal penalties like disgorgement of bonuses for excessive risk taking.

Good bond investors ignore ratings and read reports.  Rating agencies get blame, but much of it should go back to the regulators who require use of ratings.

Focusing on assets is a loser here, because it is liquid liabilities that lead to failure.  Focusing on funding structures would have the greatest impact on solvency.

Dean Baker makes the good point that the Fed Chairman and other regulators should have been fired as well.  Carnell added that the three thrift regulators appointed by Reagan — the first two were destructive, but the third got the blame.

Commenter/questioner brings up off balance sheet liabilities.  All assets and liabilities that affect cash flows should be brought on balance sheet for regulatory purposes.

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Okay, here is tonight’s rule: Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.  (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)  The five stages of grieving apply here.

I know I wrote it 8+ years ago, but it feels very live now.  At present it is most obvious to apply the logic to the PIIGS, and American municipalities that have overextended themselves.

But consider New Jersey that has cut back considerably, and the Kansas City School District that has cut almost half of their schools.  Their backs were to the wall, and they took brave actions to cut back.

But many municipalities remain in denial.  They have long distinguished histories, they cannot fail.  They just need to tax (or borrow) a little more to make ends meet.  Maybe they should raise the rate they expect to earn on pension assets, or offer sweeter pensions instead of greater wage hikes.  This is a big part of the crisis now, and is biting hard.

When the taxes do not come in as expected, or budgets were underestimated, and there is more spending than expected (Snow, Flood, Hurricane) there is anger, and anger drives the hopeless negotiations (bargaining) over spending cuts, over which no one wants to budge.  Not only are there priorities in what interest groups want, there are things that are guaranteed by statute, and some guaranteed by constitution.  Consider the constitutional guarantees on public sector employee benefits in Illinois.  Just try to change the Illinois Constitution; that won’t be easy.

The next stage of grieving is depression, and there are some places like California, L.A., Harrisburg, PA, Greece, etc. that are close to the point where one might say, “There’s no hope.”

After that comes the final stage of acceptance, where finally the tough adjustments are made, and solvency restored, or, bankruptcy is entered, with all of the attendant costs.  Deals are made to reduce budget items that were previously sacrosanct, such as entitlements, public sector employee benefits and salaries, etc.  That is not happening today, not even in New Jersey.

One final note: just as the last refuge of scoundrels that run companies is to blame the shorts, so it is for scoundrels that run governments — they blame the speculators.

Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.  It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.  All we need to know is the mean and the variance, which are very simple to calculate.  And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.  I would guess that it is wrong more often than it is right.  Academics continue to drag out studies assuming normality because it allows them to publish.  academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.  Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.  Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.  Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.  Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.  The company couldn’t earn an adequate return on capital at such low levels of leverage.  Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.  So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.  But that stopped when the Fed could not drop rates below zero.  Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.  It does not work in finance and economics.  When looking at loss statistics, don’t look at the mean or the variance.  Instead look at the maximum 3-year loss, and gross it up by 20%.  The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.  I use this as an example rule; tailor it to your needs as you see best.  I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.  Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.  Very unlikely.”  Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.  Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.  A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.  When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.  Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.  The regulations have been too loose for too long.

While on the Ron Smith show today, one caller asked, “So, where would you cut spending?”  Given my recent piece, The Virtue of a Big Bang, I was ready.  My view is that in a crisis, pain should be shared as evenly and broadly as possible.  Thus when someone claims that the schools or hospitals must be exempt, you come back with “No one is exempt.  There are lower priority projects and functions everywhere inside government.”

An aside: I live in Howard County, Maryland, which has the best school district in the state.  We homeschool anyway.  Unlike most places in the US where homeschoolers tend to be evangelical Christians, here most homeschoolers are purely secular.  We hear tales of those who have left the public schools decrying the sloppiness and waste in the system.  Also, we experience that the system demands more of homeschoolers than it asks of those that go to the public schools.

Earlier in my life, I have been on school boards — as a homeschooler, of course not now, that would be impossible.  No one would elect someone who homeschools to the school board.  But from my earlier work, and what I know from a basic understanding of the economics of public school systems, when counting in the fair value of pension accruals, teachers are very well paid.  We can freeze their pay, and freeze their benefits.

And, that is true for all government programs.  Cut an even amount everywhere; freeze them in nominal dollars at least.  Yes, that’s painful.  Pain needs to be shared as we cut back after years of growth beyond our ability to sustain it without additional debt.

Governors and mayors, ignore the screams.  People need to learn to make do with less.  If you lead, they will follow.  People love politicians that flout pandering, and stand for something, particularly during times of crisis.

The Same Idea on the Federal Level

Okay, much as I am not in favor of Obama’s plan for national health care, let me propose something like it.  It is time to tame Medicare.  The concept of a safety net means basic care, not extraordinary care.  News bulletin: every one of us will die, regardless of how much medical care we receive.  Too much money is spent in the last six months of life, for too little good.  If people want to spend their own money for extraordinary care to extend life, that is their own business, but it should not be the way the government spends, if it spends at all on health care.

Away from health care, let’s consider “Defense.”  To any who think me a slave of living near DC, pleazzze get it, even though if implemented, most of my friends would be hurt by what I am about to say, I will say it anyway.

There are bases overseas where soldiers face no real possibility of combat.  There is no real reason for the bases, aside from the US acting like an empire over the rest of the world.  We need to close bases in the US, and even more overseas.  They don’t benefit US interests.  We do not need to be the global policeman.

Also, many weapons programs fail.  They don’t produce anything useful, and yet a huge bureaucracy gorges on the cash from the US Government.

We need to focus on defense.  Defense, not dominating the rest of the world.  We don’t need a large military.  We don’t need to be in Iraq, and maybe not Afghanistan, and we don’t need legacy bases all over the world.  Cut “defense” spending, it is useless to the US.

If we didn’t try to dominate the Mid-East, we would not face many terror threats.  We get what we deserve.  Would we like it if outsiders tried to influence our leaders, and our selection of leaders?

Everything Must Be Cut

Fairness is paramount.  Americans have a strong sense of fairness.  If everything is being cut, then the sense of shared pain will reduce support for riots and demonstrations where people plead for their special interests.  Let the students that want lower tuition at the state University pay more.  Much more, but in rough proportion to the cuts in the rest of society.

If we cut Medicare by reducing our willingness to pay in the last six months of life, even so, let us make other cuts, such as reducing or eliminating Medicare Part D.  There is no good reason to have a Medicare drug benefit.  Please end this signature program created by George W. Bush.

I will say it again, cut everything.  Get your head around the idea that preserving the nation, state, or municipality is worth a lot more than preserving the stupid programs that venal ideologues are ranting must be kept.  There is nothing that must be kept, aside from police, fire, justice, and public health.  Even they should have wage cuts — the pain must be shared everywhere.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

If you are in the leadership of a municipality, or even a state, I have some advice for you, and it is worth many times more than you will pay to get this advice.  This is no time for half measures.  If you are just shaving here and there, and looking for the magic bullet that offends no one, let me say, “Sorry, that won’t work.  Better you should try ‘Steady as she goes for another year, borrow more, and see if the economy turns around for you.’”

But better still is to take charge, and deliver a Big Bang of pain everywhere.  If the pain hits everyone, and you put it in the language of shared sacrifice, where no one is really happy with the results, most of the electorate will respect it, and accept the reductions in services.  But make it deep, and challenge the municipal unions, whose pension plans have in the past gained exorbitant pension promises.  Don’t let anyone escape the cuts.  If everyone in the government is not hollering at you, you did not do it right.

Case in point: New Jersey.  Governor Chris Christie made draconian cuts to bring the budget into balance, and has gained respect for it.  Out of 378 possible reductions in the budget, he implemented 375 of them.  Everything got touched, and there was/is a lot of screaming.  Truth is, the government can work with fewer people, and with them paid less.  Services can be curtailed considerably.  Tell the schools they are getting less from the state/county/city.  Let them figure out what is least valuable in the system, and eliminate it.

But don’t count on help from governments above you.  They are strapped as well.  They will deliver “tough love” to those under them, much as Germany is doing to Greece.  What, you are surprised?  They are governments as well as you, and know that if they got aid, they would merely postpone action.  So they know it would do the same for you.  If you get extra aid, be grateful, but I would not count on it.

Then, there is the other side of this, for those that can legally do it: Chapter 9 bankruptcy.  More cities are considering it.  And, muni bond holders are beginning to fear it.  Those that lead municipalities are best off with a bold course.  If you are going for Chapter 9, then plan hard for how you will get compromises out of it and do it.  Otherwise, go for the draconian cuts.  These are not ordinary times where half measures will do.  The electorate will listen to the story that spending was way too high in the past, and we need to cut back for the survival of our municipalities.

Now, the same applies to the Federal Government, but the logic is trickier, because they will have to cut defense and entitlements, along with everything else.  But who aside from Paul Ryan (from my home state Wisconsin) would suggest such an idea?

We need to recognize that survival of our governments is more important than all of the programs within the governments.  Let the pain come as a “Big Bang,” and reduce funding everywhere.  The municipalities that do this will find that their funding costs will be far less than those who don’t.