Kevin Drum - September 2008

Four Down, One to Go

| Tue Sep. 23, 2008 10:38 PM PDT

FOUR DOWN, ONE TO GO....Here's some interesting news:

Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett's company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.

....The Berkshire investment will be a big boost to Goldman. Even though the firm hasn't posted a quarterly loss since the credit crisis began, its profits have waned and its stock got hit last week. It has examined a number of options aimed at bolstering its capital position.

So let's count: Fannie and Freddie have been bailed out. Bear Stearns and Merrill Lynch have been acquired. Lehman is gone. Goldman Sachs is apparently in good shape (I'm willing to take Warren Buffett's word for it, anyway). The big conglomerates (Citi, Chase, Bank of America, etc.) don't seem to be under any serious pressure.

So who does that leave? Morgan Stanley, of course. But who else? For better or worse, bailouts are usually limited to firms so big that their failure would cause systemic meltdown. So who are we planning to bail out? Little firms? Big firms that would survive regardless? Insurance companies? Hedge funds?

I'm not questioning the basic need for a rescue plan. I'm just wondering who needs rescuing right now. For more, see this post from Yves Smith, which quite plausibly argues that although a bailout may be necessary, it's not urgent after last week's intervention in the money fund market. If this argument is correct, it means we don't need to be stampeded into action. We can afford to spend some time to figure out who really needs help and what the best mechanism for helping them is.

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Executive Compensation

| Tue Sep. 23, 2008 9:26 PM PDT

EXECUTIVE COMPENSATION....Should the Wall Street bailout include provisions to punish executives who were responsible for bad behavior during the housing bubble? Megan McArdle asks if this is even legal:

Here's a question: a lot of Democrats seem to want the Wall Street executives to disgorge things like their retirement packages and bonuses before cutting any deal. Can Congress do this, legally? I mean, yes, they make the law. But my understanding is that while you can grandfather in benefits, you can't retroactively punish people for behavior that was legal when committed. Can Congress reach in and retroactively void a private contract? I'm not asking for commentary on the wisdom or morality of such a move, just whether it would withstand a court challenge.

Not a chance. The Fifth Amendment prohibits the direct impairment of contracts, and Article 1 prohibits both bills of attainder and ex post facto laws. Felix Salmon adds some practical questions:

Which folks did you have in mind? The ones who ran subprime mortgage originators which have now gone bust? It'll be pretty much impossible to get money back from them. The MBS and CDO desks in investment banks? Most of them have been fired at this point, there's not much work for them any more. The senior executives at the banks? They've seen their net worth plunge along with their share prices. There might be a couple of fat-cats still around whom the government could ask to repay their bonuses. But it would be gesture politics.

Obviously this is a bummer. We can, of course, demand that executives voluntarily agree to new compensation packages going forward if they want to participate in the bailout, but even there we need to be careful. For example, John McCain, in his new role as the Scourge of Wall Street, says we should just limit all executive compensation to $400,000 or less. But who knows what that means? Does it include only direct income? Perks? Stock options? Retirement pay? Bonuses? Or is it all of the above? If it is, all that will happen is that the brightest people at these firms — which, remember, we would like to succeed since we'll all have equity stakes in them — will scurry away for more lucrative futures at small hedge funds and boutique banks. Granted, given the performance of the brightest people over the past few years, maybe we'd be better off with a few dullards instead, but be careful what you wish for.

Much better, I think, would be structural changes that reduced income for everyone in the finance industry, not just the bankrupt firms. If Democrats had a spine, that might be feasible. Under present circumstances, however, I realize it's pie in the sky. A few ritual disembowelments is probably the best we can hope for.

Rick and Freddie

| Tue Sep. 23, 2008 8:47 PM PDT

RICK AND FREDDIE....John McCain says his campaign manager, Rick Davis, hasn't worked for Freddie Mac for several years. However, according to "two people with direct knowledge of the arrangement," that's not true. In fact, his lobbying firm been receiving $15,000 from Freddie every month since 2005:

Mr. Davis's firm received the payments from the company, Freddie Mac, until it was taken over by the government this month along with Fannie Mae, the other big mortgage lender whose deteriorating finances helped precipitate the cascading problems on Wall Street, the people said.

They said they did not recall Mr. Davis's doing much substantive work for the company in return for the money, other than speak to a political action committee of high-ranking employees in October 2006 on the approaching midterm Congressional elections. They said Mr. Davis's firm, Davis & Manafort, had been kept on the payroll because of Mr. Davis's close ties to Mr. McCain, the Republican presidential nominee, who by 2006 was widely expected to run again for the White House....No one at Davis & Manafort other than Mr. Davis was involved in efforts on Freddie Mac's behalf, the people familiar with the arrangement said.

You know, I'm basically willing to concede that Fannie and Freddie were bipartisan clusterfucks and just call it even as far as the campaigns are concerned. But only if they fess up to their sins and stop regaling us with ridiculous lies about their relationships. Rick Davis either needs to tell us what his firm was doing for its $15,000 a month or else he needs to provide a plausible explanation for why his firm continued to receive that sum for doing nothing. Come on, folks.

Debt and Equity

| Tue Sep. 23, 2008 5:53 PM PDT

DEBT AND EQUITY....If Uncle Sam is going to bail out America's banks, should taxpayers receive equity in these banks in return for handing over vast piles of cash? Sure. But here's the specific language from the Dodd "discussion draft" of the enabling legislation:

(A) CONTINGENT SHARES.—

(i) IN GENERAL.—The contingent shares to be received by the Secretary under paragraph (1) may, at the determination of the Secretary, include shares of the financial institution, its parent company, its holding company, any of its subsidiaries, or any other entity which is owned, controlled, or managed by such institution. [Details are laid out later in paragraph 2.C.3.]

(ii) DEBT INSTRUMENTS.—In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares, which shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to 125 percent of the dollar amount of the difference between the amount the Secretary paid for the troubled assets and the disposition price of such assets. The Secretary may demand payment of such contingent debt instrument under such terms and conditions as determined appropriate by the Secretary.

So: the idea is that the Treasury buys toxic waste from the banks and eventually sells it off. If it sells at a loss, it receives shares equal to 125% of the loss. This is based on the share price at the time it bought the assets, which means that if the bank prospers in the meantime and its share price rises, the taxpayers share in this good fortune.

Fine. But note the second paragraph: if we bail out a private firm, we get senior debt instead of equity. Fair enough: equity in a private firm is hard to value, so why add in the additional complexity of trying to negotiate a fair value?

But here's the thing: Does accepting senior debt do the banks any good or doesn't it? Taking debt instead of equity essentially amounts to restructuring the bank's debt and giving it some breathing space, possibly enough to allow it raise capital privately. It doesn't directly change the bank's capitalization ratio, but if restructuring debt without changing capitalization ratios is useful for private banks, why not for publicly held banks too? After all, they're both faced with borrowing money from the same people with the same concerns over possible insolvency.

Maybe I'm an idiot. It wouldn't be the first time. But I continue to be a little perplexed by the mania for equity. The removal of toxic waste combined with a restructuring of debt either does some good or it doesn't, and if it does, then let's use it for publicly held banks too. If the borrowing firm eventually goes bankrupt, senior debt is better than equity anyway. If it prospers instead, equity will turn out to be the better deal, but I don't really care about that. I don't especially want Uncle Sam playing the market, and I don't especially want Uncle Sam to own potentially large stakes in half the banks on Wall Street. I just want the best chance of getting our money back.

Chart of the Day

| Tue Sep. 23, 2008 3:50 PM PDT

CHART OF THE DAY....Via Propublica, here's a history of government bailouts starting with the Penn Central bailout of 1970. All adjusted for inflation, of course. Click the link for all the gory details.

Financial Innovation

| Tue Sep. 23, 2008 12:10 PM PDT

FINANCIAL INNOVATION....Via Ezra, Dani Rodrik asks a pointed question about the rapidly innovating financial markets of the past couple of decades. Would increased regulation really sap innovation and cost the world trillions of dollars in real wealth?

[Financial boffins] owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation — not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

It's an interesting question. One of Rodrik's commenters offers this: "Interest rate, currency and credit swaps have been extremely beneficial to corporate risk management. OTC Derivatives on fuel futures have been very useful to manage fuel price risk faced by airlines (which is now over 40% of their operational cost)." And that's true enough.

But it's the scale of the growth that gets me. The size of the market for credit default swaps, for example, grew from about $1 trillion in 2001 to $62 trillion in 2007. Has anything in the real world grown enough to justify that kind of increase in the CDS market? Or has it mainly been a way for purveyors of mid-rated bonds to turn their dross into something that pension funds are legally allowed to buy? Is that really useful to the economy in any real kind of way?

I should say at the outset that I'm inclined to believe that recent financial innovations have, in fact, been highly useful, and that the root problems lie elsewhere (too much leverage, stupid mortgage practices, too little oversight, etc.). Still, it would be interesting to read an in-depth defense of how financial innovation has helped the global economy, wouldn't it?

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Lehman and the Bailout

| Tue Sep. 23, 2008 11:47 AM PDT

LEHMAN AND THE BAILOUT....Was last week's financial crisis caused by the Fed's decision to allow Lehman Brothers to go into bankruptcy? I'm not sure, but here's the basic argument in favor of this scenario:

  1. Monday: Fed allows Lehman to go bankrupt.

  2. Tuesday: Reserve Prime, a money market fund with exposure to Lehman securities, announces that it has "broken the buck." Money market funds are supposed to be the safest places possible to park your cash outside of T-bills, so this causes a panic.

  3. Wednesday: Depositers start making large-scale withdrawals from other money market funds. Banks need to service these withdrawals, so they begin hoarding cash and calling in their short-term loans (excess reserves held by banks increased last week from a normal $2 billion to nearly $200 billion). Every bank is doing the same thing, so no money is available for normal interbank loans. LIBOR skyrockets.

  4. Later Wednesday: with everyone hoarding cash, the credit markets seize up completely. The commercial paper market, which funds actual operations of actual companies, is close to death. The entire financial system is near collapse.

  5. Thursday: Bernanke and Paulson announce their bailout plan. This reduces the panic that banks will go bust and thereby frees up the credit markets a bit.

More details here. If I understand everything correctly, Bernanke and Paulson basically took a look at what happened after they allowed Lehman to collapse and decided it couldn't happen again. Hence the bailout.

The Press Fights Back....A Little

| Tue Sep. 23, 2008 10:31 AM PDT

THE PRESS FIGHTS BACK....A LITTLE....Via Sullivan, the latest from the Sarah Palin wonderland is her visit to the UN. The purpose of the visit is to, um, expand her already substantial experience in foreign affairs, and the McCain campaign wanted all the networks to cover it, of course. But they didn't want anyone asking Palin any questions. And then they decided they didn't even want reporters present, even if they kept silent. Just a camera, so that Palin's smiling face would show up on the network news deep in discussion with important foreign leaders.

But what do you know? Apparently the networks actually balked at being used quite so baldly. So the McCain campaign backed down and is now allowing one (1) CNN producer in the room along with the camera operator. But still no questions, I gather. Wouldn't want to put Palin under too much pressure, after all.

Obama and Ayers

| Tue Sep. 23, 2008 10:19 AM PDT

OBAMA AND AYERS....Stanley Kurtz has been working diligently for weeks in an attempt to prove that Barack Obama has hidden sympathies for pot-smoking-bank-bombing-60s-era domestic terrorism in the form of close (but well hidden!) ties to former Weatherman Bill Ayers. His operational strategy was to comb through the records of the Chicago Annenberg Challenge, a mid-90s educational experiment sponsored by Ronald Reagan's friend Walter Annenberg, to check for damning evidence that Ayers (who founded CAC) had a serious relationship with Obama (who was chairman of the board of directors, which did fundraising for CAC). I had sort of lost track of how this project was coming along, but apparently he finished up his labors and produced.....a mouse. Jason Zengerle summarizes:

So Kurtz spends days wading through 70 linear feet of material, suffers lord knows how many paper cuts, and the best he can come up with is that Ayers was part of a five-person "working group" that signed off on Obama joining CAC's board? That's pretty weak.

Better luck next time, Stanley.

Pakistan Update

| Tue Sep. 23, 2008 9:09 AM PDT

PAKISTAN UPDATE....Just in case the imminent collapse of the American financial system doesn't have you quite worried enough, here's a report from the LA Times about the imminent collapse of Pakistan:

More than any other terrorist attack in this volatile country, the devastating truck bombing of the Marriott Hotel over the weekend has presented government and military leaders here with a stark choice: Go all out against extremists or risk the nation's collapse into chaos.

That is the growing consensus among many Pakistani analysts and commentators, who fear that without rapid, determined and ironfisted action by officials and security forces, this nuclear-armed land is in danger of becoming a failed state, with Islamic radicals in control.

....The descent into violence and fear here has been sharp.

In a country where suicide bombings were relatively rare five years ago, more than 300 people have been killed in such attacks this year. What seemed at first to be a threat confined to the nation's fringes, in the rugged and uncontrollable border and tribal areas, has now penetrated urban centers, including the very heart of this leafy, broad-avenued capital.

As usual, the real state of play is pretty murky. But murky in a bad way, not a good one.

In the meantime, it appears that the Pakistani military didn't open fire on a U.S. helicopter that didn't fly into Pakistani airspace. That's the story, anyway.