Kevin Drum - September 2008

Current Values

| Mon Sep. 22, 2008 3:08 PM EDT

CURRENT VALUES....Paul Krugman says the Paulson bailout will only work if it recapitalizes banks by overpaying for the toxic waste that the Treasury takes off their hands. Brad DeLong begs to differ:

Financial institutions will be grossly undercapitalized if bond prices don't recover and will be well capitalized if bond prices do recover. The way to make bond prices recover — and housing prices as well — is to boost the economy's risk tolerance by raising demand for risky assets and reducing the burden of risk that the private sector needs to hold by reducing the supply of risky assets on the private market. You reduce the supply of risky assets by having the government buy them up. You expand the demand for risky assets by restoring confidence and by providing capital injections. You do both of these at fair prices — at current values — and you find that values have changed without the governent having to overpay for anything.

I followed this all the way up to the last sentence. In particular, this part:

at fair prices — at current values —

But isn't that the rub? You can't simply declare that current value and fair value are the same thing and then walk away. That's the whole argument. After all, there are already plenty of vulture funds who are prepared to buy toxic mortgage securities at current prices — which are close to zero — but banks aren't willing to sell it off at those prices because (a) it would make them insolvent and (b) they think that once the panic subsides everyone will realize that this stuff is worth a bit more than we currently think.

Who's right? Nobody knows. But I will say this: many liberals, myself included, think the Fed should be more aggressive about fighting asset bubbles. However, that implicitly suggests that we don't think the market always values assets properly, and that occasionally the government needs to step in to keep everyone on an even keel. But if that's true for bubbles, it's also true for panics. So maybe the banks are right: maybe this stuff is being misvalued by the market, and maybe the government should step in to keep everyone on an even keel. But that means buying toxic waste at higher than current values, right?

Needless to say, the feds ought to get equity stakes or senior debt or something to protect against the possibility that all this toxic waste really is worthless. But given that plenty of people are already willing to buy distressed assets at their current, fire sale values, there's no point in the feds getting involved in a bailout in the first place unless they're planning to buy at higher than market prices. Right?

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The Wages of Egalitarianism

| Mon Sep. 22, 2008 2:14 PM EDT

THE WAGES OF EGALITARIANISM....We all know that men earn more than women. Is this due to sex discrimination? Or is it caused by differences in educational levels? Or different job preferences? Or average experience levels? Or number of hours worked?

Or, just maybe, none of the above. In a new study by Timothy Judge and Beth Livingston, which attempts to control for gender, age, race, marital status, education, hours worked, number of children, initial earnings, job complexity, and occupational segregation (i.e., the possibility that men on average simply choose more lucrative professions), the authors found that men and women actually earned almost exactly the same amount of money — but only if you compared men and women who had egalitarian notions of gender roles. Under the same circumstances, if you compared men and women with traditional views of gender roles, the men earned a stunning $14,404 more.

What's more, the big difference isn't that traditionally minded women, who might be expected to have spent less time in the work force, make all that much less. The big difference is that traditionally minded men make way more money than any of the other three groups — including other men. Shankar Vedantam talks to the authors in the Washington Post today:

Livingston said she was taken aback by the results. "We actually thought maybe men with traditional attitudes work in more complex jobs that pay more or select higher-paying occupations," she said. "Regardless of the jobs people chose, or how long they worked at them, there was still a significant effect of gender role attitudes on income."

....Livingston and Judge said there are two possible explanations: Traditional-minded men might negotiate much harder for better salaries, especially when compared with traditional-minded women. Alternatively, it could also be that employers discriminate against women and men who do not subscribe to traditional gender roles.

"It could be that traditional men are hypercompetitive salary negotiators — the Donald Trump prototype, perhaps," Judge said. "It could be on the employer side that, subconsciously, the men who are egalitarian are seen as effete."

The standard caveat applies here: it's really, really hard to control for everything. The controls in this study might not be perfect, and in addition there might be important factors that weren't included in the controls at all. Livingston and Judge, for example, didn't directly control for number of years in the workforce. It's not clear why traditionally-minded men might have more average years in the workforce than egalitarian men, but who knows? They might.

Still, the effect is monstrously huge. Since it turns some of our usual notions of wage disparity upside down, it's certainly worth some attention.

A Surge in Afghanistan?

| Mon Sep. 22, 2008 1:02 PM EDT

A SURGE IN AFGHANISTAN?....Iraq is hardly a finished success story yet, but there's no question that violence is down, security is up, and political reconciliation is at least a distant possibility. Credit for this goes to the Five S's:

  • Surge

  • Sectarian cleansing

  • Separation barriers throughout Baghdad

  • Sadr's ceasefire

  • Sunni awakening movements

So do we need a surge in Afghanistan? A better question is: can a surge succeed without the other four S's? After all, Afghanistan may be full of tribal animosities, but none of those tribes are going anywhere. Furthermore, Afghanistan doesn't have a single key city like Baghdad where separating those tribes with miles of concrete barriers is both feasible and productive; the Taliban hasn't and won't declare a ceasefire; and since the Taliban is fundamentally an ideological movement, not a sectarian one, there's not much hope for any kind of "Awakening" movement that will sap their strength. Bottom line: One S is the most we'll get.

Unfortunately, Fred Kaplan suggests that we can't even count on that. The effectiveness of the Iraqi surge depended on flooding a single city — Baghdad — with troops. But in Afghanistan there's no single city that we can focus all our attention on:

The ultimate military goal — one lesson from Petraeus' strategy in Iraq that is worth learning and might be applicable — is to protect the Afghan population, and that requires putting a lot of troops in the neighborhoods of towns and villages, to provide security and build trust. It might be possible to do this in Afghanistan, just as it was done in many Iraqi neighborhoods with one important difference — it has to be done by the Afghan National Army, not by us.

There are a few reasons for this. First, we simply can't do it. Stephen Biddle — a military analyst at the Council on Foreign Relations, who was an adviser on some aspects of Iraq strategy — estimates that securing the Afghan population would require about 500,000 troops. That's 10 times the combined number of U.S. and NATO troops in Afghanistan now. We don't have anywhere near this level of manpower to spare (the three extra U.S. brigades under consideration would amount to about 12,000 troops), and even if we did, and even if we wanted to send them, we'd have no way to maintain them.

So what should we do instead? Kaplan suggests building up the Afghan army, airdropping mountains of money on the region, and paying way more serious attention to Afghanistan's most troubling neighbor: "Pakistan is not a sideshow to Afghanistan. It is the main show, dwarfing every other problem in the region." Read the rest for more.

Checks and Bailouts

| Mon Sep. 22, 2008 12:26 PM EDT

CHECKS AND BAILOUTS....As near as I can tell, conservatives are outraged by the idea of a blank check Wall Street bailout because — hey, Barack Obama might win in November, and God only knows what kind of insane nutball he might appoint as Treasury Secretary. Do we really want to trust $700 billion to whatever quasi-socialist we might end up with on January 20th?

Liberals, meanwhile, are outraged by the idea of a blank check bailout because — hey, even if you trust Henry Paulson, it's possible that John McCain might win in November, and God only knows what kind of insane nutball he might appoint as Treasury Secretary. Do we really want to trust $700 billion to whatever quasi-lunatic we might end up with on January 20th? Phil Gramm, anyone?

This almost restores my faith in the political system.

More on Hedge Funds

| Mon Sep. 22, 2008 12:11 PM EDT

MORE ON HEDGE FUNDS....Via Atrios, Nouriel Roubini provides a potted history of the Great Financial Crisis of 2007-08. I'll skip right to the good part:

The first stage....The next step....The third stage....The fourth stage....The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Hedge fund apologists have been pretty smug about how all our current problems have been caused by investment banks, which are (lightly) regulated, and none at all by the big bad hedge funds, which operate with no regulation at all. And so far they've been right. But does anyone believe this is going to last? And what will Bernanke and Paulson do if and when a systemic rout in the hedge fund market threatens to undo their bailout plan? Will they bail out the hedge funds too?

Lehman Brothers

| Mon Sep. 22, 2008 11:29 AM EDT

LEHMAN BROTHERS....I've now read in three different places credible suggestions that last week's financial meltdown was caused not by generic "worsening credit conditions," but by the Fed's ill-advised decision to let Lehman Brothers go into bankruptcy. This led to a wave of defaults that rippled through the industry and eventually froze the credit markets.

Question: has anyone seen anything detailed and plausible that either refutes this or backs it up? I'm just curious. For now, I remain agnostic on the question.

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Regulatory Reform

| Mon Sep. 22, 2008 1:04 AM EDT

REGULATORY REFORM....Congress seems likely to pass some version of Henry Paulson's Wall Street bailout bill. Maybe not precisely his version, but something close, maybe with some oversight added and a few restrictions on exactly how the money can be used. We will, of course, be promised that although the bailout has to be passed this instant and there's no time to add regulatory reform into the enabling legislation, reform will be taken up just as soon as we've all caught our breath. I figure there are three ways this could turn out:

  • Option A: Republicans will filibuster, Democrats will wither, and basically nothing much will get passed at all. In other words, suckered again.

  • Options B: There will be some kind of panic and we'll end up with a gigantic snarl of regulation that sounds tough but doesn't really do anyone any good, sort of like Sarbanes-Oxley.

  • Option C: Everyone will take a deep breath, Democrats will stand up to the financial industry, and some reasonable set of new regulations will be hammered into place.

I'd put the odds at about 60% for Option A, 35% for Option B, and 5% for Option C. My only reservation is that maybe I'm being a little too optimistic about all this.

Blank Check

| Sun Sep. 21, 2008 5:28 PM EDT

BLANK CHECK....There seems to be a growing consensus on the left that if the American taxpayers are going to give Henry Paulson a blank check to bail out a bunch of investment banks, then the American taxpayers ought to get a piece of the action in return. For example, here's Robert Reich:

The government (i.e. taxpayers) [should get] an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk.

Maybe this makes sense. But I wonder: do we really want equity stakes in all these firms? I don't. I'd rather have senior debt. Besides, I'm not sure I especially want the federal government to own half of Wall Street anyway.

So here's another idea. Instead of an equity stake, we offer ailing banks the following deal: the taxpayers will buy your toxic waste for 20 cents on the dollar. (Or 10 cents or 30 cents. Whatever.) We'll hold it for a maximum of 24 months, at which point you can buy it back from us at, say, a 10% premium, and then sell it off yourselves. If you choose not to buy it back, Uncle Sam will sell it off. If we sell it at a profit, we'll keep the upside. If we sell it at a loss, you guys will make up the difference. The payback terms will be, oh, let's say three points above LIBOR over five years.

And what control do the banks have over how much we sell this stuff for? None. They have to trust us to get the best possible price. To coin a term, they have to give us a blank check. Seems like a fair exchange.

Hedge Funds Next?

| Sun Sep. 21, 2008 2:27 PM EDT

HEDGE FUNDS NEXT?....Henry Paulson announced today that the Great Wall Street Bailout will also be a City bailout and a Bankenviertel bailout and a Ginza bailout:

"The American people don't care who owns the financial institution," he told ABC's "This Week." "If the financial institution in this country has problems, it'll have the same impact whether it's U.S.- or foreign-owned." The United States is also working with foreign governments to take actions of their own.

That's not too surprising. Unfortunately, he went on to say this:

Paulson made clear that he did not expect to use the program to purchase assets from hedge funds.

That's what they usually say right before they're finally forced to admit that some particular corner of the financial industry is actually in big trouble, right? So I assume this means that a bailout of a few big hedge funds is right around the corner. After all, some of them are almost certain to be hanging on by their eye teeth right now, and at least a few of those hangers-on are Too Big To Fail. So cue up the money machine.

Petty and Childish

| Sun Sep. 21, 2008 1:44 PM EDT

PETTY AND CHILDISH....Matt Stoller passes along an email about the Wall Street bailout from "a lawmaker":

I also find myself drawn to provisions that would serve no useful purpose except to insult the industry, like requiring the CEOs, CFOs and the chair of the board of any entity that sells mortgage related securities to the Treasury Department to certify that they have completed an approved course in credit counseling. That is now required of consumers filing bankruptcy to make sure they feel properly humiliated for being head over heels in debt, although most lost control of their finances because of a serious illness in the family. That would just be petty and childish, and completely in character for me.

Hey, nothing wrong with petty and childish! There's a time and place for everything.

But while we're on this subject, one of the popular memes making the rounds right now is that in return for bailing out Wall Street, we should institute draconian restrictions on executive compensation in the financial industry. I'm skeptical. Any rule you can make, the rocket scientists will eventually figure a way around. Besides, I'd rather try to attack the root cause: compensation for these guys is astronomical because the finance industry itself has become so astronomically profitable, as the NYT chart on the right shows. But it's a mystery why this should be. After all, as finance becomes ever more efficient, as it has over the past few decades, arbitrage opportunities should get thinner and the industry should get more competitive. This should reduce profit margins and overall profitability — and aggregate bonus payouts along with it — shouldn't it?

The reason it hasn't appears to be a combination of fraud, vastly increased leverage, asset bubbles, and the increasing use of finance-for-the-sake-of-finance to tap into the global savings mega-glut in any way possible — regardless of whether the investment vehicles are of any real-world use or not. I may be off base here, but it strikes me that if the industry is properly regulated, reducing allowable leverage ratios and forcing managers back to using finance as a tool to provide capital to actual businesses, rather than as an end in itself, this would go a long way toward reining in compensation in a way that's more robust than artificial rules. Add in mortgage reforms, a legislative mandate (with regulatory teeth) for the Fed and the Treasury to pay more attention to asset inflation, and higher tax rates on extremely high incomes, and not only would compensation packages become halfway reasonable, but we'd actually reduce the insane bubble psychology that prompted the current collapse in the first place.

Can this be done? Would it work? I don't know, but I'd like to hear more about it from people who understand the intricacies of modern finance. But the bottom line is that skyrocketing compensation is a symptom of the problem, not the problem itself. So why not attack the problem directly?