Kevin Drum - May 2010

Understanding the End User Exemption

| Thu May 6, 2010 5:26 PM EDT

Over at New Deal 2.0, former Goldman Sachs VP Wallace Turbeville explains derivative trading to end users in an interesting way that I haven't seen before. You should read the whole thing, but in a nutshell here's how he describes the process:

  1. A bank sells a derivative to an end user. For example, for an airline company it might be a hedge against fuel prices rising in the future.
  2. If the hedge goes the customer's way (i.e., fuel prices go up), the bank pays up. But if the hedge goes the bank's way (i.e., fuel prices decline), the end user has to pay up.
  3. As always, though, there's a risk of default. Maybe the end user won't make good on his payment.
  4. In essence, then, the bank is selling both a hedge and a loan at the same time, and assuming credit risk on the loan.

Why do this? Why not, instead, extend an ordinary loan, have the customer post that as collateral, and sell the hedge at a lower price since there's no credit risk built in? Turbeville:

It is widely known that deployment of credit capacity to trading with a company is far more profitable than conventional lending. This means that

  • the profit from a trade coupled with the extension of credit through forgone posting of collateral is far more profitable than
  • the profit from a conventional loan plus the profit from a trade in which no credit is extended.

Viewed from the perspective of the company making the trade, it is either willing to pay more for the packaged deal or it does not properly evaluate the all-in cost.

Turbeville goes on to explain in more detail why traders benefit from this arrangement (it locks in customers and helps banks build dominant positions in particular markets) but then circles back to his starting point:

There is a lingering, unanswered question raised by the foregoing discussion: Why do the end users prefer packaged credit and trading deals, even though the banks make more than the unpackaged alternative?

The obvious possibilities are inertia and convenience — though given the efficiency of modern finance it's hard to believe that separate credit facilities would really end up being much less convenient, especially for large, sophisticated companies. But in a followup piece, Turbeville suggests a different answer: a conventional loan is carried on a corporation's balance sheet as debt, while the embedded loan in a packaged derivative isn't. So the packaged deal provides an attractive accounting loophole:

Avoiding an accounting exemption is very appealing. But perhaps the better way to address this is to encourage efficient, third party systems, short of full on clearing, to track these exposures and to facilitate efficient collateral funding in bi-lateral transactions. The simple exemption for end users in financial regulation does not encourage the development of such a system. It ignores a troubling practice which need not burden the marketplace.

In other words, maybe the end user exemption that just about everyone supports isn't such a great idea after all. Via Mike Konczal.

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Why Greece Matters

| Thu May 6, 2010 2:24 PM EDT

In an unprecedented display of 21st century comity and bipartisanship, I would like to fully endorse Andrew Stuttaford's takedown of Sen. Jim DeMint (R-SC), who remains defiantly unhappy that his proposal last year to ban taxpayer money from being used to "bail out" foreign countries was voted down:

All one can say is that, on this occasion, the Senate got it right. Senator DeMint may not like it, but we live in an economically interdependent world....Greece's problems are not just Greece's, and the threat that they pose to economic recovery stretches far beyond that unfortunate country's borders and, for that matter, the frontiers of the wretched eurozone.

The current weakness in the global economy is a clear and present danger (to borrow a phrase) to the dangerously fragile, dangerously indebted U.S. economy and to this nation's wider strategic, political, and economic interests. For all its flaws, the IMF is the best tool we have to help countries (usually on tough terms — that's why they are rioting in Greece, Senator) that have got themselves in the mess they have, a mess that threatens us, too. Seen in this light, crippling the IMF makes no sense — no sense at all.

Oddly enough, I wrote nearly those exact same words last night for distribution via email tomorrow. It's part of the answer to Felix Salmon's question, "Why should Americans care about Greece?" (For the other part of the answer, sign up for my newsletter! In addition to the rest of the answer, you also get bonus cats.)

What's more, I think Stuttaford is right about this despite the fact that even with IMF help Greece is likely doomed. In fact, as pessimistic as I've been about Greece for a long time, I've grown more pessimistic as time passes. At this point, unless the EU is almost literally willing to make Greece a long-term ward of the state and provide the massive amounts of funding needed to pull this off, it's hard to see any endgame that doesn't include debt default and Greece's exit from the Euro, with all the attendant chaos that implies. The IMF rescue delays the day of reckoning, which might be worthwhile in the same way that delaying GM's collapse until the economy improves might have been worthwhile, but I don't see how it eliminates it. I sure hope I'm wrong, though.

Quote of the Day: Our Crappy Senate

| Thu May 6, 2010 1:02 PM EDT

From Rep. David Obey (D-Wis.), explaining why he's retiring after 42 years in Congress:

I believe the job of a good politician was to be used up fighting on behalf of causes you believed in, and when you are used up, to step aside and let someone else carry on the battle. Well, today I feel used up....Given that fact, I have to ask myself how I want to spend the time I have left. Frankly, I do not know what I will do next. All I do know is that there has to be more to life than explaining the ridiculous, accountability destroying rules of the Senate to confused, angry, and frustrated constituents.

....I am also increasingly weary of having to deal with a press which has become increasingly focused on trivia, driven at least in part by the financial collapse of the news industry and the need, with the 24-hour news cycle, to fill the air waves with hot air. I say that regretfully because I regard what is happening to the news profession as nothing short of a national catastrophe which I know pains many quality journalists as much as it pains me. Both our professions have been coarsened in recent years and the nation is the loser for it.

Meanwhile, speaking of the world's greatest deliberative body, Democrats say that GOP senators are "either breaking rules or 'hold-laundering.' " Just try explaining that to confused, angry, and frustrated constituents.

What Happens When Terrorists Get Smart?

| Thu May 6, 2010 12:19 PM EDT

One of my running jokes about 24 is that it makes me thankful on a weekly basis that real terrorists are nowhere near as smart as TV terrorists. We'd all be dead a dozen times over if they were.

That's just a joke, but there's a serious question underneath: why is it that nearly all the terrorist attacks on U.S. soil over the past few years have been so laughably incompetent? Shoe bombs, underwear bombs, blowtorches, moronic plots, and now a propane bomb that wouldn't have caused very much damage even if it had gone off. David Corn asked a few experts about this and here's his conclusion:

In other words, terrorist outfits organize two types of operations: those they meticulously plan and to which they devote their best resources, and those they take a flyer on. The recent miscues have been the latter. And those are likely to continue—with the possibility of success. What's perhaps harder to know is whether al Qaeda is in the position to mount the more serious and extensive operations, which demand competent, intelligent, and well-trained operatives.

Bruce Schneier provides a more global answer:

There are actually several answers to this question. One, terrorist attacks are harder to pull off than popular imagination — and the movies — lead everyone to believe. Two, there are far fewer terrorists than the political rhetoric of the past eight years leads everyone to believe. And three, random minor terrorist attacks don't serve Islamic terrorists' interests right now.

OK. But this still leaves me scratching my head a little bit. Terrorist groups have been building increasingly deadly explosives for decades now, a story told in some detail by Mike Davis in Buda's Wagon: A Brief History of the Car Bomb. It's not a trivial task, but it's not rocket science either. Somehow you'd think that even lone wolves working for newbie groups like the Taliban would be able to pull off an operation that works. Not a massive, state-of-the-art car bomb, but still something that detonates.

But apparently not. At least, not yet. 

UPDATE: Here's another theory from Steve Coll: "When a singleton of Shahzad’s profile — especially a U.S. citizen — turns up in a place like Peshawar, local jihadi groups are much more likely to assess him as a probable U.S. spy than as a genuine volunteer. At best, the jihadi groups might conclude that a particular U.S.-originated individual’s case is uncertain. They might then encourage the person to go home and carry out an attack — without giving him any training or access to higher-up specialists that might compromise their local operations. They would see such a U.S.-based volunteer as a “freebie,” the former officer said — if he returns home to attack, great, but if he merely goes off to report back to his C.I.A. case officer, no harm done."

How the Drone War Heated Up

| Thu May 6, 2010 11:56 AM EDT

How is it that we've been able to expand drone attacks along the AfPak border so heavily? Better intelligence? More cooperation from Pakistani authorities? In the LA Times today, David Cloud explains that in the past the White House approved attacks only on specifically named militants, but now the CIA is allowed far greater discretion:

The expanded authority, approved two years ago by the Bush administration and continued by President Obama, permits the agency to rely on what officials describe as "pattern of life" analysis, using evidence collected by surveillance cameras on the unmanned aircraft and from other sources about individuals and locations.

....Instead of just a few dozen attacks per year, CIA-operated unmanned aircraft now carry out multiple missile strikes each week against safe houses, training camps and other hiding places used by militants in the tribal belt bordering Afghanistan...."The enemy has lost not just operational leaders and facilitators — people whose names we know — but formations of fighters and other terrorists," said a senior U.S. counter-terrorism official, speaking on condition of anonymity. "We might not always have their names, but ... these are people whose actions over time have made it obvious that they are a threat."

....The CIA was directed by the Bush administration to begin using armed drones to track Osama bin Laden and other senior Al Qaeda figures, as well as Taliban leaders who fled to Pakistan's tribal areas after the Sept. 11 attacks.

President Bush secretly decided in his last year in office to expand the program. Obama has continued and even streamlined the process, so that CIA Director Leon E. Panetta can sign off on many attacks without notifying the White House beforehand, an official said....The number of Predator and Reaper drones in the region is classified, but one former official estimated that the size of the fleet has at least doubled in the last year.

I imagine that this basically puts drone attacks on the same footing as manned air attacks, which have never been restricted to missions with specifically named targets. Maybe that's appropriate. But it's pretty much certain to increase civilian casualties too. There are no free lunches.

Ratings Agency Update

| Thu May 6, 2010 1:35 AM EDT

Quick ratings agency update. Al Franken has introduced an amendment that reforms the way ratings agencies compete for business. Dave Dayen explains.  Meanwhile, over at Rortybomb, former Moody's director Jerome Fons suggests that this is a good idea but not a sufficient one. He wants to remove the regulatory reliance on ratings and then crowdsource ratings by making the details of every security public knowledge. You can read the whole thing here.

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Carbon Emissions Down 7% in 2009

| Wed May 5, 2010 11:08 PM EDT

This just in from the EIA's latest report: carbon dioxide emissions in the U.S. were down 7% last year. That's on top of a 3% drop in 2008. This means that we're already more than halfway toward our goal of reducing carbon emissions 17% from 2005 levels by 2020. About one-third of the reduction was due to the recession, one-third to reduced energy intensity, and one-third to the use of cleaner energy. Joe Romm has more.

Congress and the Fed

| Wed May 5, 2010 8:51 PM EDT

Matt Yglesias comments on the prospect of the Fed finding itself on a tighter congressional leash in the future:

I think common sense holds that the Fed is losing some of its independence because the world is mired in a giant recession. When Paul Volcker was seen as having licked inflation, and then Alan Greenspan was seen as having delivered a “Great Moderation” spanning two decades, then politicians hesitated to challenge Fed leaders. With unemployment at 10 percent, people get antsy and start giving the Fed a hard time.

Personally, I welcome the idea of more attention to the importance of the Fed and its activities, but I’m not hearing a ton of constructive ideas from the Hill. The idea of “auditing” the Fed seems largely besides the point, like if your big worry was that John Roberts might be embezzling office supplies rather than issuing bad rulings.

This is pretty much where I am. If we put a Consumer Finance Protection Agency inside the Fed, then the Fed is going to have accept more oversight. After all, consumer protection just isn't the kind of thing that anyone thinks ought to be "independent." Frankly, though, that's a better argument for putting the CFPA elsewhere than it is for subjecting the Fed to more oversight.

More broadly speaking, I guess my problem is this: I don't mind stronger congressional oversight of the Fed's regulatory functions. But Congress does a lousy job of this on a day-to-day basis, and we'd be a lot better off if they didn't pretend otherwise and instead just tied the Fed's hands a little more strongly via statute. That's how you get better regulation.

But what most people seem to have in mind when they talk about increased oversight is even worse. They're upset about the extraordinary actions that the Fed took during the financial crisis, and they don't want the Fed freelancing like that anymore. But that's crazy. The Fed didn't regulate well and it didn't manage the housing bubble well, but the one thing it did do well was react to the crisis once it hit. That's the one place where having a free hand worked. If Congress had been involved in this stuff, it's even odds that unemployment would be at 20% today, not 10%.1

As for monetary policy, that's even worse. Maybe I like Ben Bernanke's monetary sentiments and maybe I don't, but Fed independence in this realm really does strike me, like democracy, as the worst possible system except for all the others. I know that inflation hawkery is out of style right now, but I'm a little more sympathetic to it than most. It's one of those reputational things that takes decades to build up and just a few days to lose if you abandon it during a crisis, so a bias toward hawkery isn't altogether a bad thing. And in any case, even if Bernanke is keeping things tighter than I would, I trust Congress to stick its oar into this about as much as I trust Homer Simpson to keep his hands off the donuts.

So the whole "Fed audit" thing doesn't do much for me. If Congress wants stronger regs, it should write stronger regs. As for the rest, until we genetically engineer better congressmen, Fed independence is probably something we should stick to. I'm open to counterarguments, though.

1No, I'm not joking. The thought of Congress being seriously involved in this just sends shivers up my spine.

UPDATE: Dean Baker disagrees. This is bad news since I'm not generally keen on disagreeing with Dean. However, his view seems to be that the Fed should disclose its actions after a certain period of time, not that it should make everything public as it happens. I could probably live with that.

The Etymology of Fannie Mae

| Wed May 5, 2010 7:13 PM EDT

Where did Fannie Mae get its name? It is, obviously, a nickname derived from its real name, the Federal National Mortgage Association, but why did this particular part of FDR's New Deal alphabet soup get anthropomorphized and not any of the others? It's not as if the WPA was known as Willie Pad or the TVA was known as Tammie Vat, after all. Ben Zimmer gets us part of the way to an answer:

Fannie Mae started out as a government agency back in 1938, as part of Franklin Delano Roosevelt's New Deal. Though it was officially known as the FNMA, it was almost immediately given its feminine nickname as a playful acronym. The July-Dec. 1938 issue of Architectural Forum explained that the agency had already been "nicknamed 'Fanny May' by Washington's bureau wags."

Fine. But why did Washington's bureau wags nickname it Fanny May? Whatever the answer, it must have happened quickly. The NMA only became the FNMA in May 1938, and the July-Dec issue of Architectural Forum must have gone to press by June at the latest. So that means the wags began their wagging within a few weeks.

It seems like the name must be somehow related to the Fannie May candy company, right? But according to their site, they were still a strictly midwestern company in the 30s. Did the nickname originate with some wag originally from Chicago? Or what? Maybe this is completely lost in the mists of time and oral history. ProQuest provided no clues. If there's any kind of further explanation, I've been unable to find one.

Mark Levin vs. Everyone

| Wed May 5, 2010 5:32 PM EDT

Did I ever write a post about the great Manzi-Levin feud? A quick search says I didn't. Nickel summary, then: NRO contributor Jim Manzi, who accepts the fact of global warming but opposes aggressive action to fight it (see here), opened up Levin's Liberty and Tyranny the other day and read his chapter on climate change. Manzi was appalled at the hackish level of Levin's rant and wrote a post saying so. Levin responded in the fourth grade vernacular that he specializes in.

(Seriously. The guy makes up names like "Keith Overbite" and "Susan Dumass" for his enemies. He brags about how great he was at their age and how little they've accomplished compared to him. He tosses out juvenile insults like M&Ms. He really, genuinely, sounds like a fourth grader with a temper problem.)

Anyway, NRO's Kevin Williamson, after reading a Levin tirade today directed at Ross Douthat, has seen the light:

When I first read Manzi's much-remarked-upon remarks re: Mark, I thought them unduly harsh. I am revising that opinion, just a little.

I guess a little is better than nothing. I mean, even Rush Limbaugh usually manages to sound like an adult. A crazy one to be sure, but an adult. Levin, on the other hand, is a petulant child. He needs a few days in detention hall, not a cheering squad.