naked capitalism

I’m surprised the little conundrum has not dawned on the officialdom sooner.

Any return to safer practices means less leverage and less freely available credit. Less freely available credit, short term and maybe even intermediate term, means less rapid growth (with a binge as big as we had, the drying-out will take time), although it will presumably mean a more sustainable rate of growth. But policy makers think the economy has a God-given right to growth, and more is better.

Now I actually think that intellectually, a lot of people do recognize the first set of conflicts intellectually, but emotionally, they do not want to make the choice. It’s the modern version of St. Augustine’s plea, “Lord, give me chastity, but not just yet.” And as a piece by Gillian Tett in the Financial Times illustrates, some of the interconnections may not be obvious to those trying to rewrite the rules:

But as the political jostling – and lobbying gathers place – the more important sector to watch might yet be the securitisation world. To most non-bankers, the word “proprietary trading” conjures up images of sharp-fanged bankers or hedge funds darting between assets, eager to make a quick buck.

However, in practice the big concerns of global regulators may lie elsewhere. After all, what blew the really big holes in the balance sheet of banks such as Citi, Merrill Lynch and UBS back in 2007 and 2008 was the fact that these banks had all taken huge quantities of so-called “super senior collateralised debt obligations” (or supposedly safe mortgage assets) onto their trading books.

While those trading books were supposed to be used for short-term deals (including “proprietary activity”), in practice those CDO assets were held for a long time, using the bank’s own capital.

This move was driven partly by necessity (the banks could not flog the super-senior assets anywhere else). However, another crucial issue was that Basel capital rules allowed banks to hold these items in their “trading book” with virtually no reserves, whereas provisions would have been demanded had these instruments been placed in the normal banking book.

So, in light of that, international regulators linked to the Basel committees are eager to dramatically tighten trading book rules, to force banks to hold more capital. And this might yet give a new twist to Volcker’s plans. Most notably, if the Obama threat to clamp-down on “proprietary trading” can be redefined as an attack on the abuse of the “trading book”, then groups such as the Basel committee will almost certainly lend their support. And if the debate does then move into that redefinition of “proprietary trading” then the banks will find it hard to fight back.

That will undoubtedly please some US politicians. However, there is one catch. One key reason why credit was so cheap in the early years of this decade was that banks were pumping out CDOs. And a central factor behind that was that it was cheap – and easy – to produce CDOs when banks kept burying the super-senior debt on their own books, or with entities such as AIG.

Yves here. The short form of what Tett said is CDOs are bad news (that may seem like an overly broad conclusion, but my book takes you through their destructive uses). The FDIC’s proposed rules on securitization would ban “resecuritizations” which would include CDOs whose elements were tranches from other bonds. But that was one of the major raisons d’etre of CDOs was to bundle up the bits of securitizations that investors did not want, structure the cash flows again, and sell the various pieces. So not having an outlet for the unwanted tranches would constrain the securitization process and make less credit available

A second set of conundrums may be operative as well. Our economic and financial model of the last 30 years, that of a high degree of international trade and robust cross border capital flows, may be inherently unstable. There are three factors that suggest why.

The first is empirical: large cross border capital flows are associated with bigger and more frequent financial crises. Correlation is admittedly not causation, but that conclusion emerges resoundingly from Carmen Reinhart and Kenneth Rogoff’s work on financial crises. Similarly, the post war period through the mid-1970s, which was notably free of major incidents, was one of capital controls and less trade than now.

The second is that we have a defect in our current currency arrangements, similar to one that plagued the gold standard. Countries that run sustained trade deficits are punished via deflationary adjustments. But there are no mechanisms from discouraging countries from running sustained surpluses, particularly by pegging their currencies too cheaply. France accumulated large gold reserves in the runup to the Great Depression in just this fashion, as China and the Asian tigers have accumulated large foreign exchange reserves in our day. While it is easy to blame the profligate borrower, it takes two to tango.

The third is that it may prove impossible to have an effective international regulation for capital markets firms. As a second Financial Times piece, on Obama’s plans to increase capital ratios, indicates, some of the measures the US would like to implement do not sit well with European banks:

If the much-debated “Volcker rule” that would ban deposit-taking banks from proprietary trading is not approved, the Federal Reserve and other bank regulators could be asked to fine-tune capital requirements to make risky activity more expensive.

However, at the Group of Seven meeting in Canada earlier this month finance ministers complained to Tim Geithner, the US Treasury secretary, about the rule, unveiled a month ago by Paul Volcker, the veteran former Fed chairman.

“We can’t just transpose or copy ideas proposed by Obama to the European continent,” Michel Barnier, the European commissioner, told a press conference this week.

Dominique Strauss-Kahn, writing in the Financial Times yesterday, complained of “locally reasonable but globally myopic initiatives” and argued that global regulators needed to work more closely to form a co-ordinated approach.

Another impediment to effective international regulation is Dani Rodrik’s policy trilemma: that nation-states would have to cede too much authority to an international regulator. Now there could be some half-way houses on some issues, although it isn’t at all clear how to make transitions even on narrow issues.

So that means if the authorities do not find a way to reduce the high degree of interconnectedness in our financial system, another big blowup in the not-too-distant future is likely. And as the Depression did, that may force a reversion to institutions that are national in scope. Again from the FT, quoting Dominique Strauss-Kahn:

“If banks have to lock up pools of liquidity in every national jurisdiction, their capacity for intermediating capital across borders could fall, and their charges for doing so rise, to the detriment of the world economy,” he said.

Yves here. It would be better if I were wrong, but it may be that intermediating capital across borders with insufficient checks is indeed part of the problem. If so, then policy makers are faced with the sort of choice they hate, namely, among unattractive options, where the best is the least bad. There may be no way to have large, fairly unfettered cross border capital flows and financial stability. While greater growth looks enticing in the short term, the political and social costs of the periodic blow-ups now look too high relative to the apparent gains.

Why is AIG being permitted to continue to give the finger to the government, and ultimately, the US public that saved its bacon?

The sort answer, is that the US government’s need to resort to accounting fictions is being used skillfully against it.

The latest AIG stunt is that it is refusing to sell its derivatives business. Remember that AIG owes the taxpayers a mind-numbingly large amount of money, but intransigent CEO Robert Benmosche has refused to execute on the agreed-upon plan, and instead is off on his own mission.

And why might that be? This is yet another, classic management favoring “heads I win, tails you lose” bet that is given more respectful treatment than it deserves by the Financial Times:

AIG has shelved plans to sell the whole of its derivatives portfolio, which nearly destroyed the insurer in 2008. It believes that keeping up to $500bn worth of complex positions could help it to survive as an independent entity and repay US taxpayers….

Yves here. Having AIG survive as an independent entity was NEVER an objective of this exercise, never. The fact that that management/company flattering notion is given any credence at all is appalling. Many storied companies are dead or very much diminished due to poor management decisions: A&P, Woolworths, Polaroid, U.S. Steel, Pan Am, TWA. AIG has no God-given right to exist.

The logic of the “let us hang on to the money” is that AIG can improve returns by keeping the money longer. But that was never the purpose of this exercise. The intent was very clear: that AIG was to be dismembered. And that is a fine outcome. Taxpayer money recouped, systemic risk eliminated. And AIG is hardly a deserving candidate for any kind of break. It was extraordinarily badly managed from an operational standpoint; Sorkin’s Too Big Too Fail makes it clear than the company had antiquated accounting systems and was unable to gauge its cash needs (another sign of how badly the company was run: I am told a Greenberg relative was buying the stock all through 2008 through the bailout on insider reports that everything was fine, the concerns were way overblown). As important, AIG has never been a good corporate citizen. It is a master of loophole-bending, aggressive lawyering to avoid claims payment, jurisdiction shopping, bribes (see here and here), kickbacks and dubious accounting.

Let’s return to the Financial Times:

Gerry Pasciucco, who joined AIG after it was rescued by the government in September 2008 to wind down AIG Financial Products, said the troubled unit would still be out of business by the end of this year….

The original plan…was to sell off all the positions and close down AIGFP as soon as possible. But Mr Pasciucco said that derivatives with a notional value of between $300bn and $500bn – or between 15 and 25 per cent of the derivatives portfolio’s original size – would not be sold. The assets could either be managed by AIG or outsourced to an external fund manager, he added.

AIG’s management, led by chief executive Robert Benmosche, believes that such a move reduce the need for fire sales and enable AIG to reap the benefits of rallying credit markets, Mr Pasciucco said. AIG recorded billions of dollars in paper profits on its derivatives in the third quarter of 2009…..

AIG executives said the Treasury and the New York Federal Reserve, which took an 80 per cent stake in the insurer in return for more than $80bn in federal funds, had been consulted on the decision to keep the derivatives. Peter Hancock, the derivatives expert who has just been hired to oversee AIGFP, among other responsibilities, is also believed to back the move.

Yves here. I prefer Rep. Brad Sherman’s take on this matter:

If [Benmosche] holds onto [the assets] and their value goes down, the taxpayer loses, and if they go up, he and AIG’s shareholders win… “It’s heads he wins, tails we lose.

Yves again. This is basically a market timing bet. And how seriously ought we to take this?

The Fed’s massive securities purchases had the effect of suppressing volatility, which would be particularly flattering to derivatives positions as AIG has found. As the Fed stops its market interventions, AIG will no longer have this wind in its sails. As Nouriel Roubini noted:

… the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low…. the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring.

Yves again. Now AIG claims to have in fact reduced its portfolio’s exposure to changes in volatility (known as vega) considerably. But if that is indeed true, that AIG has been unwinding its riskiest trades (riskiest measures in volatility terms) one might think what remains would be easier to value (I’d be curious for reader input on this notion, plus whether “gross vega”, the measure that AIG keeps citing, is really the best way to look at portfolio-wide exposure to vol).

There is another possibility, that now that AIG has wound down the portfolio by a bit more than half, that, what is left is utter dreck, so this is a kick the can down the road exercise, to camouflage the full extent of the losses as long as possible. But even in that case, there is still a market bet operative.

Ultimately, this incident is yet another symptom of the problematic governance arrangements in place with AIG. The authorities find it necessary to pretend that AIG is a private company when it never should have been afforded that privilege. AIG was unquestionably bankrupt. The Swedish model, which most experts consider to be best practice, is to fire top management and the board. Their replacements are given specific targets and timetables, are required to report on their results and progress pretty frequently. and have considerable latitude in how to meet their goals,. This is similar to the way private equity investors manage portfolio companies.

But what do we have with AIG? Rather than take 100% ownership of AIG, it has taken only 79.9%, which was a bit of a fiction, since the original Fed loan was secured by all the assets of AIG. But the not taking full ownership was to avoid consolidating AIG debt on the Federal balance sheet (that’s is why the Feds similarly own 79.9% rather than all of Freddie and Fannie). So that means AIG is still subject to an SEC reporting regime, with minority shareholders. That still might have been workable had the government demanded letters of resignation from all board members as a condition of the bailout (the idea being they would leave as soon as replacements were found; two stepped down after the bailout, and three did not stand for re-election last May). Uncle Sam has installed three trustees to oversee AIG, but they did not make much of an impression on Ed Liddy, Benmosche’s predecessor, and Benmosche seems impervious to outside influence.

As we noted last August, which started with a remarkable quote from Benmosche, then AIG’s new CEO:

Benmosche told employees that he “had the luxury to say to the government, I’m not going to rush to do this. I’m appalled at how much pressure has been put on all of you to just sell it no matter what, because the Fed wants out, or the Treasury wants out. If they want out in a hurry, they shouldn’t have come in in the first place.”

For anyone who followed the rescue, this is a staggering bit of hubris and revisionist history. First, the idea that the government “came in” implies that this was some sort of normal investment process, as opposed to AIG begging the Federal government for a rescue, even though states, not the national government, are the main regulators of insurance business (the AIG Financial Products business was overseen, if you can call it that, by the Office of Thrift Supervision. AIG structured its operation so as to get them as supervisor precisely because they were guaranteed to do next to nothing).

Next, the original deal called for AIG to pay back the money in two years. That inconvenient fact has been airbrushed out of the story Benmosche tells us. AIG made great assurances that the operating units were worth a lot of money and paying back the loans would be no problem. They accepted a high rate of interest given the riskiness of the loans and the desire of the Federal government to keep the heat on AIG. This original deal in theory fit Bagehot’s rule: lend generously, at a penalty rate, against good collateral.

But AIG fooled itself, or maybe just everyone else. Those supposed crown jewels were worth a lot less than AIG thought.Once they had established they would not be permitted to fail, they started retrading the deal. When AIG realized it couldn’t sell some operating units, pronto, suddenly it started complaining the interest rate (I think Libor plus 8 1/2%, forgive me for working from memory) was too high. Oh, and they happened to need more money too, a wee oversight in their initial demand. So the deal was reworked to give them better terms, a bigger commitment, and NOTHING ADDITIONAL was obtained. This was a free concession, a very bad move in deal land.

The government owns 79.9% of AIG. Any private sector owner who had an overwhelming majority interest and got that kind of attitude from a CEO would fire him immediately. But no, we live in a world where arrogant members of the financial services industry engage in looting, dictate terms to the government, and try to rewrite history to make baldfaced lies seem plausible. Why shoudn’t the government pressure AIG? The idea that owners don’t pressure companies (the subtext of this remark) is an absurd misrepresentation. Go talk to the management of any underperforming company owned by a PE or venture capital firm. For the most part, they do not play nice, and would never tolerate Benmoshe’s posturing, and he knows that. He is simply playing the media and the public for fools.

When you think this AIG drama can’t get any worse, predictably, it does.

Readers may recall that I solicited their comments on an FDIC Advanced Notice of Proposed Rulemaking on its proposal to link deposit premiums to executive compensation programs (the high concept is to charge higher premiums to banks that reward executives for undue risk-taking. Now admittedly, a program like this would take some thought to make sure it was not easily circumvented (as in measures need to be in place to make sure that banks don’t simply skirt the rule, say by putting risky exposures in off balance sheet entities).

I was going to pen a simple cover note expressing general support and attach reader comments, but I wound up writing up something more substantive. The letter raised a couple of issues that have not gotten the attention they warrant, namely, the need for bank executives and key operating staff to bear greater liability, and the way that the bank merger wave seems to have been driven to a considerable way by the fact that it leads to higher CEO pay post-merger.

Sheila Bair

Chairman

Federal Deposit Insurance Corporation

550 Seventeenth Street, NW, Room 6076

Washington, DC 20429

Dear Chairman Bair,

America can no longer afford to have a banking system that serves the ends of its executives rather than those of taxpayers and communities who have been saddled with cost of reckless profit-seeking. The FDIC proposal to tie deposit insurance premiums to the incentives in executive compensation programs would be an important step forward towards making sure that bank managers operate in a way that reflects the value of the extensive government support and safety nets they enjoy. Bank officers should not be encouraged, as they are now, to take “heads I win, tails you lose” bets with deposits.

There is no question that the annual accounting/bonus cycle is badly out of line with the time horizon of many of the wagers that financial institutions take. Unfortunately, the belief that using stock options or restricted shares as an important part of compensation would lead to responsible behavior has proven wildly false. Both Bear Stearns and Lehman had substantial equity ownership at both the executive level and among the rank and file. By contrast, when Wall Street was dominated by private partnerships, so the management group was jointly and severally liable for losses, the sort of profligate risk-taking that took place in the run-up to the global financial crisis was virtually unheard of.

Unfortunately, all compensation arrangements at public companies are inherently, “heads I win, tails you lose.” No matter how badly a corporate team performs, its pay is immune from clawback, except in the case of fraudulent conveyance in bankruptcy, and even then, the “lookback” period is usually shortly before the failure of the firm. By contrast, it often takes years to reap the bitter harvest of bonus-flattering decisions.

It may be that the only way to cope with the agency problems inherent to risk-taking in a public firms is to make pay arrangements more symmetrical, as in to find ways to recover compensation from executives and senior business unit managers who managed and led programs and products that were ultimately destructive to their companies. The better the arrangements of the old private partnerships can be approximated (admittedly a tall order) the better.

In addition, I would encourage you to think hard about the perverse incentives posed by acquisitions. One of the striking developments in the US banking industry over the last 20 years is an increase in concentration, particularly among the largest players, which has played directly into our current “too big to fail” policy problem. The usual rationale given in greater efficiency, that is, that bigger banking is cheaper. Yet every academic study I am aware of has found the reverse: that once a minimum threshold is reached (there is some disagreement as to where that lies), banks in the US exhibit a slightly negative cost curve, which means the bigger the bank (measured in assets) the higher its cost ratios. Thus the dramatic expense cutting that occurs in the wake of acquisitions could have been done by each of the merged institutions, separately.

Another reason to be skeptical of bank acquisitions is the poor track record of mergers generally. Virtually every academic study ever done has found most mergers “fail” as in they deliver negative outcomes to stockholders.

So why do deals continue? First, there is a large constituency that promotes them because they are particularly lucrative, in particular, investments bankers (who collect M&A and financing fees) and management consultants. A host of other “helpers” such as lawyers and accountants also reaps fat fees from deals.

But the biggest incentive is again flawed executive compensation. Bank CEO pay is highly correlated with the size of the institution, measured by total assets. And the senior team of the acquired bank is effectively bought off via golden parachutes.

I strongly encourage the FDIC to remove the incentive for executives to bulk up their banks solely to pay themselves more. One way might be to require that executive bonuses be set in relationship to the pre-acquisition peer group for a substantial initial period (at least three years, better yet five) and be benchmarked against the new peer group of bigger banks only if the merged entity had met certain operational performance targets.

I also asked readers of my blog, Naked Capitalism, to offer their comments on the proposal that you, Vice Chairman Martin Gruenberg, and Thomas Curry are supporting. They are glad that the FDIC is serous about bank reform and are keen to see meaningful measures implemented to curb executive-serving, public-endangering compensation structures. I am attaching their remarks.

Sincerely,

Yves Smith

The short answer to the question in the headline is “When there are no rules.”

A headline in a current Bloomberg story illustrates the problem: “Goldman Sachs, Greece Didn’t Disclose Swap, Investors ‘Fooled’.”

“Fooled” is an unusual choice of words, particularly when applied to to presumed grown-ups like institutional investors and international overseers. Bloomberg seems to be mincing around the more obvious F-words, like “fraud” (as in defrauded) or “fleeced.”

Although there is a considerable amount of well-warranted consternation about how Goldman sold swaps to Greece that allowed it to mask how bad its deteriorating finances were from the EU budget police, there has been perilous little discussion of why the fact that this was permissible says there is something very wrong with the rules in place.

The latest twist is that Goldman managed $15 billion of debt sales for Greece after the debt-disguising swaps were in place, and (needless to say) there was no disclosure of the existence of the hidden debt (Bloomberg was able to obtain only six of ten prospectuses in question and found no mention of the swaps; it seems pretty unlikely that the others disclosed their existence). That means investors were hoodwinked. It goes without saying they would have seen Greece as a worse credit risk if they had been in full possession of the facts, and would presumably have required a higher interest rate.

Yet we get amazingly weak statements from the experts quizzed by Bloomberg:

Goldman could face legal liability “if it could be established that they were knowingly hiding risk, and therefore knew or had reason to know that the bond disclosure documents were misleading,” said Thomas Hazen, a law professor at the University of North Carolina at Chapel Hill. “But that would be a tough hill to climb, in terms of burden of proof. There’d have to be some sort of smoking-gun memo.”

Yves here. I’m not certain how much a US law professor knows about the securities laws that govern this particular offering (as in it most certainly is NOT US securities regs). But there seem to be three issues:

1. What disclosure standards would apply to the Greece bond offering. The offering memorandum, from a legal standpoint, is the issuer’s document, meaning Greece’s, not Goldman’s. So any shortcoming in disclosure is a liability issue for Greece (no joke, the deal manager makes the issuer sign a little letter acknowledging what portions of the offering memo were provided by it, and it is just a few sentences, like the selling price of the bonds, the underwriters’ spread, stuff like that. The description of the issuer and the securities themselves is most assuredly NOT the responsibility of the underwriters. Update: this is a simplification, and arguably an oversimplification; reader Brown Ram in comments describes how underwriters absolve themselves almost entirely from liability for the accuracy of offering documents).

2. OK, but what about this famous due diligence that investment bankers are supposed to perform? Well I have to tell you, even in good old SEC land, it’s less than you might think. In my day, the only thing that seemed to be required was visiting the major facilities of a new issuer (as in a company doing an IPO or first bond offering) and having outside counsel read board minutes (and tell the managers if they saw anything they found troubling).

3. But in this case, we have an interesting conundrum. Goldman clearly HAD TO KNOW the Greek offering documents were incomplete, right? They had arranged those swaps, they knew there was more debt than Greece was ‘fessing up to in its later offering memoranda.

Point 3 is where matters get a bit sticky. Under SEC regs, the failure to mention the swaps or their effect (that there was additional debt that had been deferred) would be a violation. This is a simplification, , but the concept is that the offering documents have to make a full and fair disclosure. That means not only do the statement made need to be accurate as of the date when they were made, but further more, they cannot fail to state a material fact if leaving that information out would be misleading. So question is whether under the regs governing this deal, whether an omission of this sort would also be considered a regulatory violation and/or an investor fraud.

If so, it’s pretty clear Greece defrauded investors. But what about Goldman? Here, Prof. Hazen is far too charitable to Goldman. “Smoking gun memo?” No, you just need to understand how Goldman works. Even though my knowledge is dated, I strongly suspect the firm is still organized more or less the same way, because it was considered a competitive strength and was widely emulated in the industry (t had the effect of creating loyalty to the brand rather than individuals).

Goldman has centralized account management. One person, a relationship manager, is ultimately responsible for selling all products to particular corporate clients and government entities. His full time job is client coverage; he then works with product specialists as needed to get deals done (specialists are also assigned to particular accounts, but the relationship manager is always in the mix. Hank Paulson was one of these relationship managers, called investment banking services). So Goldman cannot pretend that somehow the team that handled the bond offering didn’t know about the swaps deal. That’s unlikely to begin with, given Goldman’s fetish about communication, but structurally impossible (the new business guy would have known about both sets of deals).

In addition, Goldman new business officers (the account managers) are required to document every meeting with the client (this is to protect the firm in case someone is hit by a bus or leaves the firm). This was also a long-standing fetish. In the 1980s, I as a junior account member could ask the library for the “credit memos” as these notes were called. On well-established clients, the meeting notes went back to the 1950s.

So I’m not certain you need a particular memo, even though such documents probably exist. All you need to do is walk through the structure of Goldman relationship management and their usual client communication protocols to establish that it is just not credible that the team working on the bond issues could not have known about the swaps. Then you just need to figure out a legal theory as to why what Goldman did was not kosher (presumably it was an investor fraud, but you’d need the relevant statutes and precedents).

Some people are willing to say in a pretty straightforward fashion that this sort of thing is not right. And if the regs really are so lax that this sort of omission is permissible, that is yet another bit of evidence that deregulation has gone too far (and I fail to understand why investor would be willing to buy paper in a disclosure regime that inadequate, but that is a bigger topic that we will hopefully turn to at another point). From the Bloomberg story:

“Investment banks are guilty of being part of a wider collusion that fudged the numbers to make the euro look like a working currency union,” said Matrix’s [Bill] Blain. “The bottom line is foreign exchange and bond investors bought something sellers knew not to be the case.”

Even before this latest wrinkle, Simon Johnson was quite clear that these deals did not pass the smell test:

Faced with enormous pressure from those eurozone countries now on the hook for saving Greece, the Commission will surely launch a special audit of Goldman and all its European clients…

If the Federal Reserve were an effective supervisor, it would have the political will sufficient to determine that Goldman Sachs has not been acting in accordance with its banking license. But any meaningful action from this direction seems unlikely….

To preserve Goldman, on incredibly generous terms, in the name of saving the financial system was and is hard to defend – but that is where we are. To allow the current government-backed (massive) Goldman to behave recklessly and with complete disregard to the basic tenets of international financial stability is utterly indefensible.

Yves here. Goldman has made a science of being too clever by half, but it may have made a fatal mistake. Governments do not take well to being abused or made to look foolish, and Goldman appears to have done both.

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

It is award season and I would like to nominate the 13-author “Preventing Deflation: Lessons from Japan’s Experience of the 1990s” for an award, (International Financial Discussion Paper number 729, June 2002, Research Department Board of Governors of the Federal Reserve System.) It is probably the most alternative reality-driven and misguided piece of macroeconomic research ever published-certainly ever published by the Fed. While purporting to draw useful lessons from the Japanese experience, the paper missed the lessons to be learned and reinforced policy decisions and a mindset which contributed to the financial crisis of 2007 and the subsequent recession.

The authors provided the following background for Japan’s crisis and the lost decade(s):

Japan’s protracted slump can best be understood as the outcome of developments that date from the “bubble economy” of the late 1980s…. between 1986 and 1989, both equity prices and land prices rose precipitously. This, along with relatively low interest rates substantially eased the financing of investment. As a result the ratio of bank loans to GDP soared …

By early 1989, however, as equity and real estate prices continue to soar and inflation moved upward, the BOJ began raising interest rates in a bid to moderate the degree of overheating. In response to monetary tightening and its own unsustainably high level, the stock market collapsed at the beginning of 1990. …The BOJ continue to raise the official discount rate until August 1990. It started lowering rates ashore. Thereafter as GDP growth fell off more sharply, Inflation starts to move down, and land prices began to decline as well.

In many respects, the peaking of the bubble economy and the subsequent slowdown followed a standard pattern for postwar business cycles in industrial economies. Yet, it is apparent, with the benefit of hindsight, the unusually strong forces were at work to hold down growth. First, the high ratio of capital to output accumulate by 1990 which was predicated on expectations of continued high output rose in the future was revealed to be excessive once the economy slowed. In consequence, profits fell and business investment exhibited protracted declines over the 1990s.

Second, the collapse of equity and, eventually, housing prices lead to severe balance sheet problems for households and firms, particularly the latter. Weak stock markets discourage issuance of as a means of financing investment, while declining stock and land prices undercut the value of collateral used to secure new loans. Moreover, with a net worth of many firms, particularly in construction and real estate, substantially reduced by the collapse of the asset price bubble, the demand for investment funds fell off sharply.

As a third and related factor, the balance sheet problems of corporate borrowers led to deterioration in loan performance and in the financial strength of the banking system. Owing to both weaknesses in the Japanese supervisory system and too ingrained practices among Japanese bankers, Japanese banks failed to resolve the nonperforming loans adequately recapitalize themselves. The continued fragility of the banking system, in turn, has limited its ability to extend loans in support economic recovery.

All of these factors weigh heavily on growth…. which decline from nearly 5% (Q4/Q4) in 1990 to nearly zero in both 1992 and 1993.

In response to the slowdown, Japanese economic policy clearly loosened. The overnight call money interest rate declined from a peak of 8.2% in March 1991 to 2% in March 1995, and decline further to 1/2% by October 1995. Fiscal policy also moved toward stimulus, with the structural budget balance moving from a surplus of 1.3% in 1992 a deficit of nearly 5% 1996.

In retrospect, however, it is apparent that the mid-1990s recovery was quite fragile, and with the advent of a hike in the value added tax in 1997 and the Asian financial crisis in 1997-98, economy once more fell into a protracted slump, interrupted only briefly by the high-tech boom in 2000.”

The authors’ most salient conclusions and the arguments supporting them are presented below:

First, notwithstanding the severity of a collapse in asset prices and the vulnerability of the financial sector to this collapse, Japan’s sustained deflationary slump was not anticipated.

This point is well supported by the second major finding of our study: while loosening of monetary policy in the early 1990s by the Bank of Japan (BOJ) seemed appropriate given the expectations of future economic developments held at the time, in light of the weakening of spending and prices that took place subsequently, this loosening prove to be inadequate.

This suggests that… policymakers did not take out sufficient insurance against downside risks to a precautionary further loosening of monetary policy. Simulation of the staffs FRB/Global model suggests that, had the BOJ lowered short term interest rates by a further 200 basis points at any point in time between 1991 and early 1995, deflation could indeed have been avoided.

The third key issue addressed in our study was whether the effectiveness of Japanese monetary policy in influencing the economy might have diminished in the early 1990s. We uncovered, at most, mixed evidence that monetary policy became less effective during this period. ..In the 1992-95 period, the growth of the monetary base rose above that of the broader aggregates, an indication that a “liquidity trap” may have emerged, but this differential in growth rates did not become especially pronounced until the second half of the 1990s. Finally, the collapse in asset prices and the resulting deterioration of balance sheets by making firms more reluctant to borrow and banks more reluctant to lend most likely diminish the ability of monetary policy to stimulate the economy, although by how much is difficult to say. In sum, the effectiveness of Japanese monetary policy may have diminished somewhat in the early 1990s, but probably not to the point of the benefits of earlier sharper easing would have been obviated.

To sum up, analysis of Japan’s experience suggests that while deflationary episodes may be difficult to foresee, it should be possible to reduce the chances of their occurring through rapid and substantial policy stimulus. In particular, when inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As cited earlier, the authors of this piece ran a series of counterfactual simulations that buttressed their argument that an additional 200 basis points of eases would have forestalled deflationary pressures. The counterfactual simulations were carried out in the context of the Federal Reserve staff’s FRB/Global model. Three simulations were run with rate reductions commencing in Q1 1991, Q1 1994, and Q2 1995. The authors report the key finding as:

The key finding is that, had the BOJ loosened monetary policy to the extent modeled in the simulations at any time up to early 1995, inflation would have been positive for the end of the decade.

Another important finding is contained in the charts titled “FRB/Global Simulations of Alternative Japanese Monetary Policies”-Exhibit IV.2. The chart of the actual and simulated output gaps indicates that if the BOJ had reduce interest rates as per the simulations that negative output gaps would have been closed and that the negative output gaps that opened late in the decade due to the increase in the VAT tax would have been small and of short duration.

In short, the authors view Japan’s “lost decade(s)” as a standard pattern downturn that morphed in to a prolonged period of economic stagnation simply because the central bank failed to cut interest rates by enough prior to mid-1995. The paper argues that the economic costs to Japan (in terms of lost output) of burst bubbles (that reflected inappropriate policies and the buildup of massive financial imbalances, resource misallocations over decades) could have been avoided if the BOJ had simply cuts rates faster and 200 bps farther than it normally would have when responding to a standard cyclical downturn.

In particular, the argument and results of the simulations suggest that in the early to mid-1990s in Japan:

200 bps of additional easing could have compensated for an unprecedented decline in equity prices (about 60% between the bubble peak 1989 and mid-1995). (The words “out of sample” come to mind.)

200 bps of additional easing could have compensated for an almost 30% decline in land prices and the implications for credit availability and balance sheets given that credit was generally collateralized by real estate. (The words “out of sample” again come to mind.)

200 bps of additional easing could have compensated for a nearly complete collapse of the banking system. (The words unprecedented in modern Japanese history come to mind.)

200 bps of additional easing could have compensated for the collapse of corporate balance sheets and the crippling of the keiretsu system.

200 bps of additional easing could have compensated for decades of misallocated capital via the keiretsu system and vote-buying-pork-barrel public works projects.

200 bps of additional easing could have compensated for the policy promoted-export-dependent economy for the loss of competitiveness stemming from the growth of the “Asian tigers”.

In fact, the argument and the simulations suggest that 200 bps of additional ease could have insulated the Japanese economy from the costs of all of the above shocks and structural changes.

The argument was fanciful when it was written. The nearly two decade long underperformers of the Japanese economy since the equity and property market bubbles burst and financial system nearly collapsed were more shock and structural change than 200 bps of additional counter-cyclical easing could possibly have offset.

Post the bursting of the bubbles and near collapse of the US financial system, it is also clear that the US did not learn enough from the Japanese experience to avoid repeating major elements of it. In fact, the failure of the precipitous decline in official rates, the quantitative/credit-easing ballooning of the Fed balance sheet, and the explosion of the federal fiscal deficit, to maintain economic growth indicates that the Fed and the authors of the paper learned nothing of value from the Japanese experience.

The major problem with the paper, however, is that it is “spin” of Orwellian Ministry of Truth dimensions. It implicitly assumed that a strategy cleaning up after asset price bubbles and financial crises would be more efficient than one of than leaning against them.

Its Orwellian aspect should not be surprising given that the paper was published in the aftermath of the bursting of the NASDAQ bubble. It was presumably published with an eye to reinforcing the perception that Greenspan was correct in his choice to wait and clean up after rather than lean against the NASDAQ bubble. If additional easing would have insulate the Japanese economy from the collapse of equity prices, the collapse of real estate prices, the near bankruptcy of the financial system, etc, then expedited easing in the US should have no problem offsetting the NASDAQ collapse given that real estate prices, the financial system and household and corporate balance sheets emerged, relatively speaking, unscathed.

The real cost of the “spin” and the underlying mindset that cast interest rate policy as an uber-policy tool was that it gave the Fed pseudo-intellectual license to ignore its regulatory and supervisory responsibilities, asset bubbles, financial innovations, etc.

For example, why should the Fed have concerned itself with a possible real estate price bubble in the US when expedited interest rate cuts could offset any negative effects should the possible bubble burst? In particular, this paper suggests that the effects of a 33% decline in land prices could be easily offset. Why should the Fed have worried about or leaned against the 2001-2007 real estate asset price bubble in the US?

Why should the Fed have considered leaning against a possible equity bubble when any problem arising from the bursting of an equity bubble can be offset by expedited interest rate cuts?

Why should the Fed have let regulatory and supervisory issues distracted it from questions concerning monetary policy when the effects of an almost total collapse of the banking system can be offset by expedited interest rate cuts?

Why should the Fed have concerned itself with possible downside risks associated with new financial instruments or the growth of the “shadow banking system” when the effects of an almost total collapse of a financial system can be offset by expedited interest rate cuts?

Why should the Fed have been concerned about external balance when the effects on income and inflation all erosion of international competitiveness can be offset by expedited interest rate cuts?

Why should the Fed have been concerned with over-investment in real estate (relative to tradable goods manufacture or other forms of business investment) when any associated problem can be offset by expedited interest rate cuts?

Why should financial firms and households limit their use of leverage when the Fed is asserting that it can insulate the economy from financial dislocations by simply cutting interest rates?

Why should financial institutions have been concerned with problems of systemic risk, when the Fed has announced that expedited interest-rate cuts can insulate the economy and presumably financial institutions from the effects of bursting asset bubbles and the misallocation of economic resources?

Post-2001and pre-2007, Fed monetary and regulatory policies were certainly consistent with the policy prescription laid- out in the paper (although the paper undoubtedly reflected attitudes at the Fed rather than was a shaper of them.) Unfortunately, the unemployment rate is 9.7%, despite the expedited interest rate cuts, the quantitative/credit easing reflected in the change in the size of the Fed balance sheet, and the stimulus implied by the Federal fiscal deficit ballooning from 1.17% in 2007 to 9.92% in 2009.

Clearly, the US would be in a much better position today if the Fed had decided that (given the low-levels of inflation and interest rates and the limited room for monetary stimulus) it should direct attention at preventing the asset price bubbles and economic imbalances that gave rise to the crisis in Japan two decades ago and in the US today. The Fed’s misplaced confidence in its ability to use monetary policy to clean up asset price bubbles contributed mightily to today’s problems.

Insofar as the whole point of the paper was to “shed light on a host of questions that potentially could face policymakers in the United States” it failed and contributed to the public’s misplaced confidence in the Fed’s ability to deal with the aftermath of asset price bubbles. It gave a justification for the authorities to ignore their regulatory and supervisory responsibilities; it gave households and financial institutions a misplaced confidence in their ability to deal with leverage. Most of all, it erroneously endorsed the clean-up-after approach to dealing with asset price bubbles by dismissing the lean against approach without so much as a mention.

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.

Surprise, surprise: Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece, Spain, Portugal, and undermined the euro by enabling European governments to hide their mounting debts. This has now become front page news in the Sunday New York Times.

According to the Times:

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards (our emphasis).

Sound familiar? This is exactly how AIG built up its credit default swap business, in essence facilitating regulatory arbitrage on behalf of the banks. Basically, banking regulations encouraged companies to buy cheap swaps so that they could treat risk assets as almost risk-free, concealing their toxic nature via the ledgerdemain of financial engineering. This, in turn, allowed them to take money out of their reserves and buy more risky assets, which they then covered up with more credit default swaps. All of this was designed to evade the capital adequacy requirements mandated under the Basel banking accords.

AIG was destroyed, but as the NY Times article illustrates, the practices still persisted. As late as November 2009, Goldman Sachs, its own survival now successfully assured by repeated US government lifelines and guarantees, was seeking to perpetuate a similar kind of ruse over the European Union.

We have railed against the stupidity of the rules underlying the European Monetary Union many times, but poorly thought-out rules do not give a bank the right to destroy an entire continent, even “Government Sachs”. In the words of Simon Johnson,

These actions are fundamentally destabilizing to the global financial system, as they undermine: the euro zone area; all attempts to bring greater transparency to government accounting; and the most basic principles that underlie well-functioning markets. When the data are all lies, the outcomes are all bad – see the subprime mortgage crisis for further detail.

But it’s nothing new. Virtually the same thing happened in East Asia during the late 1990s. Most people are now familiar with standard derivative contracts used in hedging risk, such as forwards, futures and options. While foreign-currency forwards remain the province of bank foreign exchange dealers, most basic futures and options contracts are standardized and traded in organized, regulated markets. Banks have also long offered derivative contracts to their clients in what is termed the “over-the-counter” (OTC) market. But, there is no market involved in these contracts, which may involve the stipulation of standard futures and options contracts outside of the organized market on a bilateral basis with individual clients.

The majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments packaged together with derivative contracts designed to meet the particular needs of clients. These kinds of contracts involve very little direct lending by banks to clients, and thus generate little net interest income. But during the 1990s, they had the advantage, given the necessity of meeting the Basel capital adequacy requirements, of requiring little or no capital, or of being classified as off-balance sheet items because they did not represent a direct risk exposure of bank funds. Or so it appeared. And they had the additional benefits to Wall Street of generating substantial fee and commission income.

The volumes of these OTC structured credit notes rose substantially in the mid-1990s. While these derivatives were by no means unique to East Asia (see Orange County in 1993, Mexico in 1994, Long Term Capital Management in 1998), an IMF study from 1998 suggests that most of the initial losses sustained during the initial impact of the Asian crisis were related to derivative-based credit swap contracts. Furthermore, the Bank of Korea reported in March 1998 that trading in financial derivatives by South Korean banks increased by 60.1% in 1997 to $556.5 billion and largely contributed to the virtual nationalization of the entire Korean banking system as these positions blew up. It also helps to explain why heavily exposed banks such as JP Morgan (which had huge exposure via their derivative positions to the Korean banks) were at the forefront of the move to convert Korean banks’ short-term debt into sovereign debt.

Much the same can be said for Thailand, Indonesia, and Malaysia. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Indonesia’s real GDP shrank 17 per cent in the first three quarters of 1998, Thailand’s 11 per cent, Malaysia’s 9 per cent, and Korea’s 7.5 per cent. It took nearly two years to reach the bottom. Many millions who were confident of middle class status had their lifetime savings destroyed. Public expenditures of all kinds were forcibly cut as all of the countries fell under the punitive aegis of the IMF. The IMF itself mounted the biggest financial bailout in history — $110bn, almost three times Mexico’s $40bn “rescue” package from the 1994-95 “Tequila crisis”.

Yet the experience of the past 2 years suggests that we have learned nothing and our political leaders seem determined once again to avoid dealing with the problem once and for all. God forbid that Congress should antagonize one of its main funding sources.

Perhaps now that these destructive practices are appearing in Europe’s own backyard, the authorities there may be sufficiently motivated to do something, if one is to judge from the recent comments of French Finance Minister, Christine Lagarde. Of course, cracking down on “currency speculators”, or short sellers, is largely beside the point, when you’ve got clear evidence of a bank deliberately conspiring to hide the true extent of an EU government’s debt. That’s abetting fraud, plain and simple. Jeffrey Skilling, former CEO of Enron, is sitting in jail today for that very offence. By contrast, Gary Cohn’s boss, Lloyd Blankfein, just received a $9m bonus.

It seems more than extraordinary that nothing was done following the economic implosion of East Asia during the 1990s. Eighteen months ago, we experienced the near the near wipe-out of our global banking system, and today we face the threatened destruction of the European Monetary Union. And still all we get is nothing more than the vague threat of action, and feeble efforts at regulatory reform.

Hey, as Jamie Dimon noted at the FCIC hearings a few weeks ago, stuff like this happens every 5 to 7 years, so what’s the big deal? Why bother letting the potential vaporization of a currency stop Wall Street from behaving recklessly and with complete disregard to the basic tenets of international financial stability? Heaven forbid that government should impede something as important as “financial innovation”. Shit happens. That’s no reason to “punish” a growth industry, even one where the main growth component appears to be the perpetuation of financial fraud.

In a New York Times op-ed late last year, Bill Black, Frank Partnoy, and Eliot Spitzer called for an open source investigation:

we know where the answers are. They are in the trove of e-mail messages still backed up on A.I.G. servers, as well as in the key internal accounting documents and financial models generated by A.I.G. during the past decade. Before releasing its regulatory clutches, the government should insist that the company immediately make these materials public. By putting the evidence online, the government could establish a new form of “open source” investigation.

Once the documents are available for everyone to inspect, a thousand journalistic flowers can bloom, as reporters, victims and angry citizens have a chance to piece together the story. In past cases of financial fraud — from the complex swaps that Bankers Trust sold to Procter & Gamble in the early 1990s to the I.P.O. kickback schemes of the late 1990s to the fall of Enron — e-mail messages and internal documents became the central exhibits in our collective understanding of what happened, and why.

Now it is worth noting that the emphasis in the Black/Partnoy/Spitzer argument was to get a lot of eyeballs on a large stash of source material that is presumably pretty accessible to the public, namely, e-mails.

But there is a second line of potential open-source inquiry that would be at least as valuable: getting people who have expertise in certain types of documentation to look probe transaction documentation for deals that were deceptive or had significant negative outcomes. Even with more and more investigators of various sorts getting their noses into various suspect-looking activities, a lot of the destructive behavior took place in the form of transactions that industry participants at the time would argue fell within normal, accepted practice. Understanding what was deficient about prevailing practice is therefore key to developing durable reforms.

For instance, one of the requirements in the FDIC’s proposed securitization reforms is to have the participants disclose their motivations and intentions as well as their fees. That means that parties like Goldman and Deutschebank, who teed up CDOs for the purpose of them taking a short position would have had to disclose that objective under the proposed regulations.

Reader Nick has provided a link to one of the now-infamous Goldman-Greek government swaps, which served to camouflage the magnitude of its fiscal deficits from the EU. His comments:

I came across the prospectus for the 5.1bn Euro Titlos PLC Asset Backed Notes which Goldman arranged for Greece in 2008.

This was the restructuring of a controversal 2005 swap, which, in turn, related to the infamous
“Aeolos” deal in 2001. Aeolos was the SPV which GS and the “Hellenic Civil Aviation Authority” used
to enable the Greeks to hide its borrowing and enter the EU under false pretenses.

See page 47 of the pdf file (page 43 of the document) under “Use of Proceeds”. I’m curious that no mention of Greece’s real motivation to do this deal — or previous ones — is mentioned. (Maybe it’s in the doc, but I sure couldn’t find it.)

Will the final net result of these derivative trades be a transfer from German and French taxpayers to Greece along with $300mm or so to GS?

Yves here. Per the remarks above on the FDIC, I’m not surprised at all regarding the lack of disclosure. And Nick’s comment raises a more basic point: how the use of forms and mechanisms from regulated markets have served to lull investors and issuers into a false sense of security.

Now here, Greece presumably knew exactly what it was doing. The whole point of this deal was to allow it to hide its failure to live up to its Maasricht obligations.

But even though I have looked at various types of deal documents for decades, something that should have been blindingly obvious occurred to me only tonight. This document, like all of its cousins, says very clearly that the securities (in this case, notes) will not be registered with the SEC, but will be listed on the Luxembourg stock exchange. So this one at least is subject to certain disclosure requirements. But as Nick points out, you sure couldn’t tell what the real motivation for the note deal was from this prospectus (as in the stated aim, while not necessarily untrue, was not the real driver).

But investors have over the course of decades come to expect that documents like this make a full and fair disclosure. The use of this particular form of presentation conveys the message (among others) that everything you need to know to invest is here. It may be somewhat obscured by clever lawyering or the relegation of key facts to financial footnotes, but the belief surrounding documents like this is that the investors have been told what they needed to know.

But we now know they weren’t. The SEC has a key notion in its disclosure rules, that failure to state a material fact is a no-no. It isn’t just that what a prospectus says has to be accurate, it also must not omit to state any material fact that would make the statements in the disclosure documents false or misleading.

And where did the chicanery that led to the crisis take place? Not in areas subject to the full force of SEC regulations, but areas completely outside its reach (derivatives) or where much weaker rules were operative (the rule 3a-7 exemption for asset backed securities).

In case readers think I am making overmuch of this process, consider: propaganda similarly suborns existing channels, in this case, the media. Most people believe that the press and TV tell them what they need to know, both in the sense that what they say is accurate, and anything they fail to cover must not be newsworthy. And even though we have had some stark evidence to the contrary, that the media can be used by the state for its own ends (witness the Creel Commission in World War I, as well as the run-up to the Iraq war) as well as influenced by powerful private interests, the conditioning, which is to trust the media, remains very much intact.

So as much as I welcome and encourage reader comments on the document that Nick pointed out, I’d also welcome reader input on where they think disclosure fell short, and why.

It turns out some businesses are thriving in the downturn, with lobbyists a prime example. According to the Center for Responsive Politics, lobbyist revenues increased 5% in 2009 versus 2008. As The Hill noted (hat tip DoctoRx):

Lobbyists have said business for them managed to remain upbeat throughout 2009 despite the poor economy because of the Obama administration’s aggressive legislative agenda.

With expanded Democratic majorities on Capitol Hill from the 2008 election, the White House pushed sweeping bills to reform the healthcare industry, tackle climate change and bring Wall Street under control. None of that ambitious legislation has come to fruition yet, but President Barack Obama and other Democrats will want to finish those bills this year, so expect a busy 2010 for lobbying as well.

The healthcare debate took up much of the oxygen in Washington last year. So not surprisingly, the pharmaceutical and health products industry spent a record amount last year — close to $266.8 million — on federal lobbying.

That is the biggest lobbying expenditure ever by a single industry in one year, according to the report.

The detailed breakdown of spending by industry shows the broader “health” category spent $544 million, up 11.7% over 2008, while “finance, insurance, and real estate” doled out $465 million, up a mere 1.4% over the prior year. Of course, since bankers spend so much on Congressmen directly, maybe they don’t need to shell out as much on lobbying.

Can someone shut these banking industry narcissists up?

The one and only time I met Steve Schwarzman was in 1986, when he and Pete Peterson had just started the Blackstone Group. I was a manager (meaning a mid level working oar) at McKinsey. We had teed up a deal and were assisting our foreign client in hiring an investment banker. This transaction was sufficiently sexy that Felix Rohatyn wound up working on it personally.

But what did we get when we presented the idea to Peterson and Schwarzman? We explained why we came to see them. We got 40 minutes (I kid you not, I checked my watch) of name-dropping by Peterson, of all the senior folks he knew in our client’s country. But that wasn’t why our client came to see him; had he bothered to listen, the matter at hand was in the US.

Then he and Schwarzman spent the next 20 minutes talking about Blackstone, and they make it abundantly clear how jealous they were of leveraged buyout king Henry Kravis (at the time, Peterson and Schwarzman were mere advisor types, their looting wealth creating opportunities were far more limited than if they had oddles of investor and bank money to play with).

So in effect, they spent an hour telling us that they really wanted to be doing LBOs, that was SO much better paid than M&A, they wanted to grow up to be Henry Kravis, but since they hadn’t raised the money to do that yet, then yeah, our client’s deal might be worth their while in the interim.

I have never seen a pitch meeting (and this had been arranged at the senior levels of the firm) devolve into such a naked display of personal greed. The two partners who were there with me, neither one of them naifs, were as appalled as I was. As much as I have seen a lot of unprofessional conduct in my life, this still ranks as one of real doozies.

So nothing about Schwarzman since has surprised me. His Washington Post op ed today, “Lawmakers’ rush to punish banks threatens recovery,” in it attempts to defend the new world order of finance uber alles, is every bit as appalling in its own way as that brief encounter I had with him 25 years ago.

His article starts with the “We’re having a recovery!” meme, citing the 5.7% fourth quarter GDP growth, and improving output statistics overseas. But the US GDP results were largely inventory-driven. The improvement in reported unemployment was largely the result of a change in statistical methods. There have been some mildly encouraging signs, like an increase in the length of the workweek. But there has been, and continues to be, a substantial gap between financial market performance, which is still pumped up by super cheap money, and the still weak real economy. For the vast majority of the public, there has been no recovery.

But this is where Schwarzman starts with his defense of the indefensible, namely, that the banking industry should get a break:

We have also learned, however, that bank lending is still contracting in the United States and Europe, especially for small and medium-size businesses. Unless we reverse that trend, this incipient revival of the global economy could well sputter to a halt.

Yves here. Before we get one step further, it is important to note that the last survey of loan officers pointed to low loan demand, as well as tight credit conditions. Back to Schwarzman:

Blackstone is a major client of many of the largest banks around the world. And if there is one common theme that I have heard in conversations with senior bank executives over the past several months, it is that their fundamental business model is under siege. They are uncertain about the amount of equity capital needed to run their enterprises. They are uncertain about the amount of reserves required for various business lines. They are uncertain about the potential new requirements for special reserves they will have to retain in good times to use in bad times. They are uncertain about the ongoing level of taxes they will be paying. They are facing various proposals for what are described as new fees, which are the equivalent of new taxes. They are facing proposals to limit the number of businesses they will be allowed to be in and thus are contemplating having to shrink their banks and divest themselves of otherwise profitable assets. They are facing restrictions on what they can pay their people and are facing the possibility that many talented employees will leave for other financial institutions outside the public eye.

These uncertainties have severely hampered banking executives’ ability to plan how to run their businesses or even know what their businesses may include. Predictably, bankers are reacting to this unprecedented uncertainty by becoming conservative and cautious. The result is that there is less lending and less credit available.

Yves here. Notice what is missing? Do we have a single mention, or even an allusion, to the financial crisis? He has airbrushed out the excessive risk taking, predatory behavior, looting, and excessive leverage played, and that in turn was the result of over two decades of effort to free financial firms from restraint and oversight. Damned right their business models are “under siege”. That’s what happens when a populace mobilizes to respond to bandits.

The industry’s inability to see, much less admit, any culpability, and hence the need for root and branch reform, is pathological. The reaction of the bank chiefs, at least as depicted by Schwarzman, is utter denial. It’s as if someone who drove his car at 150 miles an hour, lost control, plowed through several houses but miraculously survived (only by virtue of going to the head of the line in the emergency room). He is miffed that what is left of the wreck has been impounded and he is forced to go to the police station and explain himself, and might have to pay fines, have his driver’s license suspended, or face other restrictions as a result of his reckless and destructive conduct.

And notice how the banksters are depicted as victims. There’s no mention of the fact that their business models aren’t working because the industry itself tested them to destruction. Securitization, which had become a crucial mechanism for everything from residential and commercial real estate to credit card and takeover loans, is in the deep freeze because investors were burned. As much as Schwarzman and the banks he is shilling for would have you believe otherwise, the difficulties in large measure result from aggressively redesigning their firms around “innovations” like credit default swaps that might have been salutary if used in only in carefully selected circumstances, but weakened their foundations by allowing them to operate with too little equity and too much leverage (note I am very skeptical re the genuinely productive uses of CDS, but I am willing to be persuaded otherwise).

And he fails to mention the 800 lb. gorilla in the room, the biggest reason for banks not lending: that they still have lots of unrealized losses. That leads to considerable risk aversion and the need to hang onto liquidity buffers. The “under seige” story is a convenient excuse to divert attention from the yawning hole on their balance sheets and blame correctly critical outsiders instead. For instance, the Congressional Oversight Panel anticipates another $200 billion to $300 billion in losses on commercial real estate. Similarly, I participated in a lunch with Josh Rosner and Chris Whalen earlier in the week. They went on at considerable length how much further banks had to go in writing down bad loans, how the industry marks were wildly unrealistic in some of the most obviously troubled categories (HELOCs), and that even a mild increase in short term rates would be very problematic.

But to Schwarzman would have you believe that the reluctance of banks to lend is due solely to government (and by extension, public) interference and hostility. He continues:

This country, of course, needs fundamental reform of our financial regulatory system, as I, and many other financial institution executives, have publicly advocated for a considerable period. But we are debating this hugely important issue in an inflammatory political atmosphere in which key participants seem determined to single out the banks for special retribution in reaction to the financial crisis.

Yves here. Please, this is laughable. How many executives have called for fundamental reform (and how do you define “considerable period”?). For the most post, the proposals offered, like the one Schwarzman penned last year, have more to do with consolidating oversight mechanisms and practices, and offer little in the way of substantive measures (for instance, Schwarzman called for consolidation of off balance sheet vehicles. While that is a welcome and needed measure, the FASB released its exposure draft on this topic on September 15, 2008, for a sixty day comment period. The odds are high that as of the date of his November 2008 op ed, this proposal looked likely to go through. So is lining up with a pretty certain to be done deal the same as being an advocate of “reform”? Not in my book. Note nowhere does his list include more equity for banks and broker dealers (a sure negative for his business), and it argue for an abolition of mark to market accounting for hard to value assets, when the abuses of recent approaches (the use of Level 3 accounting, or “mark to make believe”).

Now we go to the next bit:

It is important to remember that a variety of actors helped create the financial crisis. From our government, there was congressional pressure to expand homeownership by lending to borrowers who would not otherwise qualify for traditional mortgages. . As a result, Fannie Mae and Freddie Mac dramatically expanded their activities to accommodate this objective.

Yves here. Making Fannie and Freddie the focus of blame for the growth of subprime is overdone. The agencies were under severe restrictions as to balance sheet growth from the outbreak of their accounting scandals in 2002 and 2003 though late 2005. The GSEs lost market share in mortgage origination when suprime and near prime mortgages were taking off (note I am not denying that they played a role, merely focus on them). Back to the article:

Federal Reserve monetary policy reduced the cost of lending and encouraged borrowing. Private market participants may have used excessive leverage in some transactions. Regulators permitted dramatic increases in leverage at investment banks, and billions of dollars of debt stayed off some banks’ balance sheets. There was failure at virtually every level of regulatory oversight, including, critically, minimal controls over mortgage brokers, who encouraged many subprime borrowers to contract for houses or take out additional loans that they could never afford. Many banks lowered lending standards for various other commercial, residential and consumer loans while reducing their reserves for bad debts. Rating agencies bear a heavy burden of responsibility for assuring investors that securitized pools of subprime mortgages could get the highest AAA rating, when in reality they were highly speculative risks. Banks underwrote and sold these AAA securities around the world without a sober, objective examination of the underlying risks. Many of the purchasers of these securities failed to perform even the most rudimentary independent due diligence.

Yves here. The comments re lax regulation again misplace blame. Why was oversight so weak? Because the industry fought tooth and nail to have it that way. As the old saying goes, it’s like shooting your parents and asking for sympathy because you are now an orphan. While the rating agencies should join in any perp walk, but the article is again wide of the mark on the “complex securities.” Those AAA tranches often would up being retained by the banks themselves because, if they were hedged, the results were very flattering to trading desk P&Ls and trader bonuses (and yeah, the hedged failed for predictable reasons, but no one has tried to get the money back). And the vast majority of the value of those deals was in those same AAA tranches. The other parts were flogged very aggressively around the world, often picked precisely because they were incapable of understanding them, much the less evaluating them.

Back again to the piece:

To single out banks for blame is dangerous to the economy. If, as a result of this anger, credit becomes unavailable, particularly for small and mid-size businesses, in the amounts needed to fuel economic growth and job creation, then at best the economy will slow and, at worst, we will find ourselves in a dire situation, to which we all will have contributed. We need sobriety, rationality and civility in the discussions on the regulation of financial institutions so that the banks can return in a robust manner to their central role in funding the economy. We are on the road to an economic recovery. Let’s stay on it.

Yves here. This could not be further from the truth. What helped produce durable, well though out securities reform was relentless, public exposure of the abuses by the Pecora Commission, which kept public ire at a high enough level to maintain pressure for the development of complex legislation. The fact that Roosevelt threw his support behind financial reform in general and Pecora in particular was another important impetus. It led some bankers to break ranks on enough issues (for instance, smaller securities firms and the Rockefeller interests backed Glass Steagall; famed speculator Joe Kennedy proved an effective reformer as the first chairman of the SEC) to allow for expertise to be devoted to crafting sound measures, rather than obstructionism and Potemkin reforms.

The last thing the public should do now is turn down the heat on bankers. We have just been through the greatest looting of the public purse in history. We cannot relent until we understand how it happened and have put new rules in place to prevent its recurrence. People like Schwarzman need to understand that the populace is increasingly understanding that what has been depicted up as reform is mere industry serving pablum. Even if Schwarzman is incapable of seeing it, continued pressure will lead some of his colleagues to recognize that they need to embrace change or else wind up in the dustbin of history.

The top story at the Financial Times at this hour, “‘Volcker rule’ gives Goldman stark choice,” is a accurate report of Paul Volcker’s latest remarks, but gives a wildly misleading impression of the “choice” facing Goldman:

Goldman Sachs and other banks should give up their bank status if they want to avoid the ban on proprietary trading proposed by the White House, Paul Volcker, head of President Barack Obama’s Economic Recovery Advisory Board, said.

“The implication for Goldman Sachs or any other institution is, do you want to be a bank?” Mr Volcker said in a video interviewvideo interview with the Financial Times. “If you don’t want to follow those [banking] rules, you want to go out and do a lot of proprietary stuff, fine, but don’t do it with a banking licence.”

Yves here. Oh, so Goldman has to chose between prop trading, aka being in some high return businesses, or being a bank. But why in God’s name does Goldman want or need to be a bank?

Let’s rerun the tape on the crisis. Two investment banks, Bear and Merrill, were kept from failing subsidized mergers into banks. The conventional wisdom is that allowing Lehman to fail was a really bad idea, although a significant minority school of though holds that if there was a better organized way for Lehman to have failed, maybe that would not have been so terrible. Morgan Stanley and Goldman got cheap money, TARP equity, access to lotsa special facilities to keep them from falling over. They were given banking licenses simply to make it legally (and therefore operationally) easier for the Fed to give them access to emergency cash.

So what is the lesson? If you are a big enough player in the financial markets, you will not be permitted to fail, particularly after the blowback of the Lehman collapse. And the Fed has gotten over the intellectual and procedural hurdle of letting an investment bank become a bank holding company a when it looks desirable. So hey, just go back to being an investment bank, if you and your buddies screw up the financial system again, the Fed will find some way to rescue you. And they’ll probably be faster about it, since they just have to restart mechanisms they set up in the crisis.

Now the answer is that banks and firms like Goldman (assuming Goldman decided to give up its banking license) is that these systemically important firms will have had to come up with living wills, they will be wound down if they become insolvent.

I’m pretty skeptical of this idea. Goldman and other players active in the debt and OTC derivatives markets have extensive counterparty exposures. Moreover, if one firm was on the brink of failure, it is likely that others are vulnerable too, that the turn of events that led one firm to be in serious trouble has affected others as well.

So you have two risks: that the mechanics of winding down the euthanized firm will be seen as interfering with, and potentially damaging, the operations of its counterparties (how can you hold creditors at bay without freezing positions? How can you let an insolvent company continue to trade? I don’t see clean answers to this problem). Independent of the operational problem of an untested process for winding down a trading firm (which is likely to make counterparties and customers nervous) you have the separate risk of contagion, the fact that one firm has been taken down can lead to a run on others.

Unless I see a great deal more done to solve the problem of connectedness, and I see perilous little here (we’ve discussed the considerable shortcomings of derivatives “reform” in previous posts, and even that inadequate plan may not be passed), one major financial firm going down will still have the potential to jeopardize others.

Let’s use a simple metaphor. Say a real moron designed a bunch of nuclear reactors. Not only do they have the risk of suffering an uncontrolled chain reaction every ten years (aka a meltdown) but when one reactor goes haywire, it has high odds of triggering similar behavior in other reactors.

You have a costly and politically unpopular way of controlling a reactor that looks in danger of going critical but it leaves the faulty reactor in operation. You have a cheaper and untested way that that your engineers devised that might allow you to shut down the reactor if it misbehaves again. But if it doesn’t work, the other reactors will go critical.

Now in a real world situation, what do you think the government will do? Even if the engineers’ plan sounds great, is anybody going to risk a test on an untried approach with so much at stake? The banking industry (remember, it is full of narcissists) is likely to assume not and act as if they have a backstop. Recall that is the biggest danger here, not so much what the government actually does in the next crisis, but what the incumbents believe it will do, since that will affect how much risk they take.

But in a replay of Lehman, the powers that be may feel compelled to take a stand and shut down a troubled firm. And if it goes badly, we’ll be right back to a “no more Lehman/____” policy for the rest of the crisis.

And the amazing confirmation of sorts comes at end of the article:

Goldman declined to comment but executives say that if the Volcker Rule is passed, it would probably sell its deposit-taking bank, which is an insignificant part of Goldman’s $900bn-plus balance sheet.

However, Goldman leaders do not believe they would have to give up the financial holding company status acquired at the height of the 2008 crisis to escape the rule’s ban on in-house trading.

Yves here. So get this: Goldman believes that to escape the Volcker rule, all it has to do is ditch its depositary. It can still keep its bank holding company license, which was granted to make it easier for the Fed to lend to Goldman. It also appears that Goldman will keep its FDIC guaranteed deb outstanding too.

In other words, Goldman will be able to keep the most important bennies of its status of being a bank, that of ready access to a Fed lifeline, as long as it makes an “appease the peasants” disposition of its depositary, in the hope that no one gets what is really going on.

A former Fed staffer wrote me early after the Obama administration started making Volcker the front man for its new banking reform PR campaign, saying “I can’t believe Volcker is allowing himself to be used like this.” I cant’ fathom it either, but it certainly looks like that is what is happening.