Financial Zombieland

The hit movie “Zombieland” could very well be a metaphor for the current state of our banking system. The fundamental purpose of the banking system is to lubricate the economy by intermediating credit between savers and borrowers, enabling both parties to obtain greater benefit than they would without a banking system. Unfortunately, our current system of “zombie banks” benefits neither savers nor borrowers. Zombieland has no winners, except the zombies themselves, who drain resources from the broader economy for their survival.

To start, the savers in our economy are being sucked dry. Yields on treasury bills and CDs are at or near record lows. Though they inject money into the system, savers get very little in return. Similarly, borrowers are getting bludgeoned. Credit for individuals and businesses is either unavailable or obscenely expensive due to sky-high rates and onerous fees. Circumstances would be acceptable if rates where high for savers and borrowers, or low for both. In today’s Zombieland, however, you get the worst of both worlds, as banks hoard cheap capital to protect themselves against the deterioration of toxic assets. Of course, the government has generously allowed them to value these assets at pre-crash prices.

Worse yet, the banks are not just hoarding their cash, they are funneling a portion of it into "proprietary trading operations", a.k.a. in-house hedge funds. The capital for these trading operations has been provided at near 0% from the Fed, depositors, and government backed loans. So what do we have now? Strong returns for the zombie banks, at the expense of the living.

Bondholders for big banks also thrive in Zombieland. With the exception of Lehman bondholders, all other bondholders for the big banks have emerged unscathed, as the government backs their securities 100%. Rest assured, if something were to happen to one of those in-house hedge funds, the government would continue to provide blanket protection to bank bondholders, essentially offering up the life-blood of our economy as a zombie sacrifice.

One would expect a society-wide rebellion given the stakeholder casualties in Zombieland. From Ron Paul supporters to Michael Moore supporters to anti-capitalist leftists to anti-socialist tea-partiers to small business owners, or just plain folks who need to borrow or save, everyone is horrified by the ongoing destruction. Why can’t these potential victims see that a strong, united coalition could slay the zombies? Unfortunately, Zombieland also suffers from a bankruptcy of imagination....

CFPA - Vanilla, States, Auto dealers, and small banks

Well, the CFPA has moved through the House Financial Services Committee, with 4 compromises from the initial Administration Backed blue-prints

1. "Vanilla" is out
2. States cannot pre-empt the Feds with stronger regulation - well, atleast not blantently
3. Auto Dealers who offer financing are not covered
4. Small banks, defined as under $10B in Assets, will be exempt from regular CFPA "visits"

Resolution Authority Coming on Monday

Maybe, or so says reuters

Looks like the admin might put out a formal proposal on how to unwind the large Tier-1 Financial Holding Companies (FHC). So far, the admin's proposal has only made it more expensive to be a Tier 1 FHC. Well, we should say it does so "in theory", because as we've seen with the myriad of Fed/FDIC/Treasury support programs during an actual crisis go to disproportionately benifit Tier 1 FHCs, on top of the implicit support that in the event of future troubles.

The new draft bill is expected to take a tougher stance toward troubled financial firms than the administration's original plan, and may take out some language that would allow for temporary bailouts.

Giving the government "resolution authority" would serve as a rebuttal to the concept that some firms are too big to fail. Federal Reserve Chairman Ben Bernanke on Friday highlighted the need for this authority as well as other measures to reduce the likelihood that one firm could destabilize the financial system

Emphasis added was mine. That would probably be a good thing, although my guess is that the implicit bailout guarentee remains very storng unless explicitly taken of the table in the strongest of terms. We'll see what the actual specifics are...


NY Times gets more specific. Apparently some "living wills" on how to unwind the Tier 1 FHCs.

Setting up the equivalent of living wills for corporations, that plan would require that they come up with their own procedure to be disentangled in the event of a crisis, a plan that administration officials say ought to be made public in advance.

“These changes will impose market discipline on the largest and most interconnected companies,” said Michael S. Barr, assistant Treasury secretary for financial institutions. One of the biggest changes the plan would make, he said, is that instead of being controlled by creditors, the process is controlled by the government.

Wow! We'll what that actually means, the whole "being controlled by the government". So far, bank creditors have made out very swell, essentially getting a government guarentee. The key here of course is that there be a transparent, process with no uncertainty, so as to ensure discipline of relavent stakeholders, from boards/shareholders, bond holders, and regulators.

Underfunded pensions, risks, and rating agencies

We learned this past weekend from the Washington Post that Pension funds are seriously underfunded and are now facing the stark choice of either taking even "greater risks or cutting benifits" to meet obligation. For those wondering, both choices are bad.

And then Gretchen Morgenson reports in the NY Times this past Sunday that the "Stale Bond Ratings " with regards to their municipal bond ratings. She writes that according to testimony from the former head of compliance at Moody's that agencies rarely go back and review ratings for a muni bind after it has been issued... sometimes waiting decades!

While a few very high profile/frequent issuers (City of New York, etc.) were receiving some periodic reviews, the vast majority had received none — in some cases there were bonds which had been outstanding for 10 or 20 years but which had never been looked at since the original rating.”

Bad enough, but it get's worse. Apparently, municipal financing isn't as plain vanilla as it was in your grandfather's (or father's) muni bond portfolio.

The increased complexity of municipal issuers’ financing methods also makes it tough to analyze their bonds. In recent years, for example, municipalities have been persuaded by Wall Street to enhance their returns or reduce their interest-rate risks through the use of derivatives. Some of these derivatives have become black holes on issuers’ books, and can be unwound only at a heavy cost. Keeping track of which issuers are using such derivatives, and the implications they hold for bondholders as interest rates rise and fall, would be a Herculean undertaking.

At a minimum, investors should be asking the agencies to update and rerate, these securities.

How do these 2 stories relate?
Can you imagine what pension funds and other institutional portfolios will look like when you adjust for not only the secondary market value of the CDOs on their books, but also the possible implications of the true secondary market value of Muni bonds carrying pre-crisis investment grade ratings?

Special Congrats to Ostrom and Williamson on their Nobel Prize in Economics

Actually, congrats to all winners in all fields this year, with a special congrats to the winners of the Economics prize. And an extra special congrats to Elinor Ostrom for being the first woman to win the Econ prize.

Interestingly, there work on organizational there may be implications in their research with regards to how we regulate financial markets, especially in light of the financial crisis. Williamson's research on institutions and organizations could be suggestive to experts involved with corporate governance and the debates around reglation/supervision of financial institution. When asked, Williamson said "there is no silver bullet" to the "too big to fail" problem but suggested: "that it is better to regulate large companies than to try to break them up or limit their size"

Derivative Legislation, no slam dunk and super regulatory capture

So one would have thought that with the disasters of the last 2 years within the financial system, the huge loss to tax payers of the AIG bailout due to naked credit default swaps in the Financial Products Group, and the broad decries against "casino capitalism", OTC derivative regulation would be a slam dunk. Well, unfortunatly, not so fast. We find out today that there is no broad consensus - even significant resistance - to derivative legistlation. Interestingly, it's not just financial firms that are fighting it! The AP reports that companies such as Boeing, Caterpillar, Ford, GE, and Shell are part of coalition of 170 companies lobbyng congress to make the case that regulation could significantly increase their costs!

Apparently the Republicans on the House Financial Services Commitee and even some Democrats are joining in the resistance! Shockingly, some of the resistance comes from proposals that "major swap participants" would be required to hold capital against risk. As if insurance companies shouldn't be required to hold capital just in case they have to pay out claims.

Hopefully, this is just posturing by some industry officials - perhaps they are fully expecting to come around. Either way, it seems a sad story that large swaths of the companies in the non-financial sector would be become captured by the agenda of the very narrow interests of the financial sector, even if it goes against the own interests of the non-financial sector. This is more than regulatory capture, this is super-regulatory capture

TBTF is Costly....more costly than saving the whales!

The Great Gretchen Morgenson addresses the myriad of problems of tax payer support for the various support programs of the Fed that have been used to keep the big banks afloat. Her article in this past Sunday's NY Times Business section She cites a report by Dean Baker of CEPR where he estimates the discounted cost of funds afforded to the big banks comes out to about $34.1 billion a year. He derives at this by looking at the spread between the cost of funds for small banks who have not received the bulk of the government support and the large banks and bank holding companies that have.

Generally speaking, liquidity programs and the various Fed programs like the TLGP (where the government guarantees short term liabilities of the BHC in exchange for a small fee) have taken away the major competitive advantage that the small community banks have; access to cheap and reliable deposit accounts. The closeness to the localities where the community banks operate in gives them a competitive advantage that the large BHC cannot easily replicate. After all, the one competitive thing that small fish have that whales do not is agility and maneuverability in tight spaces.

Paul Volcker Speaks out

Chairman Volcker testified in front of Congress. He was on a panel that including Mark Zandi from Moody's Economy.com and Jeffry Miron from Harvard, though it's Volcker that's getting most of the media buzz.

Surprisingly, Volcker gave a sober assessment of the Obama administration's actions thus far, while supporting most of the future policy agenda the administration is pushing. Most negatively, Volcker critiques the current situation by asserting that the "Too Big to Fail" (TBTF) problem continues to exist and will continue into the future. "The danger is that the spread of … moral hazard will make the next crisis bigger,”

Volcker seems resigned to the fact that we will continue to have TBTF and bailouts will occur, but says that best way to deal with this is problem is to split up commercial and investment banks, with commercial banks (by which I assume he means depository institutions) subject to a government safety net but also tighter regulation (trading securities, derivatives), and investment banks exempt from the tighter regulations but not entitled to a government bailout. "The safety net has been extended outside the banking system.... That's what I want to change"

Volcker thinks that the administration should make it more clear that the safety net from the government will only apply to traditional banking institutions.

This sounds an awful lot like a call for bringing Glass-Steagall back, among other things.

On other issues like Consumer Financial Protection Agency, he supports the Administration's plan. Interestingly, he thinks too much is made of issue around executive compensation and was worried about too much "political involvement". My optimistic guess is that Volcker thinks that too much attention is paid to the high levels of compensation, whereas the more critical issue should be around the risks and incentive systems, such as the "deferred blowup" strategies that many traders have implemented.


All in all, lucid testimony from one of the most "blue chip" economic thinkers / leaders. It will be interesting to see how Volcker is able to influence the debate. On the one hand, he is officially the Chair of the President's Economic Recovery Advisory Board (ERAB), but on the other hand, the "inside baseball" story is that he is not involved on a day-to-day basis like Geithner, Summers, Romer, Goolsbee. He has an office but is rarely there. In fact, The ERAB is largely council of outsiders that includes executives, academics, union heads , and other leaders from a cross-section of society, with Austan Goolsbee as the lead staff economist. Most of the board itself is just a part-time group that meet’s periodically. In that sense, Volcker is in many ways an “outsider”, with merely nominal insider status.

Optional Public Option might be path to a viable compromise on Health Care Reform

Optional Public Option

The “Public Option” is the most contentious single item in the entire health-care reform debate. The debates touch not only the implications and effects of the public option, but on the very definition of what it is. A possible compromise on this most contentious item in the heath-care reform debate might be creating an “optional public option”. What is this is “double option”?
In short, the federal government would create and fund the infrastructure for a public insurance plan similar to Medicare, or allow the public to directly buy-in to Medicare for some X-amount in premium cost. However - and this is key to the compromise - states would get to decide if they wanted to opt-in (or Opt-out) of the public option program. In short, states would get an option to allow their residents the option to buy into this medicare like program.
To be clear, this will not be a “state based” program or co-op. This will be a federal program which will involve the federal government setting reimbursement policy and prices (either through negotiation or agreed to set rates such as medicare +5% ) with the health care provider community. States will get the option of “plugging in” to the system.
While purists on either side will not be completely satisfied with this approach, there are still plenty of advantages that both sides can cheer.
States with a significant fear of a "federal takeover of the health care system can opt-out.
At the same time, the Program will benefit from the economies of scale and (possible) negotiating power the a large buying entity like the federal government will have. Additionally, States may be able to customize the implementation of the program to meet specific state needs.

Perhaps most importantly, this partial roll-out of the program to only certain states will provide a great source of data and comparison to see what a public option looks like, and what the effects of it are. For those on both sides of the public option debate, the partial roll-out will provide an opportunity to say “prove it”. Will private insurance be driven out of business followed by rationed public care? Ok, prove it! Will insurance cost drop while care quality increase? Ok, prove it! With so many unknowns and unanswered questions regarding the public option, a partial rollout to states who choose the public option (or choose not to) will enable many of these questions to be answered, or to “Prove It”. Furthermore, as states may differ in implementation, this will also allow everyone to see how the public option works in various different states.
Specific details around the structure, especially with regards to the federal funding, will need to be worked out. In (accounting and microeconomics) theory, the federal government would fund all “fixed costs” and the states and individuals would fund all variable costs. Obviously, where one draws the line between “fixed” and “variable” costs would be tricky, but still easier than getting agreement among the current set of proposals.

In short, the Optional Public Option is both pro-market and federalism at its best, combining the potential benefits of centralized efficiency with decentralized diversity.

Financial Sector Compensation and Governace Reform

I think this is an interesting issue that has to be framed correctly for those making the case for compensation reform. Here is my take on how to frame it:
This shouldn't be so much about "compensation caps" as it is about aligning compensation with risk, especially systemic risk. I think if one is able to frame it like that, the nature of the debate changes to one of risk management and away from charges of "government -interference in pay"


Taleb (author of the Black Swan) has alot to say about the problem of the "deferred blow up" strategy where traders can take outsized risks that have "low frequency, super high impact". An employee can take these outsized bets and make reap huge gains for several years until a big blowup occurs. The blow-up is so big it can bring the entire firm down or even the entire system down. In such an event, the employee is effectively getting a free Put option, as their upside is unlimited, but the down side is only limited to his/her job and perhaps the current year bonus, as their is no recourse for the past bonuses. Here we've got a problem of ill-gotten gains.

There is no mechanism to guard against systemic risk. One could argue that this is a corporate governance / shareholder issue, and in part it is. Here, there might be a case that shareholders need more governance and risk tools at their disposal. At this point, the administration is focusing on this as a shareholder rights issue, which politically is probably the best way to start, as it enlists institutional investors as allies in the cause.
However, I would eventually go even further, as even shareholders are not going to be guardians of systemic risk, as their obligations are to protecting common equity portion of the balance sheet, not systemic risk.For instance, shareholders themselves might be tempted to allow risks that are "very low frequency, very very high negative impact" where these negative impacts are several times the value of common equity but supposedly only occur once every 50 years. In such an instance, they too are being given a "free put option", as they reap the outsized gains from the outsized risks, but do not bear the full costs if a blowup were to occur.