I was initially a bit worried, since I went with a colleague in my department, whose expertise is not finance and whose grasp of the financial crisis was layman-fuzzy. But she understands a lot more about what happened. Don’t be put off because you don’t know your CDS’s from your CDO’s. It’s as clear as anything I’ve seen or read or heard about the crisis, including my favorite, the Giant Pool of Money (really, take an hour and go listen to that). The movie works on a lot of levels, and it is incredibly satisfying, for a number of reasons. Most importantly I think, the director (Charles Ferguson) treats the crisis a result of people doing stuff. It’s not just disembodied institutional actors. It is absurdly highly paid people perpetrating fraud and negligence; it is regulatory overseers failing not just failing to do their jobs but actually making many people’s lives worse in order to enrich a small number of finance folks; it is academics who max out on a clueless/self-importance 2×2 to a shocking degree.

That no one has been prosecuted is such an outrage. And because we’re usually treated to the usual high-rolling assholes getting the microscope (which they do get here, and how), I am glad to see that a number of financial economists in government and in the private sector also get served a good helping of scorn. If there is justice they will be remembered in history as amoral apologists and intellectual architects of a stupid and corrupt financial system. To have so much to say, and yet so little to say. I would be ashamed to be an economist working in finance. The entire discipline is tainted by these (possibly) few people. Frederic Mishkin’s moment comes when, after being asked a tough, non-fawning question about how to justify not disclosing his financial ties to entities who have a direct stake in his research, sneered “you’ve got three minutes…take your best shot.” Lawrence Summers comes off as a horrible, horrible person. So does Martin Feldstein. Columbia and Harvard Business schools, rather than taking up a defensive stance (which I predict they will do), should take this as an opportunity to do a little soul searching. To this smug little corner of the academic world, I honestly can only say: shame. Shame.

I’m also mostly devastated by how little economic sociology has to say here. I say this, knowing that Donald MacKenzie is coming to town pretty soon to talk about electronic trading and the financial crisis: a sociological perspective. The thing is, you know how you think the thing you’re studying is about one thing, but turns out to be not about that at all? That’s what is happening here. It’s not performativity, or embeddedness, or social movements, or cultural institutionalism. It might be a little about these things, but all around the edges. The financial crisis is about fraud, and greed, and a naked power grab. Economic sociology should pick up The Power Elite.

As you can see, the film has got me riled up. It’s not a perfect movie, but if the powers that be can please get it into more than two movie theaters, it would certainly be worth your time.

The book itself follows a fairly standard formula. Tell the story, punctuated with the main characters and tidbits from their upbringing, add drama, repeat. His access to Paulson appears pretty extensive, and his quite fawning, often uncritical stance towards Paulson is consistent with that. It sort of helps readers understand credit default swaps, but doesn’t give enough information to be helpful for rank beginners. I am not sure I would recommend it if it is the only thing you’re reading on the financial crisis, but as I haven’t yet read the final word on it, this may be an interesting addition to your store of knowledge.

I’d like to focus on two elements of the book that I think are wildly problematic. The first is the attitude taken towards Paulson. Zuckerman chose the one investor (or actually the 3-4 investors) who were bearish on the housing market, and spent the entire book explaining how they were so incredibly wise and persistent in the face of an industry and even a whole country’s zeitgeist pushing in the opposite direction. This is selection on the dependent variable in the worst and most glaring sense. That is, choose people who succeed and then explain why they succeeded.

Here’s the thing: imagine 10,000 people go over Niagara Falls in a barrel, and 100 survive. Then those 100 people go over the falls, and 1 survives. That person will then write a book about how to survive going over Niagara Falls in a barrel. But without knowing what these barrel-goers are doing before they all go over, there is no way to know if the survivor made it because of what they did, chance, or whatever. Likewise, despite his sideline stories of the 3-4 others who also tried shorting the housing market (and most of whom failed doing so, despite doing much the same thing as Paulson!), Paulson was the only one who made tons of dough. As they say on the webular intertubes, causality FAIL.

But let’s say you buy that Paulson & Co. were geniuses. The problem, then, is that they decided to make decisions that benefited them at the massive expense of harming society.

Now, I’m not going to talk about how Paulson & Co. worked with banks to create even more toxic collateralized debt obligations (CDOs) than even existed at the time, so that they could bet against the housing market more directly (though from the hemming and hawing on pp 179-181 it is obvious to all that it was indeed ethically dubious and that both author and Paulson are trying to explain it without shouldering too much of the blame for it).

Instead, I’d like to focus on the fact that Paulson knew that things were going to crap, and often his willingness to speak out about it was highly subordinated to his desire to keep his trades quiet enough to make a boatload of money off of the housing collapse. Of course, the environment at the time was completely over-the-top rah rah bullish. And yet. And yet. Some examples:

1.
In November 2006, Pelligrini went to a presentation to investors by Robert Cole, the CEO of New Century. There the chief executive played up the low levels of defaults in subprime. “Pelligrini was convinced that his rivals were missing it. Wait till rates reset, he thought. He resisted speaking up, though, lest they figure how bearish his firm was, and perhaps warm to the CDS protection that Paulson was becoming enamored with, pushing prices higher” (98).

2.
In early August 2007, Paulson had been purchasing billions of dollars of CDS, betting against the housing markets:

…Paulson let his friend in on a secret. A few months earlier, he had reflected on how easy it was for him to buy billions of dollars of protection on all those toxic mortgages…Paulson began to wonder, if his fund found it so easy to buy billions of dollars of protection, who was selling it all to them? And what would happen to them as housing came crashing down?

…Banks were selling subprime protection to investors like Paulson and often keeping the positions for themselves…Paulson knew that as long as [housing prices kept falling] the banks and others holding these investments would have to record deep losses because they held so much of it themselves. It was just a matter of time before the pain began.

It was no secret that banks and investment banks like Merrill Lynch, Morgan Stanley, Countrywide, and Bank of America had pushed into subprime lending. They hadn’t acknowledged any huge losses just yet, though, reassuring some investors. But as the ratings companies lowered their grades on various pools of subprime home loans, it would have to happen” [235-237]

3.
On February 20, 2008, Paulson was invited with a number of investors to a lunch with Samuel Molinaro, Jr. of Bear Stearns. At that lunch, meant to bolster confidence in Bear, Paulson finally revealed his doubts, of course after “bulking up its bets against a range of financial giants, from Lehman Brothers and Washington Mutual to Wachovia and Fannie Mae. He had deep concerns about Bear Stearns, too” (256). The meeting, apparently spearheaded by Paulson’s accurate and massively negative assessment of Bear, “was a dagger in the staggering investment bank’s heart” (257).

On March 14th, the NY Fed tried to bail out Bear Stearns with a loan, then turning to securing their debt as they were acquired by JP Morgan Chase. Oh, and providing $29 billion in financing to help a 3rd party entity eat the BS crap assets.

In each of these cases, Paulson or his adviser turned their knowledge about the dysfunctional workings of the world’s financial system into their own private advantage, at the expense of the public welfare.

I was struggling with how to make what they were doing clear, and I remembered a maddening MassMutual advertisement that irked me to no end whenever I saw it. And then it clicked:

Exactly! There’s the rub. A responsible person would not just step back from the curb and let everyone else get wet. A responsible person would say to the other people, “Hey! There’s a bus coming! You may want to step back from the puddle!” This woman makes me want to shout. She may be making a good decision, but she’s a horrible citizen.

And that’s how I feel about Paulson. He stepped back from the brink, and was highly rewarded for it. Meanwhile the rest of Wall Street got massively splashed. But the thing is, it’s the rest of us that are getting screwed over by the damages caused.

That said, I would take issue with this particular story about how Goldman sold tons of mortgage-backed securities to investors while shorting the housing market themselves. It is a problem endemic to any financial institution with both an investment banking function (packaging financial products to sell to investors) and a proprietary sales desk. Sometimes there have been walls between these two functions, sometimes not. But it’s unsurprising that the banks takes opposite positions to the ones it sells to clients. For goodness sake, there is evidence that they shorted their own position in the sub-prime derivatives market.

And here’s the thing: the ultimate responsibility for the losses incurred by purchasing products sold by Goldman Sachs resides firmly with the people who purchase products sold by Goldman Sachs. If you can not trust the seller, do not buy their product. Financial services companies are dependent to a shocking degree on just-too-smart-for-their-own-good managers of large pools of money all over the world. Pension fund managers, state comptrollers, corporate treasurers, there are too many people who grew up wanting to be in a prestigious investment firm just like Goldman Sachs. So when GS comes along with dog and pony investment shows, these investment managers fall for it all the time.

The book has not yet been written on how poorly these investment agents all around the world get routinely hosed by the likes of Wall Street, in turn subjecting the real economy to risks it does not want or need.

Here are some of the things I’m looking at. Let’s start with the finance side, that is, where banks and other lending institutions might be extending credit or risking capital to promote economic growth.

Well….venture capital has been pretty miserable.

Levels of funding for venture capital are about at the levels seen just past the dot-com bust of 2001. So not much is going on there.

And the more traditional banking sector?

Well, the federal funds rate, which is the baseline rate at which banks can borrow from the US government remains at 0 to .25%. That is, banks can borrow money from the federal government pretty much for free. For free!

And how are banks responding? By tightening or leaving unchanged their willingness and standards for lending. That is, banks can borrow money for free and are not willing to lend it out to anyone but their most risk-free clients. What does this mean? It means that banks are collectively still massively worried about the losses and their ability to operate.

And they should be! The top tier of housing markets are now accounting for 30% of all foreclosures – it’s not all poor people with subprime credit loans. In fact, there is a fresh wave of foreclosures and financial losses linked to housing coming up around the corner. A set of loans known as option ARMs, or ‘pick-a-pay’ loans, whereby you pick the amount you will pay per month, deferring the principal payments down the road. The resets on these loans are, frankly, scary as hell:

Many people with these loans are going to see their monthly payments jump significantly right about….now. And since the real estate market as a whole has slumped, the homes are worth much less than the mortgages. How bad will this get? Well, Wells Fargo sees 60-70% loss severity on option ARMs. Pretty scary stuff.

In fact, delinquency rates on not just housing, but all forms of credit are pretty scary. In the most recent quarter: 8.8% of residential real estate loans are 30+ days delinquent; as are 6.7% of loans via credit card.

I’m not including the employment picture (awful); nor am I looking at the long-term fiscal state of, well, the State (awful). And of course, things can change pretty dramatically.

But I would say this:

1. If you are a bank and can figure out how to suss out the people who will pay you back from the people who can not, you should be making a gigantic boat-load of money right now
2. If you are looking to purchase a house, and are sitting on cash, you could buy now, but you don’t have to be in a hurry. There is no sensible reason to believe that things are going anywhere but sideways for the next year at least
3. Banks are on the brink. Still. And any ‘profits’ or ‘bonuses’ that they report are due almost exclusively to the fact that money costs them zero. Or, in some cases, because they are the last players standing in what are now less competitive markets (for, say, Government bond brokerage)
4. Lots of people are hurting, and they are likely going to hurt worse. If this recession has not affected you or someone in your immediate family, it probably will soon.

So, now you know why I’m not saying much about all this.

The CMBS’s that have disappeared of late are securities backed by commercial loans (that market seems to have disappeared for now). It is interesting to note: a) that structured finance is not gone, and that b) it looks like something like $12B worth of securities have been issued using funds guaranteed by the federal government.

I could imagine, but don’t really know for certain, why a bank would prefer to securitize debt from the TALF funds. If it were my institution, I would pair the TALF assets with non-TALF monies (which are potentially much more dubious, given that delinquency rates on these kinds of loans are also climbing sharply), call it gold, or at least gold-plated, and then sell these to investors. I would make money on the transaction, get some of the loans off my books, and make that low-low-cost, low-low-risk Fed money work for me.

I know it’s too soon to start thinking about the ‘lessons’ we are learning from this crisis/event, because we’re still in it, but I am struck at this point by the way banks are trying so hard to return to business as usual. It may not happen, and we will almost certainly have some new oversight over the next year or three. But those expecting a ‘new’ Wall Street, or the ‘end’ of Wall Street, in my humble opinion, could not be more wrong.

Now, a number of representatives are asking good, pointed questions about this exemption (the link is a .pdf):

In the fall, Goldman Sachs secured access to government funding by converting from an investment bank into an ordinary bank. Despite this shift, the CFO of the company, David Viniar, said last week that the company is continuing to operate as if it were still a high-risk investment bank: “Our model really never changed,” he noted in a quote to Bloomberg. “We’ve said very consistently that our business model remained the same.”

This statement seems accurate. Earlier this year, the Federal Reserve granted a temporary exemption to Goldman Sachs from standard bank holding company Market Risk Rules, allowing the company to continue operating as if it were an investment bank. The company and its employees have taken full advantage of its new government subsidies, and the retained ability to bet big. In its most recent quarter, Goldman Sachs earned high profits of $2.7 billion on revenues of $13.76 billion, with 78 percent of this revenue derived from high-risk trading and principal investments. It paid out much of this revenue in compensation, setting aside a record $772,858 for each employee at an annualized rate. The company’s own measurement of risk, its Value-at-Risk model, recently showed potential trading losses at $245 million a day, up from $184 million last May.

Despite its exemption from bank holding company regulations, Goldman Sachs has access to taxpayer subsidies, including FDIC-backed bonds, TARP money (since repaid), counterparty payments funneled through AIG, and an implicit backstop from the taxpayer that allowed a public equity offering in a queasy market. The only difference between Goldman Sachs today and Goldman Sachs last year is that today, the company is officially gambling with government money. This is the very definition of “heads we win, tails the taxpayers lose.”

The letter is a pdf, worth reading for some of their questions about VaR vs. SEC models of risk management. I guess we’ll see what happens.

In the meantime, although I am about as critical as anyone about Goldman Sachs, I was convinced by a friend (Doron) to rethink my complaints about GS compensation. He said that one thing he appreciates about Goldman is that they pay their workers the profits they generate. I may find the source of those profits objectionable, but the compensation itself should be something I should support. After all, if Wal-Mart directed much of its profits to its employees, I’d be happy about it – why shouldn’t the traders who make the dough get the dough? And you know what? He’s right. I’m still annoyed that their profits come at the expense of the rest of us, and that the company doesn’t give much of a crap whether its cutthroat activities put the financial system itself at risk. But by all means, pay your profit-generators your profits.

The first approach, then, would impose regulation on financial services organizations. I would include a pretty wide range of organizations: commercial banks, investment banks (not that there are any of these left), hedge funds, pension funds, mutual fund (and holding) companies, private equity funds, futures trading companies, REIT funds. This is a partial list. But conceptually, it’s any organization that participates in the keeping and investing of customers’ funds, business funds, or state funds.

Some organizations are multi-headed hydras in this sense – Citigroup does all of these things and more, nationally and internationally. Goldman Sachs trades its own accounts (called proprietary trading), brokers government bonds, manages mutual funds, and manages financing for its clients (Mergers & Acquisitions, bond issuance, etc). But your local probably does more than one of these things, and your state’s pension fund does too.

This episode of This American Life captures some of the regulatory gamesmanship that happens between federal/state financial regulatory agencies and the organizations they are supposed to be overseeing.

Still, if you think the problem is that these are sprawling organizations that are too big to fail, too big to manage, too influential to be regulated, then the answer is to break them down into their constituent parts or else to regulate them all as the simplest thing – banks. This is the reason why Galbraith’s suggestion is to give over regulation of systemic risk to the FDIC: “If institutions like hedge and private equity funds are to be considered as posing systemic risks similar to banks, they can be declared to be banks, and regulated as such. Money market mutual funds, which are now subject to insurance, can be reconstituted and regulated as narrow banks…The problem of regulation will be simplified, if we recognize that the crisis presents an opportunity to simplify, restructure and downsize the entire structure financial system.”

The challenge with this approach is that financial institutions can differ pretty dramatically, while at the same time fulfilling the same financial function. So OTC derivatives traded by a pension fund are monitored differently than the same trades by a commercial bank.

The alternative approach, which is more in line with what I would want to do, is to care less about the institutional forms of financial firms and more about the activities that they engage in. For instance, in order to securitize debt it is necessary to create a new corporation to transform that debt into investor shares.

no limited liability corp, no securitization

If we had a functioning rating system, we could use it to price these derivatives independently of the financial services organizations selling/buying them. Still, one alternative is to create an independent entity that doesn’t just slap a ‘good to go’ label on the things, but actually values them. But there remains the problem that, if a pension fund in Wisconsin needs to have a bond rated AAA in order to buy it, financial services orgs will try desperately find a way to slap a AAA rating on it (sounds like hot dog-making to me).

Or, if the SEC wanted to exceed its authority, or if we wanted to make life more difficult for financial services orgs and easier for the rest of us, we might consider disallowing these kinds of limited liability corporations. First, they are in the Caymans and other places only because tax liabilities are lower and secrecy is higher. It is just another form of regulatory arbitrage. And if there is just no possible way to structure derivatives in the US, another alternative is to simply disallow OTC derivatives altogether and have everyone trade stuff on existing exchanges. The analogy for me here is that 99% of us seem to get by with the denominations of $1, $5, $10, $20, $100, etc. It is not perfectly efficient. But the benefits of standardized, transparent commodities I think outweighs the costs to the tailored efficiency for individual firms. (this deserves its own argument, and it’s provocative: it may be the case that the public benefits of derivatives is small. Period.). The fact that Tim Geithner can say he receives letters from firms who argue they need OTC derivatives notwithstanding, we do not need them.

I don’t know how we might accomplish these goals, but at minimum, one suggestion is transparency. We ought to know who controls these limited liability corporations, what assets back them, and a plain-english translation of their values. And if that is not possible, if the only people who can accurately gauge the value of these assets are their issuing organizations, then these instruments should be disallowed.

But the Wall Street Journal can report the day before that the Option-ARM mortgage loans are failing at a remarkably scary rate (37% of these loans are 60-days past due, 19% in foreclosure) – this is worse than the subprime mortgage ‘crisis’ of 2007 – and that JP Morgan:

holds $40.2 billion in option ARMs that the bank acquired when it purchased most of Washington Mutual Inc. last year. The Seattle company’s banking operations were seized by regulators, and the holding company filed for bankruptcy protection.

The New York company said in a filing it has some exposure to an additional $46.5 billion in option-ARMs sitting in complex off-balance-sheet entities. J.P. Morgan declined to comment.

So are they at risk of losing some good percentage of $90 billion on their books (WSJ), or should we just be focusing on their ‘stellar trading and investment results’ (NYT)? The scary other-shoe-to-drop sense of foreboding in me makes me inclined to the former. But maybe I am too simple to appreciate their awesomeness.

Don’t pay attention to those last few sentences, though. The $13 billion government subsidy via the bailout of AIG, and the $28 billion in free money backed by the FDIC. Trading prowess! Embracing risks! Clap louder!

At the end of last week, James K. Galbraith testified for the Subcommittee on Domestic Monetary Policy and Technology. And it was pretty awesome. First, it was a takedown of the Fed’s potential role as the main regulatory body in charge of system risk (which he thinks would be a bad idea because it should be the main, not secondary goal of the regulatory body; and because the Fed kind of historically sucks badly at identifying systemic risk). Second, he went on to talk about ‘too big to fail’:

Would the country be worse off with a smaller, simpler financial system, largely operating out of institutions called banks and thrifts, themselves reorganized, downsized, broken up, more competitive and less profitable than the financial sector has been in recent years? I can see no reason to permit the continued existence, let alone to foster the market dominance, of financial institutions so large as to be unmanageable by their own top leadership, let alone efficiently regulated by public authority. Edward Liddy, CEO of AIG, has written that he realized quite early on that the firm was “too complex, too unwieldy and too opaque” to manage as a going concern. In general, “too big to fail” is a synonym for “too big to manage” and “too big to regulate.” Such institutions exist, in part, to help with international tax evasion, to evade regulations, to project political power, to facilitate the kind of “financial innovation” that is the essence of systemic risk. They are intrinsically unsafe. An appropriate goal of public policy would be to shrink them, permitting other institutions of more reasonable size, more conservative practice and greater alignment with public purpose to grow into their market space.

I agree so much with this perspective in general and this statement in particular. It’s worth a longer, more sustained argument to suggest that financial services organizations are not entitled to their business model just because it’s ‘working’ for them. But for now, compare Galbraith to the statement by Robert C. Merton looking for a way to mush-mouth an apology for financial innovation:

You’ll hear in this case as in the past, “Look at all this financial innovation or financial engineering–it’s caused too much complexity, and now the system has run off the tracks.” To that I would say, structurally, one would expect that in the case of a successful innovation, the infrastructure to support it properly will lag behind. Why is that? It’s because if you have 100 innovations, maybe 2 of them will be successful. So it is not practical to build a full infrastructure–regulatory, educational, et cetera–for all 100 innovations. Innovations are going to run ahead of the infrastructure. That, we have to recognize, is structural. It’s not about bad people, it’s not about incompetent people, it’s not about greedy people. It’s not about having a market system or a nonmarket system. Whether the problems are addressed by external regulation or a combination of that along with internal regulation–whatever set of ways, we have to be prepared when innovations come in to have some degree of oversight modulation. If you do too much of that and you stifle innovation, that’s not good. If you do none at all, that’s not good either. So there’s something in between. Sometimes we don’t do enough of it, or the growth of innovation is too quick, but the point is that there is a reason why you will typically find that financial crises are often connected with what are perceived as new things, big changes–innovations.

For Merton, the problem is just that we have so much great innovation and we can’t tell which ones are going to be successful, that we couldn’t possibly have infrastructure and regulation to support them all.

It’s just that Galbraith’s argument is just so much more convincing.